Troubling Signs in the Corporate Bond Market
We’ve written a lot about government debt and warning signs in the Treasuries market. The US government needs to sell over a trillion dollars in bonds a year over the next few years to finance its skyrocketing deficit. Who exactly will buy all of these government bonds remains unclear and the impact on interest rates could send shockwaves through the entire US economy.
Equally troubling, but less often discussed, are the risks piling up in the corporate bond market.
According to Moody’s, the majority of US companies have a “speculative” credit rating. They are considered high risk. As a result, their debt is “high yield” or “junk.” As an article at Wolf Street points out, there are basically two ways these companies can borrow money in the capital markets. They can issue “junk bonds” or they can take out leveraged loans.
Leveraged loans come with a higher risk of default and banks don’t typically keep them on their books. As Wolf Street explains, banks sell them outright, or they package them into Collateralized Loan Obligations (CLOs). Both individual leveraged loans and CLOs can be traded on the market. Since they are loans, they’re not considered securities, but they trade like securities. Wolf Street calls leveraged loans “the booming sisters of the languishing junk bonds.”
While firms with “speculative” ratings make up the majority of US companies, they have a relatively small footprint in the economy compared to corporate giants like Walmart, Amazon and Apple. Consider that Walmart is currently selling $16 billion in bonds in order to buy a 77% stake in Flipcart, India’s biggest online retailer.
According to Moody’s, there are $1.27 trillion in junk bonds in the marketplace. That accounts for about 17% of all corporate bonds – a relatively small sliver. But when you add $1.45 trillion in “leveraged loans” to the picture, the total level of “junk” debt rises to 37%. That represents a significant level of high-risk debt.
Interestingly, while year-to-date junk bond issuance has dropped 20% so far in 2018, the number of leveraged loans issued this year has risen 2.4% from a record level in 2017. And it surged 37% year-on-year in May. This is the first year that leveraged loans have bypassed junk bonds.
There are other troubling signs out there in the corporate bond market. The highest grade bonds are vanishing, and there are a growing number of companies on the cusp of becoming what are known as “fallen angels.” Wolf Street explains:
In terms of dollar amounts, 56% of outstanding debt is rated “medium grade” (from A3 to Baa3), according to Moody’s. Baa3 is one hair above junk. A one-notch downgrade pushes a Baa3-rated company into junk territory and turns it into a ‘fallen angel.’ In other words, the majority of companies sit one to four notches above that level. Since 2009, the amount of this outstanding “medium-grade” debt has surged at an annual rate of 10% to a record of $4.1 trillion, up 120% since the beginning of 2011.”
Medium grade bonds – just steps above junk – now dominate the market.
Keep in mind, the chart does not include the surge in leverage loans. If you include them, the total of $2.7 trillion in junk-rated debt would climb half way up the chart.
The bottom line is there is a growing bubble of risky debt out there in the corporate bond market. As interest rates climb, it will become more and more difficult for these “junk” companies to get capital. That could mean an increase in corporate bankruptcies. And many analysts say a bursting corporate debt bubble will take the stock market down with it.
Last fall, Mint Capital strategist Bill Blain issued a warning, saying the great crash “is going to start in the deeper, darker depths of the credit market.” And former Fed chair Alan Greenspan issued also warned us: Beware, the bond bubble is about to burst. And when it does, it will take stock prices down with it. How it will all play out remains to be seen, but there certainly seems to be some troubling signs out there in the corporate bond market.
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