Junk Bond Market; Negative Interest Rates: Creative Indestruction
George A. Romero knew how to make an entrance onto the Hollywood stage.
Night of the Living Dead, his 1968 directorial debut, set the ‘A’ standard for horror flicks. Though the special effects may seem unsophisticated to today’s moviegoers, the movie still terrifies modern day audiences.
The premise of the film has stood the test of time and been the subject of numerous sequels: The recently deceased find no peace in their graveyard slumber; they rise from the dead hungry to feast upon living human flesh. The film, produced on a shoestring budget of $114,000, follows a group of seven unlucky souls trapped in a rural Pennsylvania farmhouse, desperate to escape the fate that has befallen others who’ve succumbed to the grasp of the ravenous zombies.
It’s plausible that Romero had come across the work of Joseph Schumpeter before entering filmmaking. The phrase ‘creative destruction’ was coined by the Austrian American economist in 1942 and refers to what W. Michael Cox describes as “free market’s messy way of delivering progress.” Something new and innovative necessarily kills off the methodology it replaces, freeing an economic pathway to advancement. The absence of creative destruction, therefore, invites zombie industries to languish, feeding off healthy and more efficient new entrants and dragging down economic growth.
Think Eli Whitney’s cotton gin, which removed seeds from cotton in a fraction of the time it had taken to do so by hand. Imagine a world before the rise of railroads, in which horse drawn wagons were primarily responsible for transporting goods. Dare we go there? Close your eyes and picture what it would take to get through any given day with a rotary phone.
Feeling immeasurably more productive with that iPhone in hand? Then you understand creative destruction, what Schumpeter himself called, “The essential fact about capitalism.”
I suppose that makes quantitative easing and other central banking magic tricks like negative interest rates the essential executioner of capitalism. Look no further than the amount of U.S. industrial capacity that is up and running, or better put, fallow. At 76.5 percent, the rate of capacity utilization remains 3.6 percentage points below its average dating back to 1972.
A friendly reminder – the U.S. economy is technically 80 months into ‘recovery.’ Imagine how much better off we’d be if a little creative destruction would have been allowed to take hold.
It could be worse. We could be as overcapacitized as China’s industrial sector. Consider that cutbacks to production in the Chinese steel industry alone will result in some 400,000 layoffs. Tack on planned capacity reductions in China’s coal, aluminum and copper industries and you’re talking about reducing the Chinese workforce by the equivalent of Wyoming’s or Vermont’s entire population. Debt-fueled growth stories all tend to end the same, though China’s case is arguably one for the history books.
Many years ago, when my friend Oleg Melentyev was still at Bank of America Merrill Lynch, he wrote a report that haunts me to this day. In what I now realize was a channeling of Romero’s spirit, Melentyev warned that there would be repercussions for the default rate cycle of the Great Financial Crisis being cut short by the Fed’s extraordinary measures.
You will recall that step one on the road to ‘extraordinary’ entailed reducing interest rates to the zero bound, which the Fed did in December 2008. By then, there were multiple horror shows playing out in the financial markets. While the stock market bottomed in March 2009, with the Standard & Poor’s 500 hitting a devilish 666-level before rebounding, the bloodbath in the bond market continued through year end.
Companies were meeting their makers right and left. The default rate, which tracks the percentage of issuers reneging on their promised interest payments, was careening skywards and would eventually top out at 13.1 percent, according to Moody’s Investors Service. The rate was a barely discernible one percent two years earlier. Looked at through a slightly different prism, the dollar volume of defaults ended 2009 at 16.8 percent.
The what-happens-next is what so troubled Melentyev at the time. The default rate tumbled 10 percentage points, ending 2010 at 3.2 percent, while the dollar-volume rate crashed to 1.6 percent. (No, Virginia, that is NOT normal.)
For all of the analyst communities’ concerns about the inability to refinance all of this junky debt over the past few years, cheap money has managed to tear down each and every so-called ‘wall of maturity.’ Such is the reality of a world without yield in safe places.
