While the Stock Market is Partying …

There are seemingly always “good reasons” why troubles in a sector of the credit markets are supposed to be ignored – or so people are telling us, every single time. Readers may recall how the developing problems in the sub-prime sector of the mortgage credit market were greeted by officials and countless market observers in the beginning in 2007.

 

oil rigPhoto credit: Getty Images

 

At first it was assumed that the most highly rated tranches of complex structured products would be immune, as the riskier equity tranches would serve as a sufficient buffer for credit losses. When that turned out to be wishful thinking, it was argued that the problem would remain “well contained” anyway. After all, sub-prime only represented a small part of the overall mortgage credit market. It could not possibly affect the entire market. This is precisely the attitude in evidence with respect to corporate debt at the moment.

 

1-HYG weeklyA weekly chart of high yield ETF HYG (unadjusted price only chart) – click to enlarge.

 

The argument as far as we’re aware goes something like this: there are only problems with high yield debt in the energy and commodity sectors. This cannot possibly affect the entire corporate credit market. We should perhaps point out that in spite of this sectoral concentration, problems have recently begun to emerge in other industries as well (a list of recent victims can be found at Wolfstreet).

The argument also ignores the interconnectedness of the credit markets. Once investors begin to lose sufficiently large amounts of money in one sector, the more exposed ones among them (i.e., those using leverage, a practice that gains in popularity the lower yields go, as otherwise no decent returns can be achieved), will start selling what they can, regardless of its relative merits. This will in turn eventually make refinancing conditions more difficult for all sorts of industries.

It also overlooks that energy and commodities-related debt is simply huge and the losses are really beginning to pile up by now. The junk bond market has grown by leaps and bounds during the echo bubble, so a lot of money has become trapped in it. Many low-rated borrowers need to continually refinance their debt, otherwise they will simply fold. Once liquidity for refinancing dries up – and this is what growing losses in a big market segment will inexorably lead to – it will be game over.

 

2-Merill Master II and CCC and belowMerrill Lynch high yield Master Index II effective yield (black line) and the yield on the CCC and lower segment (lowest rated credit/ red line). The worst rated bonds have been in relentless free-fall since the 2014 low in yields, with a move from 7.94% at the low to 14.71% today. Note bene, this has happened with administered interest rates stuck at zero over the entire time period! The better rated junk yielded 5.16% at the 2014 low, and yields 8% as of today, adding more that 280 basis points in bad juju since then. These yields are comparable to the woeful situation in 2011, when the euro area debt crisis was nearing its peak – click to enlarge.

 

It has turned out in hindsight that when we wrote in detail about the unsound boom in corporate debt last year, the price bubble in junk bonds had actually peaked a mere five trading days earlier. Nevertheless, debt issuance in both junk bonds and leveraged loans subsequently continued at a brisk pace for more than a year or so – this has only begun to change in recent months. The reason is that the losses are now indeed becoming rather concerning. In a recent note on the spike in default rates in the commodities space, Fitch remarks by way of summary:

 

Energy Default Rate Heads to 6%; Arch Filing Would Push Metals/Mining Over 14%. November already has added five defaults from the energy and metals/mining sectors.

The energy trailing 12-month (TTM) default rate finished October at 5.3%, the highest point since a 9.7% peak in 1999, while the exploration & production subgroup TTM rate hit 9%.

The metals/mining October TTM rate stands at 9.5% while the coal subsector jumped to 27%.

A potential filing for Arch Coal Inc. would propel the metals/mining TTM rate above 14% and the coal subsector to 40%.

The October TTM rate not including energy, metals/mining and Caesars Entertainment Operating Co. is 0.7%.

Energy and metals/mining experienced no new high yield bond issuance in October, the first time this happened since August 2011.

 

As you can see from the above, excluding all the bad stuff, things still look fine, but the bad stuff looks really bad. Someone is eating big losses, that much is certain. The fact that the rest of the corporate debt universe hasn’t been affected yet is where the “it’s well contained” idea comes from, but the only relevant question is really whether it will remain contained. The data say it won’t. The corporate credit bubble has become too large, while the cash flows supporting it are beginning to crater.

 

3-Corporate net debtA chart recently published by Societe Generale’s research department: until 2012, the massive growth in corporate net debt was still supported by commensurate growth in EBITDA (earnings before interest, taxes, depreciation and amortization). In the meantime a sizable gap has opened between the two – debt has continued to grow, but the income that supports it has begun to head in the opposite direction – click to enlarge.

