For years, it appeared that nothing could shake the relentless bid for US corporate credit, whether in the investment grade space or in junk bonds. In fact, just over a month ago, on October 2, we reported that high yield spread printed the tightest levels seen since the financial crisis.
A lot has changed since then.
As discussed earlier after ignoring the move in stocks, credit spreads have been rocked sharply wider due to a confluence of negative factors ranging from the plunge in stocks and spike in the VIX, escalating trade war concerns, fears about rising rates and deteriorating fundamentals, worries about the end of the US fiscal stimulus, Brexit and Italy’s budget's woes, and last but not least, the recent collapse in GE and PG&E bonds.
In fact, junk bond spreads blew out by the most in almost two years last week, leaving the lowest-quality U.S. companies paying the most for their debt since mid-2016 according to Bloomberg. The yield on the Bloomberg Barclays US Corporate High Yield Total Return Index has risen by over 100 basis points since Oct. 1 to almost 7.2%, the highest since June 2016. The spread on the index widened by 51 bps, its biggest weekly gain since February 2016.
As the chart below from Goldman shows, last week credit had its worst return since the oil price troughed in early 2016.
The repricing was most acute for CCC-rated debt, which after outperforming the rest of the high yield market, saw a sharp, 200 basis point jump in the average yield to about 10.8%. And, as shown in the chart below, investment grade debt wasn't spared -or spread - either, blowing out by nearly 20 bps since the first week of November.
Meanwhile, after today's latest blowout, credit-default swaps on North American investment grade corporations are now wider than they were the day Donald Trump was elected. According to Bloomberg's Sebastian Boyd, since November 2016, the return on investment-grade credit has been a pathetic 0.6%.
As Boyd warns, "it's hard to see the outlook improving" adding that "the market last week got itself very excited about an apparent change in tone from the Fed, but leaving aside the likelihood that there's a bit of self-deception going on there, rising-rate environments are terrible for investment grade. They're not great for junk either."
Meanwhile, as 2019 progresses, the risk of the Fed overshooting will rise, and as Goldman warned last night, the Federal Reserve has never engineered a soft landing when the labor market was beyond full employment as it is now: "If it fails to stick this one, which is the most likely outcome, junk investors will feel much of the pain" Boyd said.
That said, not everyone is doomy and gloomy: despite the recent turmoil, the U.S. junk bond market should remain supported by steady growth and robust earnings, and the default rate is expected to be low according to Deutsche Bank's Jim Reid, however despite a relatively manageable debt maturity schedule, as financing costs increase, balance sheet risk will come into focus. Below we republish some of Reid's thoughts on what happens next to the US corporate bond market, and why the next recession could be devastating for trillions in deteriorating credits:
We have been on the underweight side of credit all year, more weighted to a US underweight of late but that’s been more of a valuation play than over too much concerns about immediate credit quality. The US economy remains strong and credit deterioration is likely to remain idiosyncratic until it rolls over.
At that point we will have big problems though and last week’s activity made us more confident liquidity will be bad when the cycle turns as we moved a fairly large amount on nervousness as much as anything else.
GE, PG&E, plunging oil and the factors discussed above provided a jolt but we don’t think this is enough for now to impact the economy so credit will probably stabilise. However once there is actual broad economic weakness, this last week will be a dress rehearsal for the problems ahead and there will be little two-way activity with spreads gapping wider.
To Reid, these various circles of credit hell are not quite here yet and are reserved for further down the cycle:
"For now credit’s main problem has been it hadn’t responded enough to the pick up in vol. The good news is that this is starting to catch-up and correct. Last week, EU non-fin. IG spread widened by 13bps and HY by 45bps while those on US IG by 14bps and HY by 49bps."
On the other hand, if predictions of a sharp slowdown in the US economy which could kick in as soon as the first half of 2019 are confirmed, then the worst case scenarios about corporate credit being the culprit behind the next financial crisis will surely be justified.