In our last article, we made the point that back twenty-years ago the total size of the corporate bond market was estimated to be approximately $3 billion, with 80% of the market falling into the investment grade sector and 20% (+) of the investment-grade sector rated Baa/BBB. The corporate bond market has at least doubled in size over the last 20 years to approximately $5 billion, and today 49% of the investment grade sector is Baa/BBB. We have seen an enormous increase in debt and an equally enormous decline in credit quality over this time period. The lowest rating category of the investment–grade sector (Baa/BBB) now appears to be somewhat bigger than the entire corporate bond market just 20 years ago. Investors in corporate bonds need to take this development very seriously.
Corporate spreads are very tight to treasuries. This current phenomenon is fraught with spread widening risks that we have highlighted frequently in previous articles. A single A-rated 10-year corporate bond is trading 55 -85 basis points, dependent on name, over a comparable 10-year treasury. This is a clear definition of a “risk-on” trade. However, spread risk is a much broader topic than simply pointing out that individual securities and sectors are tight to treasuries and are at risk of severe widening.
Let’s look at spreads among rating categories. For example the normal spread between BBB+ and BBB, a half-notch variant may vary from zero to a maximum of 25 basis points. If we look at the spread differential between an AA+ and AA municipal, the range may only be 2-5 basis points. The next example is where it all gets tricky and can impact both spreads/prices and market liquidity. Remember we now have 47% of investment grade bonds rated Baa/BBB one full notch above high yield/junk.
With the trend of declining credit quality and rising debt levels over the last 20 years comes a greater risk that we will witness more Baa/BBB credits decline, thus crossing the river into the land of high yield/junk. In this case, spreads will initially widen by 100-125 basis points. The reason for this extra widening is related to their lower quality and, by dropping into high yield/junk category, may lose up to 80% of their eligible buyers, as former holders like Pension Plans, certain mutual funds and ETFs are prohibited from owning high yield/junk securities and must sell.
The fact that we are in the late stages of the business cycle, a slowing economic trend (despite the codswallop of the consensus), non-sustainable equity valuations, the maelstrom of current geopolitics and the almost unprecedented increases in leveraged loans and high yield/junk issuance all lend support to our concern that spread product is highly vulnerable to a sizable correction.
A rising rate scenario, should it occur, would only intensify the developing disaster for those owning spread product. Early last week, the WSJ pointed out that the volume of leveraged loans is up 53% this year putting it on pace to surpass $534 billion issued in 2007. They further stated that the boom in leveraged loans was one of the early signs of markets overheating as the crisis developed. Investors in these loans lost 30% in 2008 according to S&P LSTA Leveraged Loan Index. A high percentage of these loans are leveraged as high as 6 or more times.
The spread widening crisis may come in the form of an avalanche growing and spread as the process begins. One scenario among many would see an equity correction leading to a widening in high yield/junk spreads which would intern cause a widening in the Baa/BBB sector with decreasing severity as we move up the quality spectrum.
I believe a scenario similar to the above is inevitable as the current business comes to an end.
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.