 

Defaults Poised to Surge

Not surprisingly, the credit rating agencies are beginning to increasingly express concern over these developments. A recent report by Moody’s notes under the heading “The Credit Cycle Wanes”:

 

The US corporate credit cycle now fades. Thus far, the US high-yield credit rating revisions of 2015’s final quarter hint of the fewest upgrades relative to downgrades since 2009’s recessionary second quarter.

To date, the US high-yield credit rating changes of 2015’s fourth quarter show 57 downgrades far exceeding 18 upgrades. In addition, the accompanying revisions of investment-grade ratings include 11 downgrades and only one upgrade.

The final quarter of 2015 is shaping up to be the second straight quarter of substantially fewer high-yield rating upgrades relative to downgrades. A convincing negative trend may be emerging.

As long as high-yield downgrades well outnumber upgrades, any extended narrowing by the high-yield bond spread is suspect. For example, first-half 2007’s narrowing by the high-yield spread amid a distinctive upturn by net high-yield downgrades would prove to be a big mistake.”

 

(emphasis added)

In short, if there should be a short term rally in junk, use it to get the hell out of Dodge while you still can.

 

4-Expected default ratesExpected default rates of high yield borrowers tend to lead credit spreads – click to enlarge.

 

Accordingly, expected default rates are now increasing as well, and have reached levels that were last seen in 2009. As Moody’s notes in this context:

 

“The average expected default frequency (EDF) metric of US/Canadian non-investment-grade issuer is a forward looking indicator of the default rate. Recently, the high-yield EDF metric approximated 5.6%, which topped each of its previous monthly readings going back to the 6.4% of August 2009.

Given the surge in the number of downgrades, plunging upgrades, and the likelihood of significantly more defaults, the recent composite high-yield bond spread of 595 bp is unlikely to soon approach its 424 bp average of the two-years-ended June 2015. If anything, Q3-2015’s decidedly sub-par showings by business sales and operating profits warn of wider, instead of thinner, spreads.”

 

This confirms something we warned about when the market peaked in the summer of 2014. As we wrote at the time under the heading “The Expected Default Rates Trap”:

 

“[W]e want to briefly comment on the one data point that probably contributes more than any other to investor complacency: the expected 12 month default rate. All credit agencies put this expected rate at a new low for the move in 2014, not unreasonably arguing that because companies have issued so much debt, they are currently flush with cash and can postpone their refinancing plans if necessary.

[…]

Only in the 2001-2003 post technology bubble recession was a higher proportion of HY debt employed for refinancing purposes. Obviously, with demand for HY debt extremely high, even bad credits have little problem refinancing their debt. In other words, we are observing a feedback loop here: on the one hand, investors are emboldened by low default rates to keep refinancing HY borrowers, on the other hand it is precisely because they keep refinancing them that default rates remain so low.

As long as enough new money is provided the show can go on, but obviously, this is highly dependent on investor confidence. The question is therefore, when is investor confidence at its most vulnerable? Ironically, this is precisely when it is at its highest. When spreads and volatility are extremely low, they indicate a high point in confidence. This implies however that confidence can no longer improve further. Once things are “as good as they ever get”, there is just one way left for them to go: they can only get worse.”

 

Well, they sure have gotten worse. In the time period 2009 to 2013, between 53% and 64% of all high yield debt issuance proceeds globally were used for refinancing purposes. It doesn’t take a big leap of the imagination to see that problems could arise if investors should begin to balk. Indeed, the recent surge in defaults and default expectations has been marked by issuance in the most vulnerable segments of the corporate bond market grinding to a halt (see the Fitch comment above: HY issuance by energy and metals and mining companies in October stood at zero – the dip buyers are finally taking a break).

Moody’s notes that banks are pulling back concurrently and are busy tightening their lending standards with respect to commercial and industrial (C&I) borrowers. While the agency is uncertain of the precise cause-effect vector at work, this is how credit booms usually end: lenders begin to become nervous about their exposure and stop extending credit to dubious borrowers. Tightening lending standards tend to lead HY spreads as the chart below illustrates:

 

5-Bank credit supplyBank credit supply to business is tightening – HY spreads historically tend to follow suit – click to enlarge.

 

What is so remarkable about all this is that it has happened before the Federal Reserve has hiked rates even once from their current zero to 25 bp corridor (in practice, the effective FF rate has been oscillating between 7 and 14 basis points).

This is highly unusual and indicates that the end of QE3 must indeed, as we have always argued, be regarded as a significant tightening of monetary policy.

