The Corporate Bond Market: The Start of the Matter

Of all virtues to which we must ultimately aspire, forgiveness demands the most of our souls. In our naivety, we may fancy ourselves man or woman enough to absolve those who have wronged us. But far too often, we find our pool of grace has run dry. So deeply burdened are we by our emotions that grace to us is lost. How many of us have the strength of resolve to let bygones be gone for good? Those of the cloth recognize the damage self-inflicted scars sear into our souls as they seek to guide us through life’s most difficult journeys. They pray for our deliverance from a painful inner turmoil and with it the peace only forgiveness can convey.

None who have ever heard Don Henley’s The Heart of the Matter could be blamed for thinking divine inspiration itself came down from the heavens to spawn those longing lyrics. But it isn’t just the words that scorch their way into your memory, it’s Henley’s tone, the raw pain that pierces every time you’re caught off guard by the mournful ballad released in 1989. Henley sings of our feeble struggle as no other, grasping for our collective release in humility. “The more I know, the less I understand. All the things I thought I’d figured out, I have to learn again.” In the end, Henley hands down the cruelest of convictions: If you truly want to vanquish your demons, you must find the strength within to forgive.

Astute policymakers might be saying a few prayers of their own on fixed income investors’ behalves. The explosion in corporate bond issuance since credit markets unfroze in the aftermath of the financial crisis is nothing short of epic. Some issuers have been emboldened by the cheap cost of credit associated with their sturdy credit ratings. Those with less than stellar credit have been prodded by equally emboldened investors gasping for yield as they would an oasis in a desert. Forgiveness, it would seem, will be required of bond holders, possibly sooner than most of us imagine.

For whatever reason, we remain in a world acutely focused on credit ratings. It’s as if the mortgage market never ballooned to massive proportions and imploded under its own weight. In eerie echoes of the subprime mania, investors indulge on the comfort food of pristine credit ratings despite what’s staring them in the face – a credit market that’s become so obese as to threaten its own cardiac moment. It may take you by surprise, but the U.S. corporate bond market has more than doubled in the space of eight years. Consider that at year end 2008, high yield and investment grade bonds plus leveraged loans equaled $3.5 trillion. Today we’re staring down the barrel of an $8.1 trillion market.

The age-old question is, and remains:  Does size matter?

Ask yourself, did size matter as it pertained to the mortgage market way back in 2006, when it peaked in size at $13 trillion? (That was rhetorical in the event you weren’t on Planet Earth at the advent of all modern times’ meltdowns.) Still, it’s the why behind the growth of any given market that matters most. In the case of both markets, the credit rating agencies have helped investors sleep at night, a fact that might now keep you up at night.

First, a disclaimer. Of course, speculative grade debt is riskier than its investment grade brethren. The vast majority of investors in the go-go junk market know this and are hopefully buckled up as such, especially if a true rate-hiking cycle is about to test their mettle – more on this later.

Still, it’s the blind abandon with which issuance has risen among investment grade (IG) issuers that should, but has yet to, give supposedly conservative investors pause. Consider that in 2011, a (then) record $741 billion was sold into the IG market. As an endless encore, in every single year that followed, issuance has shattered the prior 12-month record. Last year alone witnessed $1.28 trillion in issuance. As for all the rate hike anxiety permeating the airwaves, 2017 also appears to be in it to win it — $254 billion was sold in the first two months of the year, $20 billion more than the same period in 2016. Investors might soon have to call upon Archimedes’ concept of exponentiation to sufficiently capture how very large the numbers have become.

You might wonder how the health of the corporate bond market is faring as it bulks up. As Bloomberg reported last week, you’d have to time travel back to 2002 to get back to the last time IG issuers were carrying more debt vis-à-vis their profits. The sticking point is leverage ratios tend to peak as an economy is just emerging from recession, as companies’ revenue streams hit their nadir.

Today, though, as we’ve been told in tsk-tsk fashion, the economy is at the precipice of an accelerating trend. That’s a good thing as companies have sold a heck of a lot more debt than their profit growth justifies, leaving their rainy-day cash to cover their massive, mounting obligations at the lowest levels since 2009.

