October 2, 2015
A theme persistently pursued in this column this year is that the bond market is more important than the stock market, that bond yields are the critical financial variable that investors should keep track of — and that the growing problems evident in the bond market are the harbingers of a more general doom. In this context of the bond market being more closely tied to reality than the equity market, it is necessary to add that the corporate bond market is more sensitive to change — and hence more useful as a predictor of trends — than the government bond market.
If we go back to May 2013 — almost two-and-a-half years ago, we can find reports of an extraordinary phenomenon in the US corporate bond market. The latter is itself sub-divided into two main components, namely investment-grade (IG) debt and high-yield (HY) debt. ‘High-yield’ is one of those poisonously misleading Wall Street labels, coined to facilitate the marketing of risky financial instruments to innocent or stupid saps. I will refer to ‘high-yield’ by its original label — junk.
In May 2013, the index measuring the yield on junk bonds dropped, for the first time ever, below 5%. It is worth noting that July 2007, when the first serious cracks appeared in the bond market and signaled the approaching financial tempest, was the last time that the yield on 10-year US Treasury bonds was at 5%. That was before the Fed began reducing interest rates and well before the adoption of ZIRP — zero interest rate policy that has caused Treasury yields to sink to record-low levels and driven investors to seek extra yield from risky investments — such as junk bonds.
This burgeoning demand has been met with enthusiasm by corporations eager to issue new debt. Their motives in doing so have varied, but underlying the different ‘stories’ has been the desire to take full advantage of the availability of endless quantities of very cheap money (by any historic standard).
Many big companies have issued large quantities of debt for the express purpose of financing stock repurchase programs — they borrow investors’ money to buy their own shares, thereby reducing the number of shares outstanding and causing the earnings per share ratio to rise, irrespective of whether their actual profits rose or not. Managers who “looked after” their shareholders in this manner were richly rewarded, with bonuses and options.
Another major use of corporate bonds in recent years has been to finance the boom in the energy sector — with numerous companies, larger and small, funding the huge expansion of drilling by borrowing lotsa money at bargain rates.
Back now to mid-2013. That was when the spread between yields on junk bonds and yields on Treasury bonds fell to lowest-ever levels, of around 3.25%. Since then, they have risen sharply, although by no means steadily: there have been periods of rapid rises in the spread, followed by retrenchments and then further rises. But the direction has been clear-cut — the spread climbed back to 4.5% and, more recently, to 5% and 5.5%, and is still rising rapidly. Given that Treasury yields have not risen very much, the widening spread reflects sharp increases in the yields on junk bonds — and for those who may have forgotten, rising yields reflect falling prices.
Indeed, the trend in the price of junk bonds is not only downwards but, in sectors such as coal, oil and gas, it has become a total rout, with many bond issues and loans to these sectors now categorized as “distressed”. The official definition of “distressed” does not rely on an assessment from a mental health professional. It simply means that the spread between the yield on the bond in question and Treasuries (of parallel duration) is greater than 10%.
The deterioration in the junk bond market is not new — as might be imagined, it can be traced at least one year back to the collapse of oil prices last fall — but it is certainly intensifying. It has not been widely reported, because the mass media, even the financial ones, focus the sheeple’s attention on the stock market and, in the context of the endless blather from and about the Fed and other central banks, on the government bond markets.
Until July, stock markets were still engaged in trundling out a seemingly endless series of all-time highs, while government bonds — although unprecedentedly volatile — were still at very low levels of yield. However, investment houses and more knowledgeable and professional commentators in the blogosphere were avidly discussing the developing crisis in the junk bond market.
However, only now, in the wake of the reversal in global stock markets that began in late August and has shaved 10-20% off leading indices around the world, has the mainstream discussion homed in on the junk bond debacle. No less a player than BaML — Bank of America Merrill Lynch this week published a note the headline of which described the junk bond market as “A slow moving train wreck that seems to be accelerating”. It does not make pleasant reading, especially if you understand the jargon and read between the euphemisms.
The bottom line is starkly simple: investors should urgently exit junk bonds and should review their holdings of bonds currently rated investment grade, with a view to selling some or all of them, too.