INSIGHTS

Stefano Sciacca

Fri, Dec 20


Junk or Investment Grade? It does not matter anymore

A new pattern seemed to take place this week. For the first time over the past 12 months, the spread (i.e. yield differential) between junk (lower credit rating) and investment grade (higher credit rating) bonds has plunged. According to Bloomberg, the US BB-rated corporate bonds currently offer an average yield of 3.51%, only 164 basis points above the 10yrs US Treasury yield. If we went backwards by 12 months, we would see AA-rated securities such as Apple, Berkshire and Exxon yielding about 3.58%, hence, higher than the current BB rated corporate bonds’ yield. 

As shown on our Chart of the week, fixed income investors that currently own BB rates securities seem to have a one-in-a-lifetime “low-cost” opportunity to upgrade to BBB, hence, from junk to investment grade by only giving up about 0.38% of their current projected yield (0.91% and 1.13% to upgrade to A and AA, respectively). Of course, there are several factors that lie behind the scenes of this new junk bonds euphoria such as declining tail risks and facilitated funding conditions thanks to the Fed’s aggressive REPO strategy and open market operations. Most of all, the circa $17tn worth of negative yielding securities whose return has tumbled due to something like 51 rate cuts throughout 2019. Even Bank of America in its last report noted: “They are cutting rate like it is a crisis”, as we need to go back to 2008 to see such an expansionary/dovish monetary policy worldwide.

A focal point is that 55% of BBB-rated bonds would have a junk like credit rating if it was for financial leverage alone, as overall corporate leverage spiked to record highs.  

The highest headwind remains the potential rising of idiosyncratic risk in 2020, caused by deteriorating balance sheet fundamentals, corporate earnings slowdown and, overall lower free cash flow. This will complicate the corporates’ already challenging debt reduction schedule and future prolonged shares buybacks (historically associated to high newly debt issuance proceedings) and rise in dividends. Labour cost is also expected to outpace inflation flattening corporate earnings and eroding free cash flow, especially for smaller players with naturally lower pricing power.

The aftermath will disappoint equity investors and will eventually lead, coupled with a further global growth slowdown due to the inevitable approaching business cycle end (i.e. recession), to a 15 to 20 percent stock market correction.

According to Goldman’s latest quite bearish report, the current average net debt to EBITDA ratio amongst the largest non-financials BBB-rated issuers is 0.53x higher than 2017 year-end, right after the approval of the TCJA (Tax Cut and Jobs Act) stimulated the financial markets. Then, what asset class is going to benefit the most? Maybe Gold, maybe bitcoin…

 

Next week our macro spotlight will be on?

Monday:

  • New Home Sales - US

Tuesday:

  • Durable Goods Orders - US

Thursday:

  • Continuing and Initial Jobless Claims - US

Friday:

  • Industrial Production – Japan
  • Industrial Profits – China
  • Finance Mortgage Approvals - UK

 

Chart of the week

 

Fact of the week

BB-BBB Corporate Bonds Spread close to the lowest level in 10 years as surprisingly more risk-tolerant investors now seek yield within the “junk bond” category.

 

Quote of the week

“I might also say that I think in this country, there's a little bit of mis-underestimation of what's going on in the rest of the world, the e-commerce growth, the technology sector that we had, the tax cut, all of these things have led us to have a high increasing employment. It's led us to have reasonable GDP growth. That's virtually not true any place else in the world. And the industrial economy, particularly in Europe, which was hit by the ricochet bullet of the U.S./China trade war almost went into recession this time last year. And it still hasn't recovered. And Germany, in particular, is extreme”

Frederick W. Smith, FEDEX Founder, Executive Chairman and CEO


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