Published January 11, 2019
While the market’s swoon in October and December was sparked by concerns of a global economic slowdown and fears that the Federal Reserve would aggressively raise interest rates thus exacerbating the slowdown, there is another worry that played into the selloff. Increasingly, investment experts believe the corporate bond market is overstuffed with low-grade debt, debt that will falter in a recession at a rate higher than normal. The article below from consumer finance publication Kiplinger outlines the concern.
“Famished and desperate bond bears, starved for what they consider an overdue feast and riled by yet another rally in long-term Treasuries, have lately sniffed out an unfamiliar target: U.S. corporate bonds. Bond-return tables confirm a dismal year for investment-grade corporate debt. The slice of the market rated BBB by Standard & Poor’s, which I’ve often said stands for “buy, buy, buy” because of its wonderful long-term record, trailed junk, municipal and government bond returns in 2018, with a total loss of about 3% through December 7. Only dollar-denominated emerging-markets bonds did worse.
That’s not a life-changing loss. And you can attribute a chunk of it to the fact that at the end of 2017, U.S. corporate bonds were expensive relative to Treasuries. What happened is that the spread, or gap, between the yields on BBB bonds and 10-year Treasuries got unusually tight a year ago and has now widened, with corporate yields rising and prices, which move in the opposite direction, falling. That repricing of debt is the primary reason for 2018’s fizzle.
Poor returns last year were “really a function of bond math,” says State Street Global Advisors’ deputy chief investment officer Lori Heinel, who sees value again in investment-grade bonds. She forecasts “mid-single-digit returns” for 2019, which suggests a 4% to 5% yield (at current bond prices), with investors breaking even or gaining just a bit on principal. I’m a little less bullish, but BBB bonds have moved into the green again in recent weeks, so the worst may be over.
The bear case. The BBB bears do make some good points, however. There has been a massive increase in corporate bond issuance since the last recession. That in itself isn’t too worrisome because the bulk of those borrowers have loads of cash. But bonds rated BBB, the lowest quality considered better than junk, account for half of all investment-grade debt by dollar volume, a proportion that has grown nonstop from 10% in the 1980s. The market shares of AA and AAA bonds have shrunk accordingly; single-A bonds have held steady at about 35%.
Moreover, the BBB layer is increasingly populated by iconic but risky outfits you might not want to finance now. General Electric’s future is murky. General Motors can still sell trucks and SUVs but has a huge and idle fixed investment in cars. AT&T is America’s biggest corporate debtor. Pacific Gas & Electric could stumble if it is found liable for causing recent California wildfires and neither the courts nor the state legislature help it compensate victims. And CVS tripled its long-term debt, borrowing $40 billion to buy Aetna last year to experiment with the marriage of a health insurance company and a string of pharmacy convenience stores.
I’m not saying—and neither is Moody’s nor S&P—that any of these bonds are on the verge of being busted to junk. But that’s possible if the economy weakens. And when BBB debt gets downgraded, pension funds and mutual funds are forced to jettison the bonds, causing their market value to drop at a rate that could easily exceed 2018’s 3% loss.”
We see below that bank loans, which are loans of usually 5 years or less, suffered a steep selloff in November and December, followed by an even sharper rebound as the calendar turned to a new year.
This selloff is consistent with prior stock market corrections as bank loans are considered to be similar to high yield bonds in risk profile. In the chart below, we see that this sharp rebound behavior is normal for this group.
The Fed’s recent retreat on pushing interest rates higher brought immediate relief to the bond market. Though issuance of corporate bonds has doubled over the past decade, and there’s plenty of concern about this being a “bubble”, there is not yet any indication of real trouble. The charts below show that defaults remain at record low levels.
A skeptic might note that this fact was also true in late 2007 right before the market came apart – the veritable calm before the storm, if you will. Our friends at MarketTrend Advisors are in the process of releasing a strategy which takes advantage of a related concern – a new wave of consumer debt. If you share concerns about the levels of debt in the market and want to profit from the bursting of that bubble, drop them a note at info@markettrendadvisors.com.
Market Update
Stocks continued to rebound this week from their December plunge. Monday brought further advances as retail stocks rose +3%. The broader market added +0.7%. Gains continued Tuesday. After relinquishing an early rally, stocks bounded back to tack on another +1.0% to their recent move. Optimism as the U.S. and China meet to work out trade differences continued to fuel the move higher. That sentiment carried over into Wednesday and another +0.4% lift. Beaten down semiconductor stocks showed some rare leadership with the Fed’s recent meeting minutes confirming the market’s preference for a less aggressive interest rate outlook. A fifth straight gain Thursday as the market rose +0.4%. Selling pressure has been evident most days. But investors have flipped the script from late 2017 by buying any small pullbacks for fear of missing out on the recovery. Strength in oil prices has also been a supportive factor. Stocks felt pressure again Friday only to see buyers emerge. The stock market posted a flat day, a relative victory as bears were once again unable to sustain even a modest decline.
Stocks added a third straight weekly gain having recovered fully the mid-December plunge and risen to obvious resistance at 2600 on the S&P 500. The +2.54% weekly gain on the S&P 500 (SPY) was matched by a similar +2.85% lift in the Nasdaq 100 (QQQ). Small-caps continue to post sharper gains, just as they fell further during the October-December correction. The small-cap Russell 2000 (IWM) rose +4.73% for the week.
Warm wishes and until next week.