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 are currently worried about corporate bonds. On the one hand performance has been pretty good, especially for the riskiest bonds. But therein lays the problem—highly indebted companies have not been punished and there appears to be way too much corporate debt at the moment. This is the Fed’s view and many market participants, but Goldman has shared another—that the amount of corporate debt in the economy is just fine and corporate balance sheets look healthy. The bank says US companies are in an “unusually healthy position this deep into a business cycle expansion”. Goldman notes that companies are spending a smaller share share of their cash flow on interest than they were a decade ago, and that they are earning more than they are spending.
FINSUM: The corporate debt situation is all about perspective. Things look better than in the last crisis, but anyway you slice it, the debt burden looks at least somewhat daunting.
A rising tide lifts all boats right? Well it also means credit scores get lifted alongside the economy. Goldman Sachs thinks this is a problem. The bank is arguing that credit scores have been artificially inflated by FICO, a dangerous development that could have implications for all sorts of lending. Goldman thinks that current FICO scores are not an accurate reflection of consumers’ ability to pay in an economic downturn, meaning there is much more credit risk sloshing around in the economy than is currently priced into the market.
FINSUM: The big risk here is really at the lower end of the lending spectrum. There are 15 million less consumers with scores of 660 or below than there were before the last Crisis. Therefore, the risk of borrowers in that area is probably being underappreciated.
We don’t want to say that we told you so, but we have been broadcasting that bond markets had overreacted to the Fed’s change of tune. This week, bond investors have started to correct themselves as yields on the ten-year have jumped considerably on better economic news. With that in mind, limiting rate risk on bond holdings has taken on renewed importance. Accordingly, where better to be that in short-term, less rate-sensitive, bond funds. For options here, take a look at the Vanguard Short-Term Bond ETF (BSV), yielding 2.8%, and the PIMCO Enhance Short Maturity Active ETF (MINT), yielding almost 3%.
FINSUM: We think there could be some significant yield volatility in the next few months, and therefore feel it is best to stay rate hedged/defensive.
The general understanding of markets is that bond investors are signaling that there is going to be a recession. Treasury yields have tumbled, and the Treasury yield curve has inverted, both signs of a coming downturn. However, the corporate bond market is sending a different signal, and it is worth paying attention to. The big sign of economic worry in the corporate bond markets is widening spreads between investment grade bonds and junk, but that is exactly the opposite of what is happening. The market is sanguine, and showing little of the concern that Treasury markets are. “Corporate spreads are extraordinarily narrow”, says Dan Fuss, vice chairman of Loomis Sayles.
FINSUM: This is a very good sign in our opinion. While it could turn out to be wrong, we do think this signals that Treasury investors may simply be overreacting.