I am often writing down what is going on in the markets in order to help keep track of my own thoughts, and to be able to go back and see what I was thinking in the past. I have decided to share these thoughts with the general public, and hope some of you will learn something from what I have written. Please enjoy my first blog post on the bond market.
The US Government Yield Curve:
Is the bond market an efficient pricing mechanism that is capable of pricing in future economic outcomes? Unlike the stock market, the bond market is largely dominated by institutional investors with little retail participation. Generally, institutional investors are considered more sophisticated meaning they are better at processing information and accounting for changes in the market. These market participants priced in the past seven recessions which is demonstrable when looking at the 10-2s market, as seen below:
It seems the answer to my first question is yes. Now, the last four market peaks occurred approximately one, nine, nineteen, and nineteen months (rounded-up) after the yield curve first inverted (when the 10-year yield minus the 2-year yield equals less than zero). However, we have not seen an inversion in the 10s-2s; we have seen an inversion in the 5s-2s, which of course could be a temporary dip with no meaning. Although, looking at data from the past four recessions, we see that an inversion in the 5s-2s was followed by an inversion in the 10s-2s by fifteen months, eleven days, five months, and one month later. The 5s-2s did re-steepen during all of these periods after the initial inversion; however, it was never more than 6 basis points, other than prior to the 2001 recession when the fed had to loosen monetary policy during the Long-Term Capital Management fiasco (it steepened to 27 basis points before re-inverting shortly after). This is by no means a large enough dataset to infer the 10s-2s should invert because the 5s-2s inverted, however, it must be considered as the 10s-2s is only 16 basis points away from inverting at the time of this writing. If the bond market is right, then a recession and a stock market peak may not be too far off, or has already happened in latter case.
The Corporate Bond Market:
Moving onto the corporate bond market there is a common signal between Baa corporate bonds and US sovereigns that is currently flashing red. The private sector yield curve inverted earlier this year according to research from Gavekal, as seen below:
This yield curve also has a remarkable consistency of leading peaks in the US stock market and recessions. Even though it missed the recessions in 1970 and 1973 where it inverted during the recessions, and was very early prior to the 2001 recession, it is still a reliable indicator. The bond market is/has been signaling something that the stock market may only be seeing now, which is a potential slowdown as mentioned previously. I will note that, generally prices lead the market, which is why US stocks typically peak approximately one year before a recession.
The investment grade corporate bond market, specifically that rated BBB, has dramatically increased in size over the past several years. This is the lowest rating above “high yield”, which carries significantly greater risk. According to data from PIMCO, BBB's share of total investment grade debt outstanding has increased to 48% in 2017 from the 25% share seen in 1990. Strangely enough the increase in BBB ratings has come with an increase in net leverage, which has increased from 1.7x in 2000 to 2.9x in 2017 on average, as seen below. One would think this would lead to a greater share of BBB's being lower than investment grade with these higher levels of net leverage. (Net leverage is defined as (total debt – cash – short term investment) / EBITDA)).
Looking at the spread between Moody’s Baa Corporate Bond Yield and the 10-year US treasury yield, we see that in January 2018 we were at the lowest spread since just before the 2007 financial crisis with the spreads steadily widening since. (Note: Baa is the same as BBB, the only difference being the former is Moody's scale and the latter is Standard & Poor's scale). Now going from a historically low spread to a higher spread does not mean a stock market crash or recession is imminent, however, it does mean the bond sees rising risks in the lowest investment grade corporate debt.
Shifting the supply side of the credit markets, the lowest quality borrowers are most impacted in a recession due to a multitude of factors such as: leverage, cyclicality of earnings, etc. Take the HYG iShares iBoxx High Yield Corporate Bond ETF as an example, which fell 37% (excluding distributions) from its peak in August 2007 to its trough in October of 2008. Any retiree expecting to preserve their capital in the HYG, while receiving a generous distribution would of had a rude awaking when they learnt they had a 37% paper loss (unrealized loss).
Spreads are also widening in the high-yield market. This is bad news for high-yield bond investors because, according to research from Credit Suisse, default rates tend to track credit spreads, as seen below.
Meanwhile, the Financial Times reported that there hasn't been a single bond priced in the $1.2 trillion dollar junk bond market in December, which would be the first time since 2008 that this has happened. Anyone who understands how the economy operates knows it is based on liquidity and lending is the essential input to drive liquidity. If lending slows, it could mean growth slows, barring some liquidity miracle from overseas, such as a coordinated effort to pump liquidity by central banks. While liquidity slows, spread widen with default rates to follow, the bond market is sending the signal of a slowdown, even if it's only a temporary one.
The Leveraged-Loans Market:
What is the leveraged loan market telling us? For those who don't know, a leveraged loan is a "type of loan that is extended to companies or individuals that already have considerable amounts of debt and/or a poor credit history", and carry a "higher risk of default" according to Investopedia. It carries a floating-rate of interest, unlike regular bonds, which makes them more attractive during rising yield environments.
Data from the Bank for International Settlements depicts the growth in the leveraged loan markets and the covenant-lite loans issued during this cycle. Leverage loans increased from $1.3 trillion in late 2008 to over $2.4 trillion currently with just fewer than 80% being covenant-lite in nature.(Covenant-lite means there are less rules for protecting bond investors' interests).
The Invesco Senior Loan ETF (BKLN), one of the largest leveraged-loan ETFs, has seen its largest ever monthly outflow of $800 million in November, according to Zerohedge. Morningstar describes the two star fund as offering “an attractive yield with low interest-rate risk and a reasonable fee; however, it takes considerable credit and liquidity risk”. Hopefully, investors in the fund are aware of these risks.
Meanwhile according to Bloomberg, the “U.S. leveraged-loan funds saw $2.53 billion of net outflows in the week ended Dec. 12, the biggest decline on record”, and the fourth week in a row of outflows. Prior to these massive outflows, we were heading for a record year of issuance in the leveraged-loan market. If these outflows continue, leveraged loan issuers may have issues finding buyers for the staggering amount of credit hitting the market. Another example of liquidity in the credit markets starting to slow.
To summarize the risks presented by the growth in the leveraged loan market, the BIS writes:
“As business cycles mature, however, investors may start to incur losses. The default rate of US institutional leveraged-loans increased from around 2% in mid-2017 to 2.5% in June 2018. Going forward, as monetary policy normalizes, the floating rate feature of leveraged loans could trigger defaults by worsening borrowers' debt coverage ratios (DCRs): the ratio of net operating income to debt service costs.”
To answer my original question: what is the bond market thinking? Well it is quite clear that it sees a mix of growing credit risk, while leverage in credit markets continues to grow, and lower levels of liquidity. It sees slowing growth globally, which I will touch on in a later article, and it is beginning to position itself for these risks. While it is difficult to know whether this is just a temporary event, much like the first quarter of 2016 in the energy markets, or this is just the beginning of a more meaningful move. One thing for certain is that most of the world is in a bear market, while the three most important factors to corporate margins had all been rising until recently: oil, the USD, and credit costs (with the latter two still rising). Only time will tell if the bond market was thinking something the stock market is only beginning to see. In the meantime I continue to watch these developments as they occur.
Disclosure: I am/we are short HYG.
Additional disclosure: This does not constitute investment advice, and should not be taken in isolation. Use proper judgment when making investment decisions, and ask your licensed Investment Advisor about anything mentioned in this article, as I am not licensed to provide investment advice.