IG Bonds: Midnight In The Garden Of Fallen Angels
Book enthusiasts catapulted John Berendt’s classic Midnight in the Garden of Good and Evil to iconic status. The nonfiction-novel hybrid spent 216 weeks on the New York Times bestseller list, longer than any book before or since, that is, unless you include the Bible. With estimated annual sales of 100 million, lifetime sales of the Good Book exceed five billion.
Berendt’s second book may not have matched the success of Garden, but the title was unquestionably inspired by the best seller of all time. The City of Falling Angels dives into a different brand of decadence, that of the city of Venice. What few appreciate is the term ‘fallen angel’ never appears in the Bible. The closest readers get is in the 10th Chapter of the Book of Luke: “And He said to them, “I was watching Satan fall from heaven like lightning.”
Of late, investors have been witnessing more than their fair share of angels being cast out of the Investment Grade (IG) firmament to the bond market’s answer to the netherworld, that is, a high yield, or ‘junk’ credit rating.
More than any single factor, the size of the market should place IG on investors’ radar screens. Deutsche Bank tallies the size of the outstanding market ended January at $5.3 trillion, more than double 2007’s $2.4 trillion. The bulk of the growth, meanwhile, has come from the lowest-rated segment of the market, or BBB on Standard & Poor’s scale. Once the threshold to BB-rated and below is crossed, a given IG bond is branded a fallen angel.
BBB-rated IG debt issuance has skyrocketed, ending January at $2.2 trillion, up from $802 billion in 2007. Tellingly, the pristine end of the scale, bonds rated AA, has actually shrunk to $511 billion from $526 billion over the same period.
The very composition of the IG market has undergone tremendous change since the last time the credit cycle turned, which by all appearances it is doing now. The riskier tilt within the IG universe should raise a red flag for investors who should not accept calming historical comparisons to prior cycles at face value.
Set aside macroeconomic indicators for a moment. Based purely on the amount of extra compensation investors were receiving for owning IG bonds, the Federal Reserve knew it was playing with fire by hiking rates in December. In market parlance, this premium is called the spread, or the difference between a corporate bond and a comparable risk-free Treasury.
For some unfathomable reason, the Fed saw fit to begin the current rate hiking campaign with spreads at double the average level that prevailed at the onset of the past three hiking campaigns. In Morgan Stanley’s estimation, IG spreads were at two percentage points on December 16th, twice the average of one percentage point at the inception of the rate hiking cycles of February 1994, June 1999 and June 2004.
In other words, investors were demanding twice the level of protection they had previously required and were all but shouting, “Danger Ahead!” And yet the Fed pulled the trigger. It’s more than a matter of kowtowing to a bond market hissy fit. The Fed’s own in-house research warned against making a rash move in a paper that was published last April.
Former Fed governor Jeremy Stein of Harvard along with two Fed staffers, David Lopez-Salido and Egon Zakrajsek concluded the following in the seminal Credit-Market Sentiment and the Business Cycle:
“When our sentiment proxies indicate that credit risk is aggressively priced, this tends to be followed by a subsequent widening of credit spreads, and the timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity.”
The authors then go on to slam the nail into the coffin: “Unlike much of the current literature on the role of financial frictions in macroeconomics, this paper suggests that time-variation in expected returns to credit market investors can be an important driver of economic fluctuations.”
Now, all of that may have read like gobbledygook to you if your eyes haven’t already glazed over. But it’s imperative to grasp the translation. Credit was as “aggressively priced” as it has ever been – recall that the average yield in the junk bond market hit 4.9 percent in June of 2014. Those are the same kinds of yields that investment grade sported just a few years earlier.
The “contraction in economic activity” is otherwise known as a recession. As for the timing, the paper pegged the “onset” of recession to be about two years after yields hit their lows and thus prices their highs. That puts us at about now for said “onset.”
But don’t lose sight of the biggest point the paper makes, that “credit market investors can be an important DRIVER of economic fluctuations.” In other words, uncontrolled feeding frenzies in the bond market can actually cause recessions.
Pardon the all caps and bolding but these are serious indictments of quantitative easing gone wild – and they come from inside the very institution that encouraged the unleashing of animal spirits in the first place.
