Perhaps bond traders have been bad this year, leaving them with nothing but a proverbial lump of coal instead of the fat yields they were promised? It certainly appears like investors have been eager to buy low quality debt from issuers on the rating agency naughty list.
Bond markets are often viewed as the canary in the coalmine as fixed income investors tend to be more risk averse, prompting them to rush for the exits ahead of equity and derivatives traders. The current situation displays some disturbing similarities with the infamous subprime crisis, where a period of low rates and reckless lending resulted in a credit meltdown which was ultimately at the heart of the deepest financial crisis since the Great Depression.
In an ironic twist, monetary authorities have been maintaining near-zero rates for the better part of the past decade in an attempt to stimulate the real economy out of the post-crisis doldrums, instead causing overindulgence in borrowing and inflated asset valuations.
As seen during both the subprime and European debt crises, artificially suppressing rates results in skewed incentives and an imbalance between risk and reward. This combination of low quality borrowers and cheap credit historically ends in a crash. We have already witnessed the consequences of this deadly disequilibrium in retail loans and sovereign debt markets. It looks like the corporate debt may be next.
The combined effect of a strong dollar, sharp decline in commodity prices and tightening monetary policy may put too much strain on the fragile bond market. A sudden spike in the risk premiums demanded from HY borrowers coupled with a rapid outflow of capital from fixed income funds are the first signs of instability. The fact that new debt placements have ground to a halt in past weeks is also a cause for concern and indicator that the market for lower rated debt may be saturated.
Central bankers have been monitoring the real economy for signs of economic recovery, basing their policy decisions on fundamental indicators such as inflation and unemployment whilst turning a blind eye on the rickety mountain of listed securities, exchange traded funds and financial derivatives. This strategy proved disastrous in 2007 when fundamentals looked rosy and the real economy was performing well, however policymakers were completely blindsided by a collapsing tower of private loans and debt derivatives.
Conditions now appear eerily similar to 2007, with 5% unemployment and GDP of 2% GDP growth following a period of suppressed borrowing costs. Economic fundamentals show that the time is right to begin gently tightening the bolts and gradually raising rates. Financial markets have a tendency to react to changing circumstances significantly faster than the real economy however, and this is true for both boom and bust. Credit markets have responded to reduced rates years ago, and corporate borrowers have been sucking up this abundant liquidity long before the real economy got to the punchbowl.
The reverse reaction is now due, with rising rates drying up liquidity for low rated issuers, closing the door on cheap credit and preventing them from rolling their debts to a longer maturity.
The popularity of issuing junk debt, structuring leveraged loan obligations and launching high yield ETFs has resulted in the accumulation of yet another pile of potentially toxic credit instruments with a worrying level of interdependence. It is plausible that a wave of defaults could cascade through these tiers of credit, leading to contagion and ultimately a credit crunch.
Reputable voices in the industry are now raising the alarm, with Carl Icahn pointing out that debt levels are elevated and the junk bond market could turn toxic. Moody’s Investors Service recently warned that “we’ve seen the peak of the credit cycle”. Some analysts such as Albert Edwards of Societe Generale claim that we are past the point of no return, and the Fed has done too little too late in order to prevent the next crash.
Much like the average consumer, American companies have subsided on a diet of junk in the past years, causing their stock prices to inflate like the waistline of a fast food fanatic at the expense of a mounting pile of debt and deteriorating health.
The time for a diet is well overdue, and the system is currently running a high risk of cardiac arrest unless urgent preventative measures are taken.
*The views expressed in this article are of the author and do not represent those of The Political Analysis.