Wednesday, February 4, 2015

From Streetwise Research—Red Flag

Rising Credit Spread In Junk Bonds - This Red Flag Is Really Ominous

Feb. 3, 2015 1:52 PM ET 

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)


  • An expert in junk bonds warns that 33.5% of high-yield bond issuers may default in the next few years involving $1.6 trillion.
  • The deteriorating high-yield bond market is a bad omen to the stock market which is showing signs of fatigue.
  • Credit supply is tightening. A company offering an 11% coupon rate gets turned down in early 2015.
  • Defaults would begin moderately in 2015 and accelerate in 2016 and 2017 when the impact on the economy and the stock market could be disastrous.

An expert in high-yield bonds warned last November that the default rate in the junk bond market might reach 33.5% in the upcoming 2-4 years. Most alarmingly, he predicted that the total default amount could be as large as $1.6 trillion. Martin Fridson, Chief Investment Officer of wealth management firm Lehmann Livian Fridson Advisors, forecast there would be a very moderate increase in default in 2015 and the average junk bond yield would gradually rise to 7.25%. Fridson, a widely respected research strategist, estimated the total debt size at $4.8 trillion - an astronomical figure bigger than the current balance sheet of the Fed.

Junk bond market is flashing out warning signs

Fridson's warning fell on deaf ears of stock investors. The major stock indices continued to climb to record highs until the end of 2014. Today, the average yield of newly-issued junk bonds stood at 8.4%.

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Most important, the credit spread between high-yield bonds and U.S. Treasuries of similar durations rose to 5.25%. The 525 basis points are the risk premium investors are demanding from debt-issuing companies whose credit ratings are far below the U.S. government debts.

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Source: Federal Reserve Economic Data, Bank of America Merrill Lynch

When the spread rose above 4.5% or the long-term average, stock investors ought to remain alert. It is a warning sign that the credit market is concerned about possible deterioration in the local and/or global economy. The deflation trend around the world, unanticipated moves by central banks to depreciate their countries' currencies and a big drop in U.S. GDP from 5% in Q3 to 2.6% in Q4 2014 are a few of their concerns. Under these circumstances, funds would flow to safe havens such as the theoretically risk-free U.S. Treasuries, UK gilts or German bunds or even gold. The continuous rise in U.S. Treasuries in the past 12 months, resulting in the flattening of the yield curve, is an unspoken proof of the motivated flight to safety.

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Source: U.S. Department of the Treasury

On the contrary, investors are worried about the increasing likelihood of the low credit-rated companies to default or bankrupt because of a poor operating environment or geopolitical factors beyond their control (e.g. the 60% plunge in oil prices, an 11-year high in the U.S. dollar and sanctions against Russia). In the two economic recessions triggered by the 2001 dot-com bubble and the 2008 housing bubble (shaded areas), stock market crashes were preceded by a distinct trend of rising credit spread. This is not to say a market crash is going to happen tomorrow, next month or next quarter. Nonetheless, the uptrend in credit spread is usually a harbinger of something nasty or ugly.

The stock market seems uninterested in the red flag

In early January, I have raised red flags on Seeking Alpha, asking investors to have some due respect for fear at the probable end of the 6-year old Bull Run. One of the flags is the performance of the high-yield bond market, which is highly correlated to the gyrations of the stock market. I predicted increasing volatility and probably turbulence to come sometime in 2015. The first month performance of the S&P 500 was disappointing. The stock market featured high intra-day volatility and persistently strong selling pressure. At the surface, a month drop of about 3% is no big deal. Many traders may treat the drop no more than a normal swing. Look at the following monthly chart carefully.

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From a long-term technical point of view, the drop as showed in the chart is significant. It is the first time the S&P 500 index plunges below the upward trend that commenced in late 2012 and climbed along the ascending corridor until last December. The technical breakthrough is a meaningful sign for the stock market because the end of 2014 may signify the peak of one of the three longest bull runs in the history of the Wall Street. The drop occurred simultaneously with a sudden jump in bearish sentiment revealed in a January investor survey.

Source: William Market Analytics

The movement of the smart money out of the U.S.-exposed ETFs may be another indication of the trend reversal. Despite the relatively small amount, the net outflow may be a reversal of a prevalent pattern throughout 2013 and 2014.

Source: Markit

Whether the outflow trend would reverse in February or not is a one million dollar question. Without speculating on the market's next move, vigilant investors ought to heighten their awareness of the stock market's internals as well as the inter-market relationships that provide cues for its near-term direction.

How healthy is the junk bond market?

At present, it is premature to say the rising credit spread is a precursor to a market correction or another crash. What is worrying is that the valuation metrics experts use to assess the health of high-yield bonds are not promising.