Thus the often heard refrain that the “taper” did not mean a tightening of policy was and remains misguided. Once an economy is hooked on an ever accelerating expansion of money and credit, any slowdown of said expansion will eventually trip the boom up. We also have confirmation of a tightening monetary backdrop from the narrow money supply aggregate M1, the annualized growth rate of which has been immersed in a relentless downtrend since peaking at nearly 25% in 2011. We expect that this trend will turn out to be a a leading indicator for the recently stagnant (but still high at around 8.3% y/y) growth rate in the broad true money supply TMS-2.

 

6-M1Annualized growth of narrow money M1 – click to enlarge.

 

Stock Market Fantasies

The stock market is traditionally the last market to get the memo – this is the case at present as well. As mentioned above, there is no shortage of rationalizations when segments of the credit markets come under pressure, and there is no shortage of rationalizations with respect to the stock market’s increasingly deteriorating internals either. This time it’s different!

Who cares if only a handful of big cap stocks is holding up the indexes? They deserve to trade at triple digit P/Es! Nothing can go wrong! Anyone who has observed the markets for a bit longer than today’s 20-something hotshot traders has heard it all before – several times. The sharp deterioration in credit-land is however one of the starkest warnings for risk assets yet.

Given that the Fed – focused as it is on lagging economic indicators – seems bent on hiking its administered rates shortly, one wonders how an actual rate hike cycle is going to affect the situation. Our hunch is that it won’t make things easier for assorted credit and liquidity junkies. On the other hand, one can probably be fairly certain that it won’t actually become a “cycle”. More likely it will end up a version of the BoJ’s repeated attempts over the years to hike rates, i.e., it will ultimately go nowhere.

In the meantime, the ratio of junk bond prices to equity prices has trended relentlessly downward, something that can be observed with unwavering regularity ahead of major market peaks. After all, the “it’s different this time” notion is holding sway every time – and it has a tendency to sound increasingly delusional the longer the stock market remains superficially strong.

 

7-JNK and JNK-SPX ratioThe price of junk bond ETF JNK (unadjusted) and the JNK-SPX ratio – stock market participants once again assume that credit market deterioration cannot harm them. This costly error is seemingly made every time – click to enlarge.

 

Conclusion

This isn’t going to end well, if history is any guide. Meanwhile, the foundation of the economy continues to look rotten (the newest round of Fed surveys has begun with another bomb and other manufacturing-related data continue to disappoint as well). It is no consolation that the service sector’s performance is still holding up better. Fo instance, a lot of spending related to health care has increased sharply. This is simply consumption, the price of which has moreover been distorted by government intervention. These artificially inflated activities aren’t going to create any wealth.

In addition, the misguided view that “manufacturing is just not important to the economy”, continues to hold sway as well. This is based on the misleading representation of actual economic activity in GDP. Gross output is telling the real story as we often point out. It should also be noted that every boom ends with capital goods and other higher stage industries affected first and the most. This is simply the nature of the credit-driven boom-bust cycle. Ignore the signs at your peril.

 

Charts by: StockCharts, Société Générale, Moody’s, St. Louis Federal Reserve Research

 

 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

2 Responses to “Junk Bonds Under Pressure”

  • Kafka:

    ZIRP, NIRP lead to squandering money on malinvestments in plants, mines, equipment, staff, ending up in overproduction, ending in falling prices- deflation.

    Central Bankers are children that eat too much candy and wonder why they have a bellyache.

    K

  • Treepower:

    And yet Martin Wolf this morning avers that high equity prices can be justified by a corporate savings glut.

