Rising rates will result in significantly higher re-financing costs for maturing U.S. government bonds
Over the next five years, $7 trillion in U.S. government bonds (IEF)(IEI)(GOVT) will mature with an (current) average coupon of 2%. With the two to ten-year portion of the yield curve at or near 3%, that would represent (today) a 50% increase in interest expense. Keep in mind in 2017 alone, the government spent $263 billion on interest, and according to the Wall Street Journal, that figure will spike to $915 billion by 2028, a nearly 250% increase.
Exhibit 1: U.S Government Debt Outstanding
Source: Federal Reserve Bank of St. Louis
The corporate debt binge leaves little margin for safety in the next economic downturn
Corporate debt (LQD)(VCIT) has exploded to the upside having grown to over $6.3 trillion from $3.5 trillion since 2008, an 80% increase. What’s alarming is nearly 50% of all investment grade credit, about $2.5 trillion, is rated “triple-B”, just one tier above “junk bond” status. The blue shaded area in exhibit 2 below highlights the overwhelming supply of debt amassed at junk’s door step.
Exhibit 2: Non-Financial Corporate Debt Outstanding & BBB-Rated Debt Highlighted in Blue
The next downturn will likely fuel a rapid widening in credit spreads
The fall from investment grade to junk status (HYG)(JNK) comes with an abrupt increase in funding cost. Exhibits 3 & 3A highlight both nominal yields and yields differentials between investment and non-investment grade bonds. A BBB credit, pari passu, that deteriorates to junk status would see about a 240-basis point increase in funding cost.
Exhibit 3 (on left): Nominal Yield on Different Tiers of Corporate Bonds
Exhibit 3A (on right): Yield Spread Differential Between BBB to AAA-Rated Bonds & Between Junk Bonds to BBB-Rated Bonds
Widening credit spreads impedes economic growth
According to Morgan Stanley, as Baa (equivalent to BBB) credit spreads widen, the added funding cost impedes both economic growth and employment conditions, acting like an increase in the overall Fed Funds rate. Moreover, they conclude a 100-basis point increase in Baa spreads is equivalent to a 62-basis point rise in the Fed Funds rate. Exhibit 4 below highlights the relationship between widening Baa credit spreads and weakness in the unemployment rate. As spreads widen the unemployment rate rises.
In a recent report on global financial stability, the International Monetary Fund concludes that credit booms led by a rising share of junk bonds were followed by lower cumulative GDP growth of 2 percentage points over the following three years.
Investors chasing yields have ignited record corporate borrowing
Investors quest for yield have fueled the burgeoning issuance in both corporate debt and leveraged loans (BKLN)(SRLN)(LFRAX). Recently, both the FED and OCC have warned about risky corporate borrowing that has reached record levels while lender safeguards have eroded.
Exhibit 5 below highlights a new thirty-two year high in corporate debt issuance as a % of GDP. As in past cycles, junk bond defaults tend to rise rapidly, and with a lag, as debt increases relative to GDP. As the stimulus from Trump’s massive tax cuts and increased government spending begin to fade, I expect junk bond default rates to move higher and replicate past cycles.
Exhibit 5: Junk Bond Default Rate vs Non-Financial Corporate Debt as % of GDP
Source: Moody’s Analytics
“Americans for a Better Tomorrow, Tomorrow”
– Stephen Colbert, Comedian
In conclusion, a combination of both rising U.S. interest rates and fiscal deficits along with a potentially huge wave of riskier corporate credit provides a backdrop to our next recession, possible by 2020 according to the investment firm Guggenheim Partners.
So, considering the massive debt build up and societal cost of running up huge budget deficits to largely finance tax cuts ten years into an economic expansion, perhaps Mr. Colbert’s gag is truer as opposed to funny.
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.