The dovishness from the Fed has been bullish for most of the debt market, with sovereign yields falling and corporate debt getting a boost. However, the riskiest corner of the market, triple C junk bonds, have been left out, with the group falling by 1.5% since May. Triple B bonds, by comparison, were up. The odd part about the losses is that signs of an interest rate cut are usually very bullish for junk bonds because they would mean lower interest burdens for the companies. That said, anxiety about the economy is high enough that such benefits were negated.
FINSUM: This whole situation makes sense in that the downside risk of a sinking economy is greater than the upside of lower interest rates for this subsector. Thus, the bonds are losing. In other parts of the credit spectrum, the risk-reward balance is different.
For many years after the Crisis, the main theme around consumer debt was the idea that Americans were deleveraging. However, steadily, consumer debt has risen back to alarming levels. In the first quarter of this year, consumer debt hit $14 tn, surpassing the $13 tn of leverage pre-Crisis. Student debt has been a major area of credit expansion. Even when comparing debt to the population, the debt per person is a little higher than in 2008.
FINSUM: So obviously inflation needs to be accounted for here, but the picture is still worrying. It is yet another sign that we may be nearing the end of this run.
More some time now, bonds have been sending worrying signals to investors. The huge plunge in yields has been seen as a warning sign that the economy may be headed south. However, more recently, fixed income is sending more comforting signals. In particular, the recent narrowing of corporate bond spreads. Bond spreads had been rising for some time, but have leveled off recently, showing fixed income investors are not as worried about the economy and corporate performance. The overall spread is still well below where it was in the 2015-2016 growth scare.
FINSUM: The leveling off of spreads is a good sign that some stability is coming back to the market.
There has been growing consternation about the threat of a major meltdown in corporate debt. The Fed, in particular, has been very troubled by the amount of corporate debt in the economy, which has led to speculation by Wall Street that there could be a blow up. Goldman Sachs has been more sanguine, saying debt levels look healthy. Now the Fed appears to be taking a more mild view as well. In a speech this week, Chairman Powell said that the comparison to pre-Crisis debt levels are not convincing. “Most importantly, the financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages.
FINSUM: Debt levels seems high, but profits are margins are good to. The question is what happens when the economy turns south. We are especially concerned about the BBB market.
Investors beware, the muni bond market has gone through some dramatic moves over the last year, and the market looks like it might be headed for a downturn. Changes to the US’ tax policy have caused massive inflows to muni bonds as investors try to minimize their taxes. This has caused yields to plunge and spreads to Treasuries to widen. The average ten-year muni yield is now just 1.965% versus 2.6% in 10-year Treasuries, the widest gap since at least 2009. Munis in high tax states have plunged even further, with a recent California issuance having a yield of just 1.73%. One portfolio manager warns investors that they need to be responsive, saying “The best place for investors to be is shorter duration, higher-quality credit, so when opportunities present themselves, they have the flexibility to take them … You can’t really set it and forget it”.
FINSUM: This is a hard situation to call. On the one hand, the rapid fall in yields is worrying and the market seems overbought, but on the other hand, you have somewhat artificial demand being created by the government, which makes the behavior less risky and more sustainable in our view.