    He’s obviously not noticed the action in junk lately.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Coming Debt Reckoning
      Licking the Log American workers, as a whole, are facing a disagreeable disorder.  Their debt burdens are increasing.  Their incomes are stagnating.   There are many reasons why.  In truth, it would take several large volumes to chronicle all of them.  But when you get down to the ‘lick log’ of it all, the disorder stems from decades of technocratic intervention that have stripped away any semblance of a free functioning, self-correcting economy.   Happy...
  • How to Stick It to Your Banker, the Federal Reserve, and the Whole Doggone Fiat Money System
      Bernanke Redux Somehow, former Federal Reserve Chairman Ben Bernanke found time from his busy hedge fund advisory duties last week to tell his ex-employer how to do its job.  Namely, he recommended to his former cohorts at the Fed how much they should reduce the Fed’s balance sheet by.  In other words, he told them how to go about cleaning up his mess.   Praise the Lord! The Hero is back to tell us what to do! Why, oh why have you ever left, oh greatest central planner of all...
  • India: Why its Attempt to Go Digital Will Fail
      India Reverts to its Irrational, Tribal Normal (Part XIII) Over the three years in which Narendra Modi has been in power, his support base has continued to increase. Indian institutions — including the courts and the media — now toe his line. The President, otherwise a ceremonial rubber-stamp post, but the last obstacle keeping Modi from implementing a police state, comes up for re-election by a vote of the legislative houses in July 2017.  No one should be surprised if a Hindu...
  • The Triumph of Hope over Experience
      The Guessers Convocation On Wednesday the socialist central planning agency that has bedeviled the market economy for more than a century held one of its regular meetings.  Thereafter it informed us about its reading of the bird entrails via statement (one could call this a verbose form of groping in the dark).   Modern economic forecasting rituals.   A number of people have wondered why the Fed seems so uncommonly eager all of a sudden to keep hiking rates in spite...
  • Moving Closer to the Precipice
      Money Supply and Credit Growth Continue to Falter The decline in the growth rate of the broad US money supply measure TMS-2 that started last November continues, but the momentum of the decline has slowed last month (TMS = “true money supply”).  The data were recently updated to the end of April, as of which the year-on-year growth rate of TMS-2 is clocking in at 6.05%, a slight decrease from the 6.12% growth rate recorded at the end of March. It remains the slowest y/y growth since...
  • What is the Buffet Indicator Saying About Gold?
      Chugging along in Nosebleed Territory Last Friday, both the S&P 500 and the Nasdaq composite indexes closed at record highs in the US, with the Dow Jones Industrial Average only a whisker away from its peak set in March. What has often been called the “most hated bull market in history” thus far continues  to chug along in defiance of its detractors.   Can current stock market valuations tell us something about the future trend in gold prices? Yes, they actually...
  • The 21st Century Has Been a Big, Fat Flop
      Seeming Contradiction CACHI, ARGENTINA – Here at the Diary we have fun ridiculing the pretensions, absurdities, and hypocrisies of the ruling classes. But there is a serious side to it, too. Mockery makes us laugh. And laughing helps us wiggle free from the kudzu of fake news.   Is it real? Is it real? Is it real? Above you can see what the problem with reality is, or potentially is, in a 6-phase research undertaking that has landed its protagonist in a very disagreeable...
  • A Cloud Hangs Over the Oil Sector
      Endangered Recovery As we noted in a recent corporate debt update on occasion of the troubles Neiman-Marcus finds itself in (see “Cracks in Ponzi Finance Land”), problems are set to emerge among high-yield borrowers in the US retail sector this year. This happens just as similar problems among low-rated borrowers in the oil sector were mitigated by the rally in oil prices since early 2016. The recovery in the oil sector seems increasingly endangered though.   Too many oil...
  • Will Gold or Silver Pay the Higher Interest Rate?
      The Wrong Approach This question is no longer moot. As the world moves inexorably towards the use of metallic money, interest on gold and silver will return with it. This raises an important question. Which interest rate will be higher?   It’s instructive to explore a wrong, but popular, view. I call it the purchasing power paradigm. In this view, the value of money — its purchasing power —is 1/P (where P is the price level). Inflation is the rate of decline of...
  • Rising Oil Prices Don't Cause Inflation
      Correlation vs. Causation A very good visual correlation between the yearly percentage change in the consumer price index (CPI) and the yearly percentage change in the price of oil seems to provide support to the popular thinking that future changes in price inflation in the US are likely to be set by the yearly growth rate in the price of oil (see first chart below).   Gushing forth... a Union Oil Co. oil well sometime early in the 20th century   But is it valid to...
  • A Bumper Under that Silver Elevator – Precious Metals Supply and Demand
      The Problem with Mining If you can believe the screaming headline, one of the gurus behind one of the gold newsletters is going all-in to gold, buying a million dollars of mining shares. If (1) gold is set to explode to the upside, and (2) mining shares are geared to the gold price, then he stands to get seriously rich(er).   As this book attests to, some people have a very cynical view of mining...  We would say there is a time for everything. For instance, when gold went ...
  • Warnings from Mount Vesuvius
      When Mount Vesuvius Blew   “Injustice, swift, erect, and unconfin’d, Sweeps the wide earth, and tramples o’er mankind” – Homer, The Iliad   Everything was just the way it was supposed to be in Pompeii on August 24, 79 A.D.  The gods had bestowed wealth and abundance upon the inhabitants of this Roman trading town.  Things were near perfect.   Frescoes in the so-called “Villa of the Mysteries” in Pompeii, presumed to depict scenes from a...

Support Acting Man

Austrian Theory and Investment

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com