The Dow Jones Industrial Average is down nearly 4,000 points since early October, that’s 15%. What is going on? The answer may lie in the Bond market. The Fed is tightening: raising rates and not repurchasing maturing bonds, while the U.S. Treasury is issuing new bonds at record rates to cover the Federal deficit and Corporate America is highly-leveraged.
The graph shows Bank of America Merrill Lynch U.S. Corporate High Yield OAS for the past 3-years. From the low in early October at 3.16%, it has risen 1.95% to 5.11%. AAA and BBB spreads tell a similar story; click over to our website: https://www.cubicadvisors.com/credit-spreads/ for more graphs.
Credit spreads are rising, at a time when Corporate America is loaded with debt. Low quality Corporates, if down-graded, could flood the High Yield market. Moody’s Analytics warns that 3Q18’s Baa3-rated bonds ($705 B) comprises an unmatched 56.8% of the outstanding High Yield bonds. “…the next deep and extended contraction of corporate earnings may flood the high-yield Bond market with fallen angel downgrades.” In contrast, Baa3-rated bonds were a smaller 32.5% of outstanding High Yield at the end of 2007, the start of the great recession.
The Corporate Bond Debt to EBITDA ratio is significantly higher than at the end of 2007, a symptom of financial leverage. This is disguised somewhat by favorable Interest Coverage ratios (higher than in 2007), but this is due in part to the relatively low level of interest rates. Coverage ratios have recently declined (less favorable), as rates have risen.
The issues in the Bond market are many; rising credit spreads are just the symptom. The U.S. Treasury is issuing $78 B per month to cover the Federal deficit. The Federal Reserve in not repurchasing maturing bonds at the rate of $50 B per month, as it winds down its balance sheet. (We haven’t even mentioned the Municipal Bond market and its under-funded pensions.) The Fed continues to raise rates, having suggested 2 hikes in 2019 and 1 hike in 2020. Powell and the Fed come-off as too hawkish at a time when Corporate debt levels are high. It looks this morning like the markets were hoping for a more dovish statement from the Fed than Powell delivered.
If a hawkish Fed manages to raise interest rates and slow the economy, then highly leveraged Corporate America will be squeezed from two sides: higher rates and lower earnings. Suddenly, interest coverage ratios would not look so favorable and the debt burden would be big news. It is pretty clear that the Fed has a fine line to walk. They’d better keep an eye on spreads.
Reference: Moody’s Analytics, “Weekly Market Outlook”, December 20, 2018