The good news is that on the surface, the chances of a hiccup appear to have diminished. According to credit rating agency Standard & Poor’s (S&P), 2016 ended on a relatively better low note: Some 68 global IG issuers were at risk of being downgraded speculative grade, five fewer than the last time the data were compiled at the end of the third quarter.

S&P refers to these envelope-pushing issuers as ‘potential fallen angels,’ with ratings at the cusp of crossing over into junk-land. Though you might be thinking one notch on a ratings scale is just that – one measly notch – crossing that line in the sand makes a huge difference for borrowing costs. The yield ‘spread’ above Treasuries paid by junk issuers is typically about double that of what IG issuers pay.

The not so good news is that the universe of potential fallen angels remains at historically high levels. The latest read of 68 potential fallen angels is identical to what it was last summer and appreciably higher than as recently as 2015’s first quarter when 42 issuers were at risk of downgrade to spec grade. Moreover, the divide that began to open between potential rising stars – those with the potential to be upgraded into the IG sphere – and potential fallen angels remains at the current cycle’s wides.

Perhaps most worrisome is the sector at the greatest risk of downgrades — that is, financials. Years ago, a high yield strategist remarked that declining commodities prices would take their toll in two waves – first, the actual commodities producers, and second, the financials who banked them as the initial commodities cycle became super-sized in magnitude. Bank balance sheets are highly susceptible to a nasty contagion effect.

And yet, here we sit watching those oil prices Janet Yellen lectured us would be at ‘transitory’ lows (several years ago) decline anew. God help us if crude’s latest swoon presages a broader downturn. Precisely because leverage is rising among IG borrowers, economic growth literally has to hang in there. If growth even slows, or worse, contracts, all this ballyhooed record issuance among IG issuers will devolve into unprecedented levels of potential-to-actual fallen angels. It will be as if the heavens have opened up as their wings burn and they tumble back to earth.

Of course, downgrades don’t necessarily denote defaults. The Start of the Matter may nevertheless require forgiveness in some form as refinancing needs are also now at record levels and must be met. If the Federal Reserve does not intervene, markets are likely to revert back to pure price discovery mechanisms; they will be brutally agnostic to the rate environment to say nothing of the economic backdrop.

Investors have begun to smell a rat. IG exchange-traded funds (ETFs) have slid more in price compared to their high yield ETF peers since the surprise U.S. election that set rates rising. But unlike junk’s magnificent rebound since then, IG has yet to stage a return rebound.

It all comes down to refinancing risk. According to S&P’s competition down the block, Moody’s, the refinancing needs of both IG and spec grade issuers will hit record levels over the next five years.

Spec grade issuers’ five-years-out refinancing needs have officially crossed the trillion-dollar threshold. Some $1.06 trillion will come due between now and 2021, up from $947 billion in last year’s refinancing risk study and double what they were ten years ago. In the event you’re concerned spec risk has been overly downplayed in this missive, rest assured, the same dynamics that propel record fallen angel levels will be the mother of all default-rate cycle accelerants. File that one away in the ‘actual forgiveness’ to come file.

As for the IG space, $944 billion comes due in the five years through 2021. But here’s the kicker – the need to roll over debt is going to come on much more quickly for IG. Maturities are roughly evenly distributed over the next five years as opposed to the needs in spec grade, whose rollover risk gains speed and crescendos in 2021 with a record $402 billion in refinancing coming due.

Is that why junk is trading more richly than IG? The yield at which spec trades vs. its Treasury equivalent has only been wider 13 percent of the time over the past 17 years (2007 should provide you comfort because…?). IG on the other hand has traded this ‘tightly’ in only 25 percent of the times records have been kept.

Would the start of the matter – the prospects for debt forgiveness and debilitating defaults – be threatening so were it not for central bankers’ meddling ways in markets designed to determine their own damn prices? The ashes will indeed scatter. They will let us know.

