The Corporate Bond Bubble Is About To Burst

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Includes: HYG, WYDE
by: Anthony Fernandez

Summary

Junk bond yields are approaching their pre-recession lows.

Corporate Debt levels are actually higher than widely believed.

Corporations have been spending money on buybacks rather than capital.

Over the past few years, a narrative has been passed around financial circles (and to the general public) that corporations have been loading up on cash and securing their positions so as to avoid repeating a 2008 style liquidity panic. While this has been generally accepted, the fact remains that the story is totally wrong.

The Real State of Corporate Debt

Corporate cash holdings are at record highs. On this fact there is no disagreement. What has not been mentioned is something that is far more important:

What has increased far more than cash holdings is the total debt held by corporations. It has outpaced the gain in cash holdings, and what instead has happened is that corporations have far more net debt than they have ever had. This is not necessarily a problem if corporations are doing well and can be expected to pay back that debt. When we look at corporate profits, though, we notice a problem:

While corporate profit is up about 50% since about 2005, net debt at corporations has doubled. Perhaps with today's low interest environment this is not a problem, and so far it has been sustainable. However, this low interest rate environment cannot last forever, and the ability of corporations to pay back this excessive debt when profits have not kept up is highly suspect.

What are Corporations Doing with This Debt

The other issue with this debt is that not only is it not keeping up with profits, but it is actually being used to increase stock prices rather than invest in capital. Camilla Hall at the Financial Times summarizes:

"Much of the corporate lending is going to fund payouts to shareholders, finance acquisitions and fuel the domestic energy boom, bankers say, rather than to support companies' organic growth."

The image speaks for itself. This is clearly what the debt is being used for, and it is propping up a market that is historically overvalued.

The Current Trend of High Yield Debt

From roughly 2009 to the present day, yields have seen significant declines. As a result, bond holders have done well, and current yields are very low. From about 2011 to the middle of 2014, we have seen yields fall gradually and steadily. Over the past few months, however, a new trend has begun to emerge. Yields have slowly climbed.

We can see that in August a new low was tested as the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) fell far below the 50 day moving average and approached the 200 day moving average. Volume picked up on that dip and brought the value back up, but volume crashed on that price gain and hasn't increased much since then. In fact, HYG now is beginning to approach the 200 day moving average again, and there is no foreseeable volume to bring it back this time.

Summary and Action to Take

With the truth of high yield credit elucidated, the implications are obvious. If you have any exposure to the high yield bond market, get out now before yields spike as they always inevitably do. We may be a few months away from the spike, or we may be a year away, but the fundamentals show that this current state is unsustainable. Personally, I have invested in ProShares CDS Short North American High Yield Credit ETF (BATS:WYDE) which follows the credit default swap market. Basically, when credit events happen, WYDE should see a good increase in value.

Disclosure: The author is long WYDE.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.