When the Federal Reserve published its first financial stability report in early December, it identified a number of areas that pose a serious risk to the U.S. financial system. Paramount among those concerns elucidated by the Fed was the level and quality of the total amount of outstanding debt carried by U.S. corporations. The central bank noted the relatively low premiums demanded by investors for assuming the additional risk of junk bonds versus investment-grade issues.
But worries about debt levels have not been limited to risks endemic to individual corporations, but rather to the health of the entire corporate bond market as well. This proposition is buttressed by the extent and scope of recent bets placed against the bond market by many fund managers.
Fed Chairman Jerome Powell has noted the last two recessions were triggered by asset bubbles, not inflation per se. The report also said that credit standards for junk bonds have deteriorated over the past six months. The number of companies with a ratio of earnings to EBITDA above 6 has risen above the two prior peaks in 2007 and 2014. In a new investment climate where the days of easy money are over, these are all disturbing trends.
Many fund managers seem to agree.
Indeed, almost as if on cue, subsequent to the release of the Fed’s debut asset risk report, many institutional investors, after chasing global yields for the past two years, are suddenly halting that strategy. The new approach is to take short positions via a number of derivatives against the largest junk bond exchange-traded funds that will rise in value when corporate bonds drop. This is a radical change in sentiment and is a potential indicator of an economic slowdown as junk bonds tend to exhibit signs of economic distress more than other assets.
How much has investor sentiment changed?
According to data from S&P Global Market Intelligence, of the total amount of outstanding shares of the largest junk bond ETF, 59% have been sold short, a remarkable increase from the 35% level in September. Investors have additionally hedged their bets through various derivative transactions. According to Citigroup (C), since October, for the first time, sellers of the popular CDS (Credit Default) index tracking junk bonds began to outnumber buyers. Since then, the ratio of sellers to buyers has increased to its highest level since 2014.
Another hedge strategy increasing in popularity is to purchase put options on the junk bond ETF that will rise if the fund's value decreases.
During the historically unprecedented era of zero-interest rates, few thought the outstanding debt loads carried by U.S. corporations would become untoward, as minimal debt servicing costs continued to whet corporate appetite for additional leverage. Many S&P 500 companies were eager to tap the junk bond market. The premium investors demanded from junk-rated issues was inordinately low, which made issuing low investment-grade debt financially viable. The Fed helped fuel the reckless borrowing with its prolonged policy of quantitative easing, which, ironically, may have created an asset bubble that, it noted in its report, has preceded previous economic downturns.
As interest rates continue to rise, investors and shareholders of highly leveraged companies are becoming more concerned. It is important to note that perhaps a bellwether moment occurred when the two-year Treasury note hit the 3% level for the first time in close to 10 years. This has had a rather sobering effect on investors, who have been acclimated to asset pricing in an exclusively low-rate environment.
One additional factor to note is that liquidity in the junk bond market has appreciably declined over the past decade due to more stringent regulations placed on the ability of investment banks to accrue excessive and unduly risky positions in junk bonds.
Investors should be mindful that over the past five years, nonfinancial corporations in the S&P 500 have added approximately $1 trillion in debt to their balance sheets. Ominously, a substantial portion of that total outstanding corporate debt is rated BBB — slightly above junk bond status. According to Barron’s, even though total debt has nearly doubled, thanks to historically low interest rates, debt servicing costs have increased by less than 40%.
In a continuous rising interest rate environment, debt service costs could increase dramatically, which would have a ripple effect throughout the entire bond market.
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