A 'Red Flag' in the Riskiest Corporate Debt

This signal says the bond boom is over... A multidecade extreme in the Treasury market... A 'red flag' in the riskiest corporate debt... An urgent opportunity from Doc Eifrig...

It hasn't happened since the great bond bull market began nearly 40 years ago...

Today, for the first time since the early 1980s, more than 75% of existing U.S. government debt is now trading below "par," or face value.

Over the past 20 years, rarely has more than 50% of this debt traded "in the red" before the bull market resumed. But that hasn't been the case this time, due to a confluence of three particular factors we haven't seen previously. As news service Reuters reported earlier this week...

This is a result of a long spell after the global financial crisis when bonds were issued at ultra-low rates, so those which still trade do so at deep discounts to match returns of newer issues. But since such "off-the-run" issues are less sought after than new bonds and so many of them are underwater, their prevalence weighs on overall liquidity – the ease with which securities trade without affecting prices.

Then there are widespread expectations that the Fed, which started raising rates in December 2015, has some way to go. Markets continue to price in two more rate increases this year, given the Fed's inflation gauge hit its target for the first time since 2012 and economic growth remains strong.

Finally, a once-in-a-generation shift in the balance of supply and demand may make bonds harder to trade, possibly hitting their prices, some investors say. While the Fed unwinds its crisis-era policies by paring back its bond purchases and shrinking its $4 trillion portfolio, the Treasury is ramping up borrowing to fund $1.5 trillion in tax cuts President Donald Trump signed into law last December.

In short, the Treasury market's behavior – and this unusually bearish fundamental backdrop – is further evidence that the 37-year bull market in U.S. government bonds is now over.

Of course, regular readers know we've also been warning of troubles in the corporate-bond market...

They know investors have not only been piling into risky high-yield (or "junk") bonds, but that they've also been buying up tons of the lowest-quality investment-grade bonds as well.

Today, there is more than $1.21 trillion worth of junk-rated debt outstanding, nearly double the total at the peak of the last credit cycle in 2007. Meanwhile, BBB-rated investment-grade debt outstanding has quadrupled to a mindboggling $2.6 trillion over the same period. All told, junk and BBB-rated debt accounts for a little more than half of the entire corporate-bond market.

In other words, more than half the bonds investors are holding today are already junk, or within a single credit downgrade of becoming junk.

That's frightening, but it gets even worse...

You see, "investors" have also been piling into even riskier debt. The leveraged-loan market – where companies that are generally too risky to access even the junk-bond market seek financing – has been booming, too.

Total leveraged loans outstanding have skyrocketed over the past five years to $1.22 trillion today, making this market bigger than the entire junk-bond market for the first time.

Again, this debt is generally riskier than junk bonds...

But as our colleague Dr. David "Doc" Eifrig recently explained to his Income Intelligence subscribers, it has been getting even riskier lately. From the June issue of Income Intelligence...

Any time a room full of professional investors are all talking about the same thing that most everyday investors aren't even aware of, it's time to worry. That's exactly what happened at the CFA Society's High-Yield Bond Conference [in May]. It's a must-attend for any type of high-yield investor.

The conference had a wide range of speakers – including a CEO of an asset-management firm, various portfolio managers, directors from credit-rating agencies, and more. And the topics they covered were even more broad – ranging from high-yield technical analysis strategies, the state of the market today, and the role of exchange-traded funds.

As Doc noted, out of all the presentations he heard, regardless of the topic, one thing was mentioned again and again: covenant quality. More from the issue...

Covenants are basically rules that borrowers and lenders agree upon for debt such as loans or bonds. Covenants are in place to enforce what issuers are required to do (positive covenants) and what they cannot do (negative covenants).

A common example is a restricted payments covenant. These protect the lenders by limiting the company's ability to make undesirable distributions and asset transfers that would hinder the borrower's ability to repay the debt. This can include restrictions on stock repurchases, prepaying junior debt, and dividends. Other covenants may require certain debt-to-assets or interest coverage ratios.

Over the past few years, covenant quality has dramatically declined. Those who thought we learned our lesson about loading up on risk in 2007 are wrong. We're taking on record amounts of risk with the rise in covenant-lite leveraged loans.

