Corporate Bonds Tell A Scary Story For The Stock Market by Evergreen Gavekal Blog

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.” – Renowned MIT Economics Professor Rudi Dornbusch

EVA Summary

  • In the spirit of Halloween, this month’s Guest EVA features a spooky Poltergeist-themed article from former Fed insider, Danielle DiMartino Booth.
  • In her letter, Danielle warns that signs of stress are starting to show in the $200-plus trillion corporate bond market and the conditions are now in place for the next corporate default cycle (which is clearly underway in the energy and mining sectors).
  • If she’s right, the damage we are already seeing in both investment grade and high yield spreads* tells a scary story for the richly-valued S&P 500, which continues to rally in the face of rising risks already reflected in the credit markets.
  • To be clear, my colleagues and I at Evergreen GaveKal are not suggesting that investors should avoid all high yield bonds. Rather, we believe investors should be selective and focus on higher-grade, high yield securities (BBs instead of CCCs) at this point in the credit cycle. While spreads may continue to widen in less beaten-up sectors, we believe stocks have much further to fall than corporate bonds.
  • Given the defensive posture our investment committee has taken over the last year – with relatively low allocations to equities and junkier-rated bonds and the highest cash reserves in our firm’s history – we believe we are well prepared to weather whatever storms may come.

*The yield difference between lower-rated corporate bonds and US Treasuries.


Corporate Bonds Tell A Scary Story For The Stock Market

In the spirit of Halloween, this month’s Guest EVA features a spooky Poltergeist-themed article from my good friend and all-around smartest person in the room, Danielle DiMartino Booth.

During her eight years in the Federal Reserve System – where she worked from 2006 to 2015 as a senior advisor to Dallas Fed President, Richard Fisher – Danielle was one of the only voices inside the Fed to warn or even acknowledge how rising defaults in subprime mortgage loans could destabilize the entire US financial system.

We all know what happened next.

Thinking the subprime threat had been successfully “contained,” the Federal Open Market Committee (FOMC) fell desperately behind the curve. And in hindsight, the Fed only “saved” the economy from a Great-er Depression scenario by employing an experimental combination of zero interest rates and massive monetary expansion… which, in turn, set a new and even less predictable credit cycle in motion.

Like the avaricious real estate developer in Poltergeist (the 1982 classic, not the 2015 flop), the Fed chose to build yet another credit expansion on cursed ground instead of cleaning out the graveyards of capital misallocated in previous cycles.

Seven years later, Danielle is warning that the conditions are ripe for yet another meltdown – this time emanating from the $200-plus trillion corporate bond market, where dealer liquidity has evaporated as a result of post-crisis regulatory reform and where the total debt stock has grown by more than 55% since early 2011. As you can see in the chart below, the combined growth in US bank loans and high yield bonds over the last four and a half years now ties for the second longest and second largest credit cycle in the past three decades.

Four Credit Cycles In Three Decades

Corporate Bonds

Source: Deutsche Bank’s Melentyev & Sorid, “The Evolution of a Credit Cycle.” October 2, 2015.

What’s more, low quality borrowers (with CCC credit ratings or lower) account for roughly 17% of total debt issuance over that timeframe. So far, this cycle falls just short of the mid-2000s at 18% and the late 1990s at 20%, but give it time. In another year – if Ms. Yellen has her way – we could be looking at the longest, junkiest credit expansion on record.

Low Quality Credit Issuance

Corporate Bonds

Source: Deutsche Bank’s Melentyev & Sorid, “The Evolution of a Credit Cycle.” October 2, 2015.

Then again, the clock may already be running out.

While equity prices continue to rally, the steady rise in even AAA corporate bond spreads* may signal – like thunder in the distance – that a storm is coming for risk assets. This divergence prompts a critical question. Do you believe the equity market? Or the bond market?

The yield difference between lower-rated corporate bonds and US Treasuries.

Trick Or Treat? (AAA Credit Spreads Versus The S&P 500)

Corporate Bonds

Source: Evergreen GaveKal, Bloomberg

It’s worth noting that whenever the corporate bond market and the equity market reflect dramatically different views on risk, bonds are very often right. And by the time high yield spreads really start moving, it’s often too late to react.

Energy & Mining Don’t Entirely Explain Recent Spread Widening

Corporate Bonds

Source: Evergreen GaveKal, Bloomberg

As you can see in the chart above, high yield spreads in the energy and mining sectors (which collectively account for nearly 20% of outstanding junk bonds) have already blown out to levels last seen during the Great Recession, reflecting elevated default rates in the high single digits. With defaults still running below 3% in the overall high yield market, it would be easy to dismiss the distress in commodity-related sectors as isolated events; but not only are spreads creeping higher in non-commodity sectors, qualitative signs of stress are clearly beginning to show in firms that should be benefitting from low commodity input costs (e.g. Walmart). There is clearly more to this story than the largely priced-in resource slump.

Danielle argues that it’s just a matter of time until the accrued policy errors of decades past come screaming back to haunt the Fed and the broader financial markets alike. With the historical prerequisites in place, the next default cycle could happen any time (and is clearly underway in resource-related sectors). All it takes for that stress to jump to non-resource stocks and bonds is a spike in volatility… like the kind we saw on August 24 when the US equity volatility index temporarily jumped from 28 to 40 in the largest week-over-week spike on record.

US Equity Volatility Index (VIX)

Corporate Bonds

Source: Evergreen GaveKal, Bloomberg

“A reading of 30 points on the VIX scale has been reached consistently at the beginning of each of the last three credit cycles,” according to Deutsche Bank’s Oleg Melentyev and Daniel Sorid. “In previous pre-cycle episodes, VIX has reached 30 points in October 1989, November 1997, and August 2007, preceding the arrival of defaults by 10 months, 9 months, and 3 months, respectively.”

From that perspective, credit markets, equity markets, and even the broader economy may be heading for trouble.

To be clear, my colleagues and I at Evergreen GaveKal are not saying that investors should avoid all high yield bonds; but we do believe investors should be selective and focus on higher-grade, high yield (BBs instead of CCCs)

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