High-yield bonds are also known as junk bonds in the financial circles. They are typically rated BB or lower by Standard & Poor's and Ba or lower by Moody's. They are debts issued by companies with no or low credit ratings to investors who believe they could get a great deal (high coupon rates 50 to 80 times of bank deposits) by lending them money. Usually these companies offer very few or even no collateral to back the debts. Once the companies run into financial difficulties, they simply default on their debts or go bankrupt. Investors stand to lose all their invested capital overnight. This is why seasoned investors regard junk bonds as the riskiest asset class after stocks. In the past, key players were institutional investors who could do due diligence on the financial profiles and business models of the issuers. Retail investors, however, began to show interest in high-yield bonds or other related derivatives without knowing the inherent risks since 2009 when the Fed adopted the Zero Interest Rate Policy. As Investopedia puts it, junk bonds arenot for retail investors.

"The obvious caveat is that junk bonds are high risk. With this bond type, you risk the chance that you will never get your money back. Secondly, investing in junk bonds requires a high degree of analytical skills, particularly knowledge of specialized credit. Short and sweet, investing directly in junk is mainly for rich and motivated individuals. This market is overwhelmingly dominated by institutional investors."

According to Bank of America Merrill Lynch index data, the $2 trillion market for global high-yield bonds was one of the biggest beneficiaries of the Fed's record stimulus in recent years. This niche asset class gained an annual 16.4 percent on average in the six years after 2008 because of their irresistible appeal to yield-hungry investors.

Investment guru Carl Icahn warned last December that the first asset bubble that would burst soonest would be junk bonds. He expected the bubble, created by excessive liquidity in the financial markets, to haunt the economy in the "next couple of years." In a recent Bloomberg survey among their customers (mostly professionals in the finance sector), the asset class which most respondents expressed disdain is coincidentally the high-yield bonds. 18 percent of 481 respondents said junk bonds would be on top of their short list.

Source: Bloomberg

Stay away from junk bonds

When investment gurus and professionals warn against junk bonds, it is time for retail investors to pause and review their stock portfolios. The wisdom embedded in their call is that they see formidable challenges besetting the economy that an average investor often fails to see. These challenges are likely to transform into economic risks including widespread layoffs, defaults and bankruptcies that would have immediate adverse effects on corporate America.

An expert in corporate bankruptcy, Professor Edward Altman of the New York University, predicted two weeks ago that a bubble in the leveraged finance market could burst in 12-18 months. Altman, who is Director of Research in Credit and Debt Markets at the University's Salomon Center for the Study of Financial Institutions, developed a model called "Z-score" for predicting corporate bankruptcies and accurately forecast the fall of junk bonds in 2007 - one year before the stock market crash in 2008.

Altman said the current "benign credit cycle" encouraged by low interest rates has been going on for five years and led to a "frothy" market. He predicted the default rate would climb to around 3.3 percent in 2015 from 2.1 percent in 2014 because the cost of debt capital has risen and the number of companies trading at distressed levels doubled last year. Distressed credits are junk-grade issues that trade at spreads over Treasuries of more than 1,000 basis points or 10%.

In an earlier presentation Altman made last May, he noted the distress ratio was well under the median of 10. The distress ratio represents the number of distressed securities divided by the total number of junk bond issues. A rising distress ratio reflects an increased need for capital and is typically a precursor to more defaults if accompanied by severe and sustained market disruptions.

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Source: Extract from Professor Edward Altman's Presentation in May 2014

Within nine months after the presentation, the ratio had more than doubled. In short, the yield has jumped to a double-digit figure (yet to reach an alarming or crisis level). The rise in ratio implies high-yield bonds are under increasing selling pressure and fewer investors are buying for fear of defaults. On the other hand, companies intending to issue new debts now would have to pay substantially higher coupon rates as competitive products offering 10%+ yield abound.

Changes in Distress Ratio in Second Half of 2014


Distress Ratio







Source: Bank of America Merrill Lynch

Altman said the tightening in credit supply could be attributable to the alarmingly high debt-to-earnings ratio - one of the key metrics he used to forecast bankruptcies - climbing close to a historic peak (6.2 in 2007). The debt-to-earnings ratio is one of the statutory guidelines used by bank regulators to alert lending institutions of default risks when a company's debt is over 6 times of EBITDA (an accounting term meaning earnings before interest, taxes, depreciation and amortization). Thanks to the abundance of easy and cheap money in the financial markets over the past six years, a considerable number of reckless companies have cranked up debts to buy back shares, pay dividends, conduct mergers and acquisitions or leveraged buy-outs. The last thing they would do is to use the borrowed money to grow their businesses. One of the SA contributors reported last December that a few excessively leveraged companies had the ratio reaching an alarming 7.7. Today, close to 30% of U.S. companies have recorded a dangerously high debt-to-earnings ratio close to the pre-2008 financial crisis (i.e. around 6).