A glance at issuance volumes doesn’t begin to suggest there was a recession underway, much less one that was ‘Great.’ Though growth slowed for a moment between 2007 and 2008, the siren call of zero interest rates that led off 2009 all but commanded investors back into the bond market.
The high yield bond market has doubled in size not once, but twice, since the start of this young century, hence the tendency for it to implode under its own weight. Outstandings doubled from 2000’s $334 billion to end 2007 at $674 billion. Then came the pause. The high yield market ended 2008 at $675 billion, up a mere billion over the prior 12 months.
Then it was off to the races. Issuance has since redoubled the size of the junk bond market to $1.5 trillion, with a capital ‘T.’ If you include all of the debt on high risk borrower balance sheets, including institutional facilities, term loans and credit lines outstanding, you’re talking about an additional $2 trillion.
“The high yield market and leveraged loan market has continued to grow,” worries Moody’s Tiina Siilaberg, “and the covenants are much looser now than they were in 2007. The default cycle this time around will be much different.”
As things stand, investors are being reminded in rude form how closely linked the behavior of risky debt and the stock market are. According to Melentyev’s latest tally, the spread, or the extra compensation investors receive for holding junk bonds vis-a-vis Treasury bonds, is nearly eight percentage points, the most since the fall of 2011.
“All-in high yield spreads today…are at their widest point since the depths of the Great Financial Crisis in 2009,” Melentyev cautions.
To his credit, Melentyev has never been one to buy into the dire need to net out energy borrowers to get the true underlying health of the bond market. After all, no analyst was doing this when oil issuance was going haywire and benefiting investors. If you must, junk bond spreads ex-energy have another percentage point to go in terms of widening and worsening before reaching their 2011 wides.
By the looks of things, investors won’t have to wait too long. Six of the ten issuers Moody’s downgraded in January to the category least-likely-to-be-able-to-refinance-their-debts were companies outside the atrophied energy sector. Overall stress, as gauged by the credit rating agency’s Liquidity Stress Index, spiked to 7.9 percent from 6.8 percent in December, the highest since December 2009 and the biggest one-month leap since March 2009.
Where’s the real worry? If you do play the neat netting game, but in a fair manner, removing financial issuers, which were a massive drag on the market, AND energy borrowers, which flattered the figures, investment grade is trading at its widest since 2011.
In other words, on a relative basis, junk is actually outperforming its hoity-toity investment grade big brother. It’s tomorrow’s fallen angels, or downgrades to junkland, that should give investors fright. At $5.3 trillion, it’s over three times the size of the high yield market. But that’s such a big story on its own, it merits its own sequel.
Of course, the Fed could truly be on the path to normalizing interest rates, which would give investors license to pull the plug on zombie companies once and for all, and allow Schumpeter to finally slumber peacefully in his ***own*** grave. What are the odds of that happening?
Investors would do well to listen to one of Wall Street’s most experienced voices, UBS’ Art Cashin, on those prospects. Cashin is sticking by his call that we’ll see zero before we see one percent interest rates care of a frightened Fed that backtracks on its ill-fated and two-years-overdue initial interest rate hike.
The next stop? That would be negative interest rates according to the dangerous theorists running the world economy.
Japan certainly seems to have bought into the notion that negative interest rates will prove to be the palliative they’re in desperate need of after 25 years of failed monetary policy. Japan’s inauguration to this sad group brings the total amount of global sovereign debt trading at negative yields to $5.5 trillion. Punctuating the implications for future countries dragged down the same path to negativity: The Japanese government has just canceled its next 10-year sovereign debt auction.
Can you imagine Uncle Sam going that same route – cancelling a Treasury auction because the 10-year was trading with a negative yield? If you answered ‘yes,’ you’re clearly comfortable co-existing with the corporate zombies in our collective midst.