The Credit Market Powder Keg

Credit Market Bifurcation

By all accounts, credit markets remain on fire. 2019 is already a record year for corporate bond issuance, beating the previous record set in 2017 by a sizable margin. Demand for the debt of governments and government-related issuers remains extremely strong as well, despite non-existent and often even negative issuance yields. Even now, with economic activity clearly slowing and numerous threats to the post-GFC recovery looming on the horizon, the occasional rise in credit spreads is routinely reversed. And yet, under the placid surface problems are beginning to percolate. Consider exhibit A:

(Click on image to enlarge)

The chart shows option-adjusted credit spreads on three rating categories – while spreads on ‘BB’ rated (best junk bond grade) and ‘BBB’ rated (weakest investment grade) bonds remain close to their lows, spreads on ‘CCC’ rated bonds continue to break higher – considerably so. An increase by 473 basis points from their late 2018 low indicates there is quite a bit of concern.

It is actually rare for credit spreads on these rating classes to drift apart to such a significant extent at a time when spreads on better-rated bonds are still close to their lows. Normally the exact opposite happens – when spreads are tightening, they also tend to tighten between the different rating classes – only when spreads are widening across the board will spreads on lower-rated bonds display a tendency to widen to more rapidly than those on better-rated ones.

This bifurcation is actually a subtle warning indicating that the credit cycle may finally be coming to its end. It is “subtle” in the sense that it is generally not yet perceived as a sign that trouble is brewing – rather, it is dismissed as a sign that bond buyers have become slightly more selective (a good thing). In view of a record year for corporate bond issuance it is probably not surprising that concern remains muted.

To be sure, high yield defaults remain very low – and while they are forecast to increase, a major surge in defaults is currently not expected. However, these superficially placid conditions are masking growing turmoil – as so often, the devil is in the details. Consider the following data point released by S&P in mid-October:

(Click on image to enlarge)

According to S&P the number of “weakest links” is at a level last seen in November of 2009 when the speculative-grade default rate stood at 10.5%. This is an astonishing datum, to say the least.

Weakest links are defined as issuers rated ‘B–’ or lower by S&P Global Ratings with negative outlooks or ratings on credit watch with negative implications. As S&P helpfully explains:

“The default rate of weakest links is nearly eight times greater than that of the broader speculative-grade segment, and the rise in the weakest links tally may signify higher default rates ahead.”

Readers may be surprised to learn that contrary to 2015-2016, oil and gas companies are not leading the pack – consumer products companies are (52 issuers or ~20%). Energy companies are in second place, representing around 10% of the total, followed closely by media companies and restaurant chains.

All of these sectors are held to be under pressure due to industry-specific problems, but that doesn’t change the fact that a great many companies have obviously over-leveraged their balance sheets. The growth in “weakest links” in the strongest developed economy is testament to the proliferation of zombie central bank policies have created in recent years.

S&P nevertheless expects the US junk bond default rate to reach a mere 3.4% over the coming year, which is actually still a fairly benign number. Presumably, this is not factoring in the possibility of a recession. It seems to us there is a substantial risk that this forecast will be subject to upward revisions as time goes on.

Leveraged Loans, Private Equity, and Banks

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Disclosure: None.

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