Is this the beginning of the end for bond markets?
The corporate bond market has had its worst year since 2008. And it doesn’t look like things are going to get much better John Stepek explains what’s going on.
"The slide and collapse in investment grade credit has begun".
That was a pretty unequivocal tweet from Scott Minerd of Guggenheim Partners last week.
Minerd was referring to the slide in the value of General Electric's bonds. The conglomerate has a whopping $115bn of debt, and has lined up asset sales worth as much as $40bn to pay it off.
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It remains to be seen if GE can pull it off. But as Minerd notes, GE is far from the only troubled company out there.
The weakest spot in the bond markets
Investment grade corporate debt has fallen by about 3.5% in value this year, according to Bloomberg. If you're more accustomed to investing in stocks, that sounds pretty unimpressive. That's nothing more than a bad day at the office for an equity investor.
But in fact, that's the worst year for investment grade corporate bonds since 2008. Back then the market shed nearly 5%. Again, it may not sound that scary. But back then, markets were bailed out by being in a deflationary environment (good for bonds overall) and also because the central bank stepped in to make sure no one could go bust.
Those comfort blankets may have been removed now. And that's one reason why the market is starting to act up.
The most specific weak spot right now is the junk bond (also known as "high yield") market. Oil and gas companies are among the biggest issuers of junk-rated debt (debt which is considered at high risk of potential default) in the market right now, accounting for about 15% of the market. The only sector with more debt is media.
The plummeting oil price both Brent crude and the US benchmark, WTI, are now in bear markets has hit sentiment hard. Falling oil prices are bad for oil company profitability, which in turn makes their debt riskier.
So for example, last week, the biggest high-yield exchange-traded funds (ETFs) suffered their worst falls since early February, which is when the markets had their last significant panic. And the iShares high-yield ETF hit its lowest level since June 2016.
We've seen this before, but Janet Yellen is not in charge now
We saw something similar to this when the oil price crashed back in 2014. Everyone started to fret about what would happen if oil companies started to go bust.
At the time, the big fear was that there would be some sort of systemic knock-on effect. I felt that this was unlikely. Everyone gets worried about "systemic" problems because that's what happened at the last financial crisis.
But oil company debt doesn't pose an obvious systemic risk. The people who own it, know that they own it. And they mostly understand that it's risky. It hasn't been bundled up and repackaged as a AAA-credit rated US Treasury substitute.
As it turned out, the last time this happened, oil companies continued to be able to roll over their debt in most cases, because lending was still free and easy. So everything ended up being just fine.
Is that what'll happen this time? It'd be nice to think so, but I think the risks are higher today.
The most obvious difference between now and 2015 is that the US no longer has a sympathetic Federal Reserve chairman in the form of Janet Yellen. Today, the Fed is much less inclined to step in with the soothing balm of potential interest rate cuts.
That's because we're no longer in a deflationary environment. Markets can't quite bring themselves around to the idea of this, but the Fed genuinely does now see inflation as the enemy. Given that US interest rates are still very low in "real" terms ie, when adjusted for inflation the Fed sees no reason to back off yet.
So what are the likely outcomes here that might turn this around? The Fed might at some point, relent. But markets would probably have to fall further from here. Jerome Powell knows that he'll be tested and I think he'd rather call the market's bluff for a while rather than roll over at the first sign of a double-digit drop in the US market.
The other option which I think might be more likely is that we see oil prices perk back up. That in turn could give the high-yield market a reason to rally.
Yet, whatever happens, it's hard to see how life is going to get any easier in the mid-to-long term for junk bonds.
The only way that junk bonds can do OK in a rising rate environment is if rates are rising because of strong economic growth. If that's the case, then the discomfort of rising rates is offset by the stronger economic backdrop (which lowers the risk of default).
But if rates are rising because inflation is perking up, but growth is still mediocre, then that's not good news for junk bonds. Your real return falls and your credit risk goes up.
And if the opposite happens we end up returning to a recessionary environment in which the Fed feels the need to cut rates or go easy on them, you've still got the problem of rising default risk.
In short, if you currently own a significant holding of junk bonds in your portfolio, I'd advise you to take a close look at your rationale for doing so.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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