Few Signs Of Trouble In The Junk Bond Market

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Includes: ACP, AIF, ANGL, ARDC, BIL, BSJP, CBND, CEMB, CIF, CIK, CJNK, CLTL, CORP, CSI, CWAI, DFVL, DFVS, DHG, DHY, DLBL-OLD, DLBS, DSU, DTUL, DTUS, DTYL, DTYS, EAD, EDV, EGF, EMCB, EMHY, FALN, FCOR, FHY, FIBR, FLAT, FTT, GBIL, GGM, GOVT, GSY, HIX, HYDB, HYDD, HYEM, HYG, HYIH, HYLB, HYLD, HYLS, HYT, HYUP, HYXE, IBD, IBDS, IEF, IEI, IGEB, IGIH, ITE, IVH, JNK, JQC, JSD, KIO, LQD, MCI, MHY, MLQD, MPV, NHS, PCF, PHF, PHT, PLW, PST, QLTA, RISE, SCHO, SCHR, SHV, SHY, SJB, SPTL, SPTS, STPP, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UDN, UJB, USDU, USHY, USIG, UST, USTB, UUP, VGIT, VGLT, VGSH, VLT, VTC, VUSTX, WFHY, WFIG, ZROZ
by: Ivan Martchev

By becoming the second-longest economic expansion in the 242-year history of the United States, the present nine-year boom is certainly long in the tooth. It is natural in such an elongated expansion for one to look for signs of trouble in the economy as recessions and bear markets tend to coincide. That’s when earnings tend to shrink the most for the S&P 500. Other than a flattening yield curve (below), normal in a mature expansion and Fed tightening cycle, there are no other real signs of trouble in the bond market.

YieldCurve.png

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In this Fed tightening cycle, one has to view the yield curve slope with a grain of salt as long-term interest rates are not as market-driven as they were in previous economic cycles. With the monthly run-off rate of the Fed’s balance sheet having grown from $10 billion in late 2017 to the present rate of $30 billion, the Fed will let more than $200 billion of bonds mature from its balance sheet, whose proceeds the New York Fed (FRBNY) will not reinvest. Therefore, the Fed’s balance sheet will shrink by that amount.

The Fed balance sheet runoff rate is forecasted to grow to $50 billion per month in late 2018 – dare I say it could be even more? – which will mean that at least $600 billion of bonds will be run off the Fed's balance sheet in 2019. Needless to say, those amounts combined with the trillion-dollar annual deficits emanating from the combination of the Trump tax cuts and increased spending may cause long-term interest rates to stay elevated and therefore “manipulate” the yield curve and prevent it from inverting. The yield curve in this cycle may not be as good of an indicator of a recession as in the prior five cycles due to the tsunami of Treasury bonds coming from the Fed and the recently-impregnated federal deficit.

If the yield curve may turn out to be overwhelmed by the Treasury tsunami, where in the bond market should we look for clues as to the end of the economic cycle? Simply put: Look to the junk bond spreads. With that in mind, I went to the Federal Reserve Bank of St. Louis website and plotted the BB, B, and CCC spreads to the relevant Treasuries on a single graph (below).

JunkBondSpreads.png

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In this case, I plotted the BB and B spreads on the left scale (left) and put the CCC spreads on another scale on the right, as the magnitude of the CCC spread is so much bigger and it otherwise distorts the chart. What we see here is that the BB and B spreads are as tight as they have been for this economic cycle and they have significantly improved since the mid-cycle spread widening in 2015 and 2016 driven by the crash in commodity prices and fears of a hard landing in China, which so far have been unfounded. While CCC spreads are not as tight as they have been in this cycle, they have narrowed notably in 2018. If “junkier” bonds see spreads narrowing in 2018, this has to be viewed as a positive economic signal.

Keep in mind that the junkiest of junk on our chart is “CCC or below” while the other two junk categories are cleaner BB and B bonds. The “CCC or below” is a relatively small part of the junk bond market and relatively illiquid, but it can offer insights as to how bond investors view prospects for the U.S. economy. By the looks of credit spread narrowing in the junkiest of junk bonds, they do not appear to be worried.

…But Signs of Trouble in the Emerging Markets Spread

While CCC spreads are shrinking in the U.S. – most likely due to the Trump tax cuts – emerging markets corporate debt is showing signs of trouble both in the investment grade (IG) and high yield (HY) categories. Here too I put the IG scale on the left and the HY on the right due to the wide divergence in rates.

CorporateDebt.png

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The fact that the IG and HY spreads in emerging markets are expanding should not be surprising to anyone as the dollar has begun to rally on the heels of expensing interest rate differentials and moves on the trade front. Since I think the U.S. Dollar Index can rise quite a bit further by the end of 2018 (to over 100) and even into 2019, then I would expect that emerging markets IG and HY spreads should continue to expand at a brisk pace, which can turn out to be quite problematic.

DollarIndex.png

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Enterprising minds are urged to read a paper published on November 20, 2017 on the Federal Reserve Bank of St. Louis website called “Global Debt Is Rising, Especially in Emerging Economies.” The first chart shows total debt by advanced economies, emerging economies (ex-China), and China-only debt.

TotalDebt.png

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Then there is a breakdown of emerging markets borrowing by currency, where yen- and euro-denominated borrowing has been tame, while dollar borrowing has gone off the charts.

EmergingMarketsBorrowers.png

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

If the dollar is rallying and emerging borrowers have to service their debts in dollars with cheaper local currencies, their cash flows are shrinking in dollar-denominated terms. If the dollar rallies much further, as I think will happen, those emerging markets borrowers’ cash flows would shrink a lot more.

In such a scenario, one should stay away from emerging markets debt and equities, as a big dollar rally can cause a financial crisis in vulnerable emerging markets that have been on a dollar-borrowing binge.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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