Query Corporate America’s balance sheet centurions, a.k.a. Chief Financial Officers, and they’ll report that the debt was simply too cheap to not binge and binge alike.
The ultimate consequences, according to Morgan Stanley’s (MS) recent initiation of coverage of the IG bonds market, remain to be seen. On the plus side, leveraged buyout activity peaked out at $186 billion in this cycle, a fraction of 2007’s $434 billion peak. On the flipside, though, is the debt-financed stock buyback orgy, the merger and acquisition spree and weak earnings to say nothing of the idiosyncratic bond market body blow, the meltdown in the energy sector.
There are still many who hold out hope that the credit market cycle has not actually turned. The problem is that would make this time be the dreaded “different.” That would make the current episode the mother of all bull-market corrections.
“Technically driven, bull-market corrections in credit historically have not gone on for almost two years,” the MS report dryly notes. “In addition, if this had been just an Energy issue, in our view, the weakness would not have broadened out as it has.” Broadened out certainly sums up the current environment, as in no single IG sector has been spared.
At the risk of painting the MS analysts as bearish, their outlook for IG is quite optimistic based purely on valuations in a historic context. The curve ball that could derail their enthusiasm centers on a continued deterioration at the bottom rung of IG where the most value could be realized if spreads are as wide as they’re going to get.
That would be the big ‘IF’ given the rate at which fallen angels are piling up. According to Moody’s latest tally, 13 non-financial companies moved into the “Crossover Zone” at year end, 27 more than a year earlier. The total of companies at risk of being downgraded to junk now stands at 57.
At the opposite end of the ether reside “rising stars,” or companies on the precipice of greatness, at least to the extent IG borrowing costs are that much lower than that of high yield. In the last three months of 2015, rising stars faded, falling to 11 from 14 at the end of September.
Comparing the celestial duo can help gauge the direction of the economy, at least through the prism of the forward-looking credit markets. The ratio of fallen angels to rising stars ended the year at 5.2x up from 2.6x at the end of September, the highest since June 2009.
An appreciably less erudite way to go about measuring the potential for deterioration among the ranks of IG bonds is to check the price at which they’re trading. At last count, over 100 IG issuers’ bonds trade at prices that reflect a junk credit rating. This suggests that the agencies that determine their credit rating could end up playing another game of catch-up as they did in the aftermath of the subprime crisis.
Just last week, metals and mining giant Glencore was downgraded to one notch above junk. It’s safe to say management checked to see if its wings were singed at the tips. That’s not a bad call considering its bonds not only trade as if they’re no longer IG but as if they’ve fallen to the lowest rung of junk debt, as in CCC-rated, just above ‘D,” which cleverly stands for ‘default.”
Moody’s Tiina Siilaberg, who analyzes the high yield market, worries there’s more stress building in the pipeline: “There is a substantial amount of oil and metals & mining debt coming due over the next five years that is currently rated investment grade that could be downgraded.”
After the usual suspects in the commodities space, there are entire governments, as in South Africa, Russia, Turkey, Columbia and Indonesia, that are trading as if they’ve already been downgraded. They are followed on the lowly list by many of the lending institutions that financed the commodities producers, many of which will not get repaid. The only other standout for future downgrades is U.S.-based brick and mortar retailers, a double reflection of insufficient household income growth and a post-Amazon competitive landscape.
Could Jeremy Stein be right? Could credit market excesses possibly lead to a slowdown in the economy and not the other way around? That would seem to be the case given the latest survey out from the Young President’s Organization which found U.S. CEO confidence to be at the lowest in five years.
One has to wonder if the Fed is keen to test hell’s capacity. Given the work that Stein was doing while still inside the Fed, policymakers were at least aware that seven years of zero interest rates would inflate a mammoth credit bubble. We know that’s happened and is now un-happening: IG spreads are a mere six-hundredths of a percentage point shy of their 2001 recession highs.
If only the “what’s next” were more under our control. We can only hope that in aftermath of the inevitable bust to come, central bankers accept their limits and acknowledge their propensity to do more harm than good when our fallen angel elected officials fail to make good on their word.