If you look at some of the areas hardest hit by fears over the economy and the trade war, there is cautious optimism starting to show up. One of the best examples of this is the corporate bond market. Investors have been pulling money from the stock market and sticking it in bonds. They appear to be unworried about high debt levels or the possibility of default. In this move, there is an underlying faith that the US economy will stay solid, otherwise credit-worthiness would be seriously in question. Spreads to Treasuries are very low too, further reflecting the optimism.
FINSUM: It seems like the market is worried that stock valuations are tapped out, but that there may not be a significant downturn. In such a case, corporate bonds look like a good bet.
It is finally happening—riskier junk bonds are seeing outflows as investors shy away from the lowest rated credits. Junk bonds have been coated in Teflon for the most part, with the riskiest bonds rallying for several months. But recently, alongside recession fears, investors have been more anxious about how such credits might fare in a downturn. Accordingly, spreads between CCC-rated bonds and BB-rated bonds have jumped to 8%, the highest level since 2016.
FINSUM: This makes a lot of sense, and is one of the more logical moves in the high yield market we have seen in some time.
The muni market has traditionally been a safe haven for investors seeking steady returns. However, things are beginning to change. The huge drop in yields is fueling some very risky behavior in certain corners of the muni bond market. With yields on even the riskiest munis down to about 4%, highly speculative borrowers, such as those building risky mall developments or far-away housing projects are raising muni money through governmental agencies.
FINSUM: Investors need to look out for these kind of deals. However, what could be more troublesome is how they will inevitably end up in many popular funds without investors even having awareness of them.
While many are worried about the domestic economy and whether the US is headed for a recession, those invested in emerging markets should perhaps be even more concerned. One of the fears specialists in the area have is that there is probably about $200 bn of unreported Chinese loans on the books of emerging market borrowers. China is not obligated to report these loans anywhere, so no one is quite sure of the size of the exposure. The risk is that as the economy sours, and these credits debts become distressed, China could impose some severe conditions on borrowers, which could cause emerging markets to seize up.
FINSUM: We could see this becoming an issue, especially because China will be feeling distress itself, which means it is likely to use a heavy hand. Even if nothing comes of this, it will likely weigh on EM asset prices in the near-term because of the uncertainty.
High yield companies have been big beneficiaries of the tumble in yields this year. But not in the way one thinks, not in the form of a big rally. Instead, highly indebted borrowers have been using the tumble in yields as a way to refinance their debt and lengthen out maturities. The practice has been very widespread. According to one portfolio manager, “It’s a recipe for disaster in the longer term … As an investor, it means you are lending to fairly risky companies at fairly low rates at the end of the cycle. It might not be three months from now or six months from now, but at some point these bonds are going to be pretty challenged”.
FINSUM: Kick the can down the road for as long as you can. That has been the mantra of junk bond markets since the Crisis. When will the musical chairs stop?