The Bond Market: Beware of Junkyard Dogs

Money Strong LLC, The Bond Market: Beware of Junkyard Dogs

Having spent a chunk of his youth “shopping” them, Jim Croce came to know a thing or two about junkyards. In those youthful days, should his clunker de jour be missing some vital part or parts, a trolling expedition through South Philly’s scrap heaps was always the enterprising Croce’s preferred method of procurement.

Amid all of Croce’s parts foraging, it was a universal joint for a ‘57 Chevy and a ‘51 Dodge transmission, two must have and must-be-cheap or, better yet, free, parts that the legendary folk singer still recalled. He also reminisced that junkyards could and would provide a no frills, but highly motivated and easy way to get in some cardio, as in running for your life.

“I got to know many junkyards well, and they all have dogs in them,” the late Croce said in a 1973 interview. “They all have either an axle tied around their necks or an old lawnmower to keep ‘em at least slowed down a bit, so you have a decent chance of getting away from them.”

So was born the junkyard dog yardstick by which to measure the meanness of one Bad, Bad Leroy Brown, Croce’s hit which landed at the top of the charts 42 years ago this week.

As for high yield bond analysts, they aren’t exactly known for catchy turns of phrase. However, in recent weeks, they’ve shed the dry and donned the dramatic, as you’ll soon see. Such is the overheated state of the junk bond market this sweltering summer.

In his latest missive, Deutsche Bank’s Oleg Melentyev, arguably the best in class high yield analyst among his sell-side peers, warned of the perils of investing in this “frenzied market.”

Legendary high yield investor Marty Fridson shares Melentyev’s concerns and has for some time. By his best estimate, high yield was already in “extreme overvaluation” territory on June 30th, defined as being one standard deviation above fair value. Flash forward two weeks, and he calculates that the standard deviation has doubled.

(A quick Statistics 101 refresher: standard deviation tells you how tightly clustered or wide-of-the-center individual components of a given data set are from their mean. Remember the grade bell curve the engineering undergrads blew in business school? When all of the test scores came in on top of each other, the bell curve was super steep; when there was vast divergence, the bell curve was low and wide.)

Defining bond valuation also requires one employ “spreads,” which compare the prevailing yields on a given credit to a supposedly risk-free Treasury of a comparable maturity. And that means you have to get down to the nitty-gritty of measuring risk in basis points (bps), or hundredths of a percentage point.

In the event your eyes have rolled into the back of your head, listen up! This is important folks, your sweet grandparents could well own junk bonds in their desperate need to generate yield on their atrophying retirement funds!

With that preamble posited, on July 15th the option-adjusted spread on Bank of America Merrill Lynch’s High Yield Index was 542 basis points. That compares to 621 bps on June 30th. The lower the spread, the less extra compensation investors are demanding for taking on the added risk of being exposed to, well, junky bonds.

Of the compression in spreads, an incredulous Fridson could only characterize the overvaluation which begat more overvaluation as, “more staggering.”

Now in light of this, just how did mom & pop investors react to the price increase? Well how else? They poured $4.4 billion into high yield mutual funds, the second highest weekly inflow on record after March 2nd’s $5.3 billion inflow.

Bloomberg caught up with yet another stunned strategist:  “They’re out there scrounging through the dumpster looking for yield,” worried Karyn Cavanaugh of Voya Investment Management. “When you have artificially low rates, you force people to go out and look for things they normally wouldn’t.”

The question is, will investor insouciance ever come back to haunt them? They, as in investors, certainly don’t seem to think so.

The Daily Shot is a must-read email proffering just about every graph that’s important for investors in one succinct one-stop shop, and it’s free. The Shot’s editor, the estimable Dr. Lev Borodovsky, is notoriously judicious with his editorial additives. So when he adds a quip, his readers understandably sit up and take note.

