After years of resolutely ignoring any adverse macro news and negative fundamental developments, bonds – whose spreads had touched decade tights at the start of October amid an unprecedented scramble for yield within the fixed income community – are suddenly being dumped with a passion. Indeed, it appears that the good times for bonds – both investment grade and high yield – are coming to an end, with this week’s turmoil in General Electric credit – first profiled here and subsequently in the WSJ – a clear sign that things can and likely will get much worse.
To see the sudden revulsion surrounding junk bonds in action, look no further than the spread on the Bloomberg Barclays Corporate High Yield index, which has spiked from a decade low of 3.03% on October 3 to 3.92% overnight, the widest since April 2017.
To be sure, there is some good news. According to Bank of America, it is far too soon to panic, because when the next slowdown strikes, investment-grade bonds will see a record-low rate of cuts to junk.
“The credit quality of high-grade companies is the best it has been in decades, as companies and industries have been tested and forced to improve,” BofA credit strategist Hans Mikkelsen wrote in a Nov. 14 note. And that’s “one key reason that in the next downturn the rate of downgrades to high yield is likely to be the lowest ever.”
According to Mikkelsen, who dedicated his entire note to placate panicked bond investors, the reason not to worry about the energy sector – one of the biggest subsectors of the US high yield market – is because 4 years ago “it went through a major stress-test” when oil prices last plunged. “That forced companies to deleverage, be conservative about capex and work to aggressively lower break-even oil prices.” Additionally, Mikkelsen argues that the financial crisis and Dodd-Frank greatly improved the credit quality of banks.
Of course, one could easily argue the opposite, namely that artificially low interest rates enabled a massive debt-issuance spree which has left most companies burdened with more debt than they can handle either during the next financial crisis or as rates keep rising, resetting the cash interest rate ever higher on existing debt along the way. This was precisely the argument behind Jeff Gundlach’s most recent warning to corporate bond investors.
And while BofA’s complacent take may be the good news, the bad news is that the market – having engaged its semi-panic puke mode, refuses to step off the gas and even though oil has stabilized in the past 48 hours after a record, 12-day rout, that’s not helping high-yield energy.
As shown in the chart below, Bloomberg’s HY Energy OAS Index soared this morning to the highest in 12 months, at just shy of 500 bps. And since energy is the third-largest sector in U.S high yield indexes, it’s now dragging the whole market wider.
Commenting on this blow out, Bloomberg’s Sebastian Boyd writes that while it’s tempting to argue that bondholders are anticipating further declines in oil prices, the index has tracked oil prices pretty closely in the past 12 months, so “it’s hard to say which one leads and which lags.”
Separately, CreditSights analysts have joined Bank of America in advising bondholders to hang on and wait for the pain to pass while Wells Fargo also agrees with Mikkelsen that high-yield oil and gas companies are better placed to get through a price slump now than they were in 2014 after deleveraging and improving balance sheets.
As a counter to this optimism, Boyd presents the following chart showing ratings of bonds in the ICE BofAML index over time. While ratings are a simplistic reflection of reality, if one accepts that they’re a decent enough proxy for credit risk then “the data does not show credit quality in the sector improving over time.“
Boyd is not the only one who is skeptical on credit, which has been hammered not only in junk, but more notably also in high grade. In the aftermath of the previously noted rout in the bonds of GE, which is facing weak demand for gas turbines, high debt levels, a federal accounting probe and is no longer eligible for commercial paper issuance and so has to rely on bank revolving credit facilities…
…blue-chip company debt has been clobbered this week, and is on track for its worst year since 2008, largely due to concerns about some $2.5 trillion in BBB-rated bonds – more than double the size of the entire high yield bond market – which risk being downgraded to junk during the next crisis resulting in a yield explosion across the high yield space.
“GE is a harbinger for what’s going to happen when large capital structures get downgraded,” said Josh Lohmeier, head of U.S. investment-grade credit at Aviva Investors, which manages more than $480 billion. “It’s going to be messy, and it’s going to be painful.”
Lohmeier isn’t the only one flagging such risks. Earlier this week, Guggenheim CIO Scott Minerd said that GE’s selloff is just the start of a “slide and collapse” in investment-grade credit. As we previously noted, Jeffrey Gundlach said corporate debt is the “most dangerous” part of the high-grade bond market.
What is notable is that for years, virtually nobody had anything bad to say about credit, whether IG or HY, and now – following the blow out in yields – it suddenly seems that everyone, with a few exceptions, is bearish as commentary once again follows price action (as usual).
Which is not to say that the bears are wrong: in fact, if the Fed indeed continues to hike rates and if oil continues to slide, if vol continues to rise and stocks continue to sell off, it is only a matter of time before the selling across credit hits a tipping point and the next widespread market puke hits, sending yields to levels that will force either the Fed, or other central banks, to step in and buy what investors have to sell. Because 10 years into the biggest central planning experiment in capital markets history, expecting traders to be able to price assets only on fundamentals, may be asking too much.