A New Blow-Up in the Junk Bond Market
A milestone for inflation... Don't expect the Fed to stop hiking rates any time soon... A new blow-up in the junk bond market... Prepare for more 'surprises'...
It's (almost) official...
According to the U.S. Commerce Department, consumer prices – as tracked by the personal-consumption expenditures ("PCE") index – rose at a 2% annualized rate in March.
Meanwhile, the so-called "core" PCE index – the Federal Reserve's preferred inflation gauge, which excludes food and energy prices – rose 1.9%. This is the highest rate in nearly six years – since April 2012 – and just shy of the Fed's official 2% target.
Perhaps most important, both measures are now at or above the Fed's median year-end forecast from its most recent meeting in March.
We noted last month that new Fed chair Jerome Powell has already been more "hawkish" – or in favor of tighter monetary policy – than previous chair Janet Yellen. He believes inflation is headed significantly higher, and these data are likely to strengthen his case. Barring a sudden reversal, expect the Fed to stick to its plan to raise rates at least three more times this year.
In other words, the "tide" will continue to go out...
Sooner or later, rising rates and tighter monetary policy will spell trouble for our debt-addicted economy...
And as regular Digest readers know, we believe the most serious problems are likely to develop in the high-yield (or "junk") corporate-bond market.
U.S. companies have "levered up" like never before. More than $1 trillion worth of these speculative bonds is set to come due over the next four years... and there is simply no way most of these loans can be repaid or refinanced.
Last fall, we got a glimpse of what is likely to happen to many of these companies, as the bonds of struggling toymaker Toys "R" Us cratered nearly 70% in less than one month. Last week, we got another...
On Wednesday, news surfaced that American Tire Distributors was in trouble...
Reports said one of the company's major customers – Goodyear Tire & Rubber (GT) – planned to drop it as a supplier. This led ratings agency S&P Global Ratings to downgrade the heavily indebted company from B- to CCC+... and the company's bonds crashed 60% almost immediately. As Bloomberg reported...
Investors got schooled on the dangers lurking in a high-yield market priced for perfection last week as bonds issued by American Tire Distributors plunged into the abyss...
The benchmark $975 million bond due 2022 tumbled to as low as 40 cents on the dollar Wednesday, according to Trace data. It traded as rich as 102.25 cents as early as April 16.
Today, junk-bond yields remain near historic lows...
Likewise, the "spread" – or difference – between the yield on low-quality corporate bonds and investment-grade corporate bonds has rarely been smaller.
Meanwhile, money continues to pour into the riskiest bonds. More from Bloomberg...
Safer types of debt, like Treasuries and investment-grade corporate bonds, have dropped this year. But the riskiest high-yield bonds – rated in the CCC range – gained 0.9 percent through Wednesday. And loans to junk-rated companies have risen even more, decoupling from bond prices that they are usually tightly correlated with.
Investors' willingness to take on credit risk was evident in the market for new bonds and loans this week. WeWork, an office-space-leasing company with negative free cash flow rated Caa1 by Moody's Investors Service and B+ by S&P Global Ratings, sold $702 million of bonds on Wednesday, and received orders for around three times that amount. Jagged Peak Energy, an oil and gas driller rated B by S&P, got orders for its bond sale equal to five times the amount originally offered.
In short, junk bond 'investors' simply aren't worried about these unsustainable debts...
Yet.
Regular readers know it's only a matter of time before the market wakes up to these problems... and these two recent examples show just how quickly it can move when they do.
We expect to see more of these "surprises" in the weeks and months ahead, until eventually a real panic begins.
Stay long, but stay smart. And keep an eye on the bond market for early signs of trouble. As Porter explained on Friday...
The most important indicators and warnings will come from the corporate-bond market. The three most important indicators are:
- The prices of junk bonds. As credit tightens, the prices of junk bonds will fall. You can watch junk-bond funds – like the Shares iBoxx $ High Yield Corporate Bond Fund (HYG) – to monitor these prices.
- The interest rate "spread" between high yield debt and U.S. Treasury securities. As defaults grow, the increased risk will be expressed in much higher interest rates for weak borrowers.
- The 10-year U.S. Treasury yield. If safe yields on government bonds reach 4% or more, there will be complete carnage in the corporate-bond market, where average rates to refinance outstanding debts will probably double.
New 52-week highs (as of 4/30/18): Pioneer Natural Resources (PXD).
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May 1, 2018