Looking At The Bond Markets: Growing Weaknesses?

Summary

• Attention this year has generally been focused on the government bond market where the yield on the 10-year bond is just above 2.00 percent, pretty low.
• However, even as the yield on government bonds have fallen this year, the spreads between government's and high grade corporate bonds have risen, and between high grade and lower grades.
• In addition, downgrades are up, defaults are up, and cash flow coverage is down, along with lower expected corporate profits, all not the best picture in the world.

The government bond market has remained strong over the past year or so, in spite of earlier thoughts that interest rates would go higher.

Over the past seven quarters going back to January 2014, the yield on the 10-year government security has varied from about 1.70 percent to about 2.5 percent.

Recently, the yield has traded in the 2.00 percent to 2.10 percent range. Most attention directed at the bond markets have been focused on the behavior of Treasury securities. Not getting much attention has been the behavior of other parts of the bond market. The news here is not that good.

Yes, corporations have continued to increase their issuance of bonds, taking advantage of the historically low rates of interest. These borrowings, however, have not gone into capital investment that would spur on economic growth, but, instead, have gone into stock buybacks, higher dividend payouts, and, increasingly, into acquisitions.

But, changes have taken place.

For example, in the past four weeks, the ratio of the yields on 10-year government debt and Moody's Aaa-rated bonds has averaged 53.3. At the beginning of August, the four-week average was 56.0.

The average yield on the 10-year government bond in the earlier period was 2.29 percent, whereas in the past four-week period, the average yield was 2.16.

The yield on the government bonds fell while the yield on Moody's Aaa bonds rose.

What happened over this time?

Well, the Federal Reserve held its short-term policy interest rate steady, as newly released statistics seemed to indicate that the economy was getting weaker and investors reduced the inflationary expectations they built into interest rates.

In other words, the yield on government bonds reflected the slower expected growth rate of the economy along with lower expectations for inflation.

What also seems to have happened during this time period is that the risk premium attached to corporate debt increased. That is the spread between the government yield and the Aaa-rated corporate debt rose.

This also happened to the ratio of the yields between Moody's Aaa-rated corporates and Moody's Baa-rated corporates. Over the past four-week period, this ratio was 75.9. At the beginning of August, the ratio was 79.3.

Clearly, the yield on the lower-graded bonds were significantly higher early in October than they were early in August.

Looking back further, we see that this deterioration has been even more pronounced. At the peak in 2014, the four-week average of the ratio of yields between government's and Aaa corporates was 61.4 compared with the current 53.3. The earlier ratio was calculated for the four-week period ending July 11, 2014.

In terms of the ratio of yields on Aaa corporates to yields on Baa corporates, the four-week average for the period ending June 20, 2014 was 88.7 compared with the current value of 75.9.

Obviously, investors are requiring more and more yield on the lower rated bonds, indicating that things are not all well in the bond markets.

Other not-so-good information is provided by Mike Cherney of the Wall Street Journal. For example, so far in 2015, Standard & Poor's Ratings Services "downgraded U. S. companies 297 times in the first nine months of the year, the most downgrades since 2009…"

Mr. Cherney continues stating that "the trailing 12-month default rate on lower-rated U. S. corporate bonds was 2.5 percent in September, up from 1.4 percent in July of last year, according to S&P."

Borrowing levels have increased to levels that concern Mr. Cherney. "According to one metric, the ratio of debt to earnings before interest, taxed, depreciation and amortization for companies that carry investment-grade ratings, meaning triple-B minus or above, was 2.29 times in the second quarter. That's higher than the 1.91 times in June 2007, just before the crisis, according to figures from Morgan Stanley."

There are other bits and pieces of information in the article, but the trend seems pretty clear.

And, the expectations for data to be released this week are not overwhelmingly optimistic about inflation and economic growth. Although economic growth is expected to continue, roughly along the same path as in recent quarters, there is no indication that things are expected to get better.

Expectations for inflation seem to be even more pessimistic.

In addition, the corporate earnings to be released over the next several weeks are not expected to be met with a lot of enthusiasm. Mr. Cherney writes that "In the third quarter, earnings for S&P 500 companies were expected to decline 5.1 percent over the same quarter last year, according to data as of September 30 from FactSet. That follows an earnings decline of 0.7 percent in the second quarter compared with the year ago period."

So, investors still have all this information to absorb, but the bottom line seems to be that the markets have priced in slower economic growth, lower rates of inflation, substantially below what officials at the Fed seem to be seeing, and greater risk in corporate debt.

Not the rosiest of pictures.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.