Source: Standard & Poor's

Soured junk bonds could be a dagger into the heart of stock investors

Since mid-2014, the global high-yield bond market has gone downhill with a drop of about 10% in prices. In the U.S., junk bonds are performing relatively better as indicated by their price actions. The current price as indicated by the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) is only about 5% below the historic high. Technically, the security, however, has already entered into a long-term bear territory as the 17-week EMA crossed the 43-week EMA shortly before the end of 2014. This implies junk bond prices are destined to go lower unless a trend reversal happens soon.

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In the "real deal" market, in January alone, two companies saw their $700 million deals fall through, even one of them offered an 11% coupon rate. This is a sharp contrast to their overwhelming popularity in 2014 when only 17 companies failed to draw adequate investor interest (mostly happening in the last quarter). Put it simply, the junk-bond party is almost over. Whether the end of the junk-bond party entails the decline of the stock market is a wild guess. Nonetheless, based on the deteriorating balance sheets of low credit-rated issuers, particularly those in the energy sector, it is highly probable defaults would start surfacing later this year and accelerate in the ensuing years. As one fund manager said once defaults happened, credit would further tighten. Tad Rivelle, Fixed-Income Chief Investment Officer at TCW, noted that there was more at stake than just the direction of bond prices.

"The credit cycle is actually the driver of the overall business cycle. The durability of the economic expansion, such as it is, is largely dependent on the capital markets and the willingness of the junk bond market to continue to finance more marginal borrowers and more marginal deals. If yields continue to rise, corporate activity is expected to feel the impact. Rising rates reflect a reduced supply of credit...If the high-yield market gives, it's going to dry up M.&A. activity and cause a re-pricing of risk-based assets including stocks."

Who will spearhead the defaults?

Tarek Hamid, a high-yield energy analyst at J.P. Morgan Chase (NYSE:JPM) estimated that up to 40% of all energy junk bonds could default over the next several years. According to the firm's research, energy companies, the fastest-growing segment of the high-yield bond market in recent years, account for nearly 18% of all outstanding high-yield bonds, up from 9% in 2009. He predicted that the number of defaults would be small in 2015 because many companies have hedged their exposure. However, once into 2016 more companies would run into trouble. The fear for default in the sector rose hand in hand with the rising credit spread for bonds issued by the shale oil players. According to Moody's Analytics, the credit spread last December was about 5% for overall junk bonds. Yet the spread was 7.86% for highly-leveraged companies in the energy sector. It is apparent that the market has already factored in the likelihood of a string of energy defaults in the years to come.

On the other hand, the aggregate amount incurred in future defaults would be unprecedented because of the huge size of the junk bond market created by excessive liquidity in the financial markets. Fridson, the high-yield bond expert mentioned at the outset of the article, forecast that the total amount in the new wave of default would be more than the combined amount recorded in the last three previous recessions.

"It's not a forecast of a worse financial crisis or a deeper recession than the last default surge."

Rather, it was a reflection of the lower quality of debt and the far higher amount issued after 2008, said Fridson. The real size of the junk bond market is difficult to assess because high-yield debt trading is usually thin and issuance often occurs off exchanges. Fridson estimated that by 2016 the total market size should be around $4.8 trillion, including those issued through private placements or debt not in the form of bonds. He reckoned that a 33.5% default would result in producing $1.6 trillion "dead money." The impact on the economy and the investors would be unthinkable, not to mention the systemic risks the defaults might trigger.

The price for QE could be phenomenal

The Office of Financial Research under the Department of the Treasury, in its latest annual report to the Congress, warned that a prolonged period of excessive liquidity has bred excessive risk-taking activities. The Office saw three distinct threats to the financial stability of the country:

"First, we see material evidence of excessive risk-taking during the extended period of low interest rates and low volatility. Second, markets have become more brittle because liquidity may be less available in a downturn and the risk of asset fire sales and runs in short-term wholesale funding markets remains unresolved. Third, we are concerned that financial activity is migrating toward areas of the financial system where threats are more difficult to assess because information is not available, and that activity may be consequential."

One of these threats is exemplified by the trillions of dollars piled up in the junk bond market whereby investors chase yields at costs they have gravely underestimated. The Office is fully aware of the junk bond problem but it seems that the regulators could do very little to address the issue.

"Nonfinancial corporate balance-sheet leverage is still rising, underwriting standards continue to weaken, and an increasing share of corporate credit risk is being distributed through market-based financing vehicles that are exposed to redemption and refinancing risk."

The findings really sent the chill down my spine. Like it or not, the demise of the current bull market would probably be due to the bursting of the "corporate debt bubble." I hate bubbles but I feel I am helpless. I believe it is in the best interest of stock investors to take a proactive approach to protect their assets in 2015 before it is too late.

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