Rates have been low for the last several years. Investors have been chasing yield; income über alles! This search for yield plus relatively unlevered corporate balance sheets going into the global financial crisis proved to be the perfect conditions to spawn a tribble-like expansion of the corporate bond market. Now here we are, contemplating risks to this vastly larger corporate bond market. What exactly should we concerned about?
Many believe that the main risk to corporate bonds has to do with “Fed liftoff”, the idea that the Fed will embark upon a series of rate rises leading to a selloff in the US treasury market. I think that the main risks have to do with other factors like the large amount of debt taken on by the oil and gas sector and emerging markets corporations. These risks, if I am proven right, will be reflected in relatively higher interest rates for corporate bonds versus US treasuries.
Corporate bond risk can be summarized in two concepts:
- Interest rate risk: This is sensitivity to the government bond market in the currency of issue. US corporate bonds are sensitive to changes in the yields of US treasuries. The higher the quality of the corporate bond, the more faithfully it tends to follow changes in treasury rates.
- Spread risk: The spread is the extra yield investors receive over the treasury rate for taking on default risk and other risks associated with corporate bonds. Though default risk is most often cited as the reason the spread premium exists, the bulk of the spread compensates for illiquidity and the exposure to market volatility.
You can see in the following chart that the yields of Baa rated corporate bonds, the lowest rated investment grade bonds, generally have followed treasury yields since 1953, when the 10 year data begins.
Given the high debt levels in the US, quiescent inflation and the likely continuation of sub par GDP growth, US treasury rates should not go very high when the Fed does finally raise rates. The current situation is not unlike the early 1950s through the mid-1960s: Inflation was low and the US was working off the high debt burden of WWII. The difference is that GDP growth was higher then than is possible today.
Spreads, on the other hand, can go higher. I don’t believe that they will approach the levels seen during the financial crisis, but we could see something closer to what we saw at the turn of the millennium. The chart below of the “Quality Spread”, the difference between Aaa bonds and Baa bonds, goes back to 1919. It shows that the largest spikes in the corporate bond spread have been associated with big macro events.
The two big spikes that bookend the chart are from the Great Depression and the Global Financial Crisis. Other prominent peaks are associated with premature tightening in 1938, the collapse of Bretton Woods in the 70s, the oil shocks of the 70s and Volcker’s slaying inflation dragon in the early 80s. (The elevated spread in the 1920s may be related to the recessions shown in gray.)
The recent spread widening and stock market selloff remind me of the late 1980s and early 2000s. Spreads widened materially, but did not attain the peaks of the macro crises. In both those instances, we had overinvestment in a number of industries that led to crises, but not global crises. In the 80s, banks were impaired by bad commercial real estate lending and emerging market sovereign lending. In the late 90s into the early 2000s, the equity market was choking on tech issuance as was the corporate bond market, a lesser known fact. A lot of capital was raised in the bond markets to fund the build out of the internet and the deregulated power sector. Many phone companies, cable companies and merchant power producers went bankrupt or found themselves at the brink.
Recently, the issuance has been concentrated in oil and gas, materials and mining. A lot of capital has been raised in emerging markets as well. Naturally, the Venn diagrams overlap substantially in the commodity focused sectors, though EM banks are heavily implicated too.
If the slowdown in China, the rout in commodities and the troubles in emerging markets continue, spreads are likely to get wider. Consider how well the Baa spread has tracked the VIX, the measure of the S&P 500’s expected volatility known as “the fear index”. Stocks are telling us something.
Whether it’s about excessive leverage in certain sectors, a slowdown in growth in China and its effects on commodity producing nations or something else entirely, it has and will continue to propagate into corporate bonds. We have been duped into following a sideshow. Dammit, forget Janet. Turn off CNBC. Pay attention to the asset markets.