In Tuesday’s Shot, Borodovsky featured a graph of the VIX Index, the so-called ‘fear gauge,’ which depicts the perceived risk of owning stocks, which have traditionally moved in lockstep with junk bonds. Reflecting extreme complacency, the VIX is sitting at the lowest level since last August. “In the equity markets,” Borodovsky recapped, “the VIX hits a multi-month low. All is well.”

Or not. The Shot goes on to depict the price-to-earnings ratio on the S&P 500 at the highest level since at least 2006. “These valuations rely on extremely low long-term rates,” Borodovsky cautioned.

As a punctuation mark, as in exclamation, Borodovsky features two charts on the high yield market. At the risk of over-paraphrasing, the high yield market is apparently no longer concerned about energy prices, which have yet to stage the oft-predicted blistering rebound. How so?

Despite the defaults that continue to emanate from the oil patch, the performance of high yield bonds has completely divorced itself from that of still-depressed crude prices. The mirror image of this nonchalance is that investors are no longer demanding a premium level of compensation for owning high yield energy issuers vis-à-vis their non-energy brethren.

In priceless understatement, Borodovsky concludes that, “High yield is definitely starting to look frothy.”

As for Deutsche’s Melentyev, he isn’t bothering to wait for the ink to dry on the clear message written on the wall. In his latest note to clients, he ratchets up his expectations for HY (high yield) defaults to rise this year beyond his worst case initial scenario – and it ain’t just an energy story.

“At this point, we have little doubt that our original forecast of a 4% ex-commodity HY default rate will be met by late 2016/early 2017. Moreover, we think there are now enough reasons to believe that defaults could rise to 5%, ex-commodities, sometime over the next year or so. Coupled with our 20% commodity HY default rate forecast, we are looking at 7.25% aggregate default rate sometime around mid-2017.”

In the event you’ve fallen off Planet Earth in recent weeks, the global corporate default count, as in companies reneging on their promises to make good on those coupon payments, is at the highest level since 2009. And if your memory’s eye has erased 2009 to prevent permanent scarring, the economy was in a full meltdown state back then.

Let’s get this straight. Defaults are going through the roof and investors are flocking to the sector in record numbers? And how.

Moody’s Tiina Siilaberg keeps an eagle’s eye on the concessions investors give to issuers in the form of protections they don’t demand. They’re called ‘covenants,’ which Investopedia defines as, “designed to protect the interests of both parties. Restrictive covenants forbid the issuer from undertaking certain activities; positive covenants require the issuer to meet specific requirements.”

By Siilaberg’s latest tally, covenant protections are at their weakest level in recorded history. To translate, investors’ collective interests are as vulnerable as they’ve ever been. Though the leveraged loan market remains open for business, Siilaberg is apprehensive about what’s just over the horizon given stretched valuations.

“Issuance in the high yield bond market is still relatively weak compared to historic levels,” Siilaberg said. “I worry, though, because refinancing risk for many lower-rated issuers is close to an all-time high.”

The culprit? That would be a delusional reliance on what Melentyev refers to as, “the new narrative,” and “its apparent reliance on (a) strong monetary response.” Unconventional monetary policy is delivering, “little tangible benefit.”

Overreaching central bankers are in fact doing more harm than good at this juncture. Though small investors may not be wise to the damage being wrought, veterans of financial market warfare are weary to the point of exhaustion.

The endless waiting for Godot has apparently worn their resolve down to near nothing…with good reason. For all of central bankers’ Herculean efforts, expectations that U.S. job losses will accelerate are at a two-year high while households’ prospects for the economy over the next year have fallen to a two-year low.

Pride will surely precede the fall of the orthodoxy of today’s accepted monetary policy framework. But at what cost?

“Everyone in the world needs yield and nothing else matters,” Melentyev laments. “This has never ended in any sort of a problem before, so we can all go back to sleep.” And what happens when we’re abruptly shaken from our slumber?

Recognizing the painfully obvious, Voya’s Cavanaugh observed, “This isn’t a really normal environment.”

Thank you Chair Yellen & Co. for rendering snarling, lawn mower toting junk bond dogs cute and cuddly critters to retirees on fixed incomes.