No doubt that retail investors’ stomachs are churning from the stock market’s recent gyrations. Now, Mom and Pop investors may also be overcome with indigestion from the flagging corporate bonds in their portfolios.
Moody’s Investors Service recently warned that an unprecedented number of corporate credit ratings could be thrown into the junk bond pile, according to a MarketWatch report.
Let’s back up a step. A junk bond is a fixed-income instrument that refers to a high-yield or noninvestment-grade bond, according to Investopedia. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds. During the 1980s, corporate raiders issued junk bonds by the billions to facilitate corporate takeovers, some of which ended in disaster. And the bond market right now is awash with corporate paper that is teetering on the edge of junk bond status, a frightening prospect.
According to a MarketWatch report, Moody’s recently said the dollar value of U.S. corporate bonds rated at its lowest investment-grade rung - Baa - rose to a record $2.8 trillion in the third quarter. That is a larger amount than more highly rated, meaning safer, types of investment grade corporate debt.
Let’s put this speculative debt explosion into perspective.
The Federal Reserve began its program of buying up debt in 2008, in the wake of the financial crisis. The reason? The Fed wanted to boost the economy by lowering the cost of borrowing. It worked. Corporate debt exploded, nearly doubling in the past decade to $9 trillion from $5.5 trillion.
A huge chunk of the $9 trillion is rated BBB, or the riskiest end of the investment grade spectrum, as described above. This has some market observers in a state of panic.
“There is now nearly $2.5 trillion of United States corporate debt rated in the BBB category, close to triple the amount of 2008, making up half of the investment-grade bond market,” wrote author and Vanity Fair special correspondent William D. Cohan in an Op-Ed for The New York Times. “It's been quite a party. Now comes the hangover.”
Those investors feeling such pain will likely include holders of General Electric (NYSE:GE) 2.09% bonds. The market is preparing for one of the world’s biggest borrowers to be downgraded to junk.
To get a sense of what that might do to the markets, look back to the turmoil caused by the 2005 downgrades of General Motors (NYSE:GM) and Ford (NYSE:F). But this time it might be worse because so many companies have been on a debt binge, according to a Wall Street Journal report.
Back in 2005 it was easier for the overall market to shrug off the troubles in credit, because corporate debt—excluding the banks—was under control, with the boom in borrowing linked instead to mortgages. This time round companies have been the big borrowers, and the riskiest parts of the debt markets are stoking concern among policy makers.
“GE’s financial troubles are self-inflicted, not a sign of broader problems in the economy,” wrote James Mackintosh last week in the Wall Street Journal. “Yet, it is the world’s sixth-most indebted nonfinancial company, behind Volkswagen, Toyota, AT&T, SoftBank, Ford and Daimler. And it has more traded debt outstanding than any of them, totaling $122 billion, according to Refinitiv. It is big enough to shake the entire market.”
“The same was true in 2005,” Mackintosh noted. “GM and Ford were two of the biggest borrowers, struggling to cope with a legacy of high costs and overcapacity as competitors grabbed market share. As their downgrades to junk loomed investors unable to hold junk-rated debt dumped their bonds, while junk investors sold too, expecting their market to be swamped by the arrival of the giant car makers.”
The potential looming corporate bond crisis resembles that of the Puerto Rico municipal bond market which imploded after a series of downgrades. Investors are still filing investment fraud lawsuits to recoup their significant losses.
Investors, beware of a wave of corporate downgrades and possible defaults.
Zamansky LLC is a New York law firm which represents investors in court and arbitration cases against securities brokerage firms and issuers. The firm may represent investors in cases against companies mentioned in this blog. Zamansky LLC also represents investors in arbitration cases against UBS and other brokerage firms regarding Puerto Rico bonds and UBS closed end bond funds and other investments. UBS Puerto Rico Funds | Investment Fraud Attorneys
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. I have no business relationship with any company whose stock is mentioned in this article.