Again, leveraged loans are generally even riskier than junk bonds...

So they tend to have several covenants in place to protect the lender. But as the name implies, covenant-lite loans have far fewer restrictions – and, therefore, more risk. But that hasn't stopped investors from buying them up like there's no tomorrow...

U.S. covenant-lite loan issues for 2017 were the highest in over a decade at a record $677 billion. This is roughly double the $350 billion the previous year and far more than in 2007, at about $150 billion. So far in 2018, we're on pace to issue over $600 billion once again. Consumer discretionary and technology firms are the two sectors leading the way.

Moody's Covenant Quality Indicator shows we're near record lows in high-yield bond covenant quality as well. The indicator recently showed a score of 4.32, with a score of 1 denoting the strongest investor protections and 5 the weakest. A score of 4.2 or higher is considered in the weakest-level territory... It's the 11th consecutive month above 4.2.

In total, Doc noted that about 77% of new loans issued today are covenant-lite...

These riskiest loans have now become the standard. And that has him worried...

Almost every speaker at the conference brought this up to illustrate the amount of risk investors are taking in the high-yield market.

With fewer covenants or weaker covenants, firms can make decisions that put their own agenda or their shareholder's needs over their debt holders. This is happening right as interest rates are on the rise, which will make it harder for firms to pay off their debt.

The increase in covenant-lite loans is not going to be a major catalyst to a market downturn. But when the credit cycle does turn, the declining covenant quality will make things ugly. Recoveries on defaulted debt will be severely impacted and investors may not be able to recoup very much money, if at all, when the defaults start to ramp up.

But the rising risk in the credit markets is just one of the potential warning signs Doc is following today...

And while he isn't getting outright bearish today, he has become more cautious on the market for the first time in years.

To be clear, he is NOT recommending his readers get out of stocks. But he is urging them to be more selective with new investments.

Like us, he recommends sticking primarily to high-quality companies and high-conviction ideas. And he says he has found an urgent opportunity that meets both of these criteria today.

In short, Doc has found a safe, blue-chip stock paying a dividend of more than 6%... that he says could double or triple over the next year thanks to two specific events.

If you know Doc like we do, you know he rarely makes bold claims like this... and only when he's absolutely certain of the outcome. Click here to learn more about this time-sensitive opportunity... and how to claim a lifetime membership to Income Intelligence for less than the normal cost of a one-year subscription.

New 52-week highs (as of 7/11/18): Amazon (AMZN) and Quest Diagnostics (DGX).

In today's mailbag, a question on yield curve "inversion." What's on your mind? Let us know at feedback@stansberryresearch.com.

"Hi, I appreciate the regular updates on the approaching [yield curve] inversion. But as with many indicators I try and understand if they are lead or lag indicators. Is it emotional and momentum driven or just the normal cycle of business? You believe the inversion is a lead indicator? Have you considered it might be a lag based on other economic cycles? Thanks." – Paid-up subscriber Jim A.

Brill comment: Looking back over the past several decades, yield-curve inversion has clearly been a leading indicator. These occurrences have preceded recessions and major market tops by several months on average. That said, history never repeats exactly...

Today's financial-news coverage is broader and faster than ever before. In addition to the major media outlets, we have now social media sites like Twitter and a vast financial "blogosphere" that is reporting and analyzing the news 24/7. This has never been the case during any of the previous economic or market cycles, and it could create some unexpected consequences.

For example, we don't recall much media coverage of the yield curve the last time it inverted in 2006. In fact, outside of professional economists, bankers, and Wall Street traders, we'd bet most folks had never even heard of it.

That is certainly not the case today. We're seeing warnings about yield-curve inversion plastered all over the financial and non-financial news alike.

Could we still see the typical cycle play out, where inversion is followed several months later by a stock market top and then an economic slowdown? Sure, it's possible. But with the entire world watching the yield curve today, it wouldn't surprise us to see this cycle play out faster – and a bit differently – than we've seen in the past.

Regards,

Justin Brill Baltimore, Maryland July 12, 2018