New Signs of Credit Trouble Appear
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The first signs of credit trouble are appearing again...
Longtime readers know Porter believes it is simply a matter of time before the next credit-default cycle begins... and "contagion" causes trouble for equities and the broad economy.
This appeared to be starting in late 2015. However, a rebound in oil prices and the spread of negative-interest-rate policy (or "NIRP") early last year granted high-yield issuers a reprieve. Corporate bonds – including even the "junkiest" junk-rated debt – have been trading higher ever since.
But Porter and his analysts have been clear: These recent moves have done nothing to change their long-term outlook. In fact, their biggest concerns are still the next few years, when a massive wave of more than $1 trillion of junk-rated corporate debt is set to come due.
And now, once again, we're beginning to see the first signs of trouble ahead. As Bloomberg reported last week...
Beneath the tranquil surface of U.S. credit markets, bearish winds are blowing. Issuer and sector-specific risks are increasing while the pile of debt trading at distressed levels is rising – evidence the post-crisis debt bull-run is peaking...
One warning sign: The face-value of high-yield debt trading at distressed levels has risen by about $30 billion from March to mid-September...
Another: The dispersion between credit spreads – the degree to which bonds are priced according to issuer and sector-specific risks – is slowly rising. That underscores increasing credit concerns that are masked at the index level, as cheap liquidity and low volatility cap risk premiums for companies with stronger balance sheets, according to Morgan Stanley.
This last point is particularly noteworthy...
During the big rally of the past several years, all sorts of bonds essentially traded in lockstep. But you'll often see the weakest corporate credits – the "canaries in the coalmine," so to speak – begin to weaken before the broad credit cycle rolls over.
We got a small taste of this in 2015, when yields on oil- and gas-related debt shot higher... But these problems extend well beyond the energy sector.
Perhaps the most worrisome is the recent bankruptcy of toy retailer Toys 'R' Us...
As regular readers know, Porter and the Stansberry's Credit Opportunities team have been following the troubled retailer since early 2016. They provided an update on the situation in their latest issue, published Wednesday. From the issue...
In March 2016, we told you that toy retailer Toys "R" Us was the most important company to watch in the bond market. The company had $1.6 billion of debt due to mature in 2017 and 2018. It's saddled with nearly $5 billion in high-yield (or "junk") debt overall.
We called the company the "first brick" in the "wall of maturities" of junk-rated corporate debt that Wall Street icon Wilbur Ross said would flood the market from 2018 to 2020.
Between now and 2020, a total of $1.3 trillion of junk-rated debt is expected to come due.
In the March 2016 issue, we predicted that the real action would come this year as companies tried to jump to the head of the refinancing line before the market turned.
As they explained, Toys 'R' Us stood at the front of this line...
And it was able to refinance some of this debt last fall. Today, it "only" has around $400 million coming due this year and next.
In other words, assuming the credit markets are as healthy as they appear, the firm should've had a relatively easy time refinancing the rest of this debt. But that wasn't the case. More from the issue...
Earlier this month, it hired well-known law firm Kirkland & Ellis to help restructure its debt. But Toys "R" Us' lenders weren't willing to kick the can down the road any further.
This week, the retailer filed for Chapter 11 bankruptcy protection. Toys "R" Us will likely close some of its underperforming stores and continue to operate the rest of its 1,600 locations with the help of a $3 billion bankruptcy financing lifeline.
As we noted last week, this is not a good sign for the junk-bond market. It shows what can happen when lenders finally cry "uncle." And it shows how quickly things can change in the bond market...
Toys "R" Us bonds were trading around par until earlier this month. Take a look at what happened to the company's October 2018 bond when it became apparent that it wouldn't be able to refinance...
And once more, it's important to remember that Toys "R" Us isn't just another troubled brick-and-mortar retailer that has been unable to keep pace with Amazon (AMZN) and other online retailers. It's much more than that... It also serves as a troubling example of what's likely to happen to many other firms...
Again, roughly $1.3 trillion in junk-rated debt is scheduled to come due in the next couple of years... That's debt that the ratings agencies consider to be just as bad as Toys "R" Us' debt.
We've been watching Toys "R" Us for a year and a half because we knew it was a signal of the market's appetite for restructuring. Now, we know... The company's bankruptcy is proof that investors banking on a 2017-2019 restructuring can easily be disappointed.
For now, the market isn't concerned...
But as we saw earlier, signs of trouble are already beginning to appear. As Porter and the team noted, today's calm could quickly be replaced by fear and volatility...
After jumping briefly last month to a reading around 17, the Volatility Index (VIX) – the market's so-called "fear gauge" – is back around 10 today.
Meanwhile, the high-yield spread – the difference between the average yield of junk bonds and the average yield of "risk free" U.S. Treasurys – fell to around 373 basis points (bps). That's near its lowest level since 2014. The average spread over the past 20 years is around 580 bps.
But if a couple other "bricks" suffer the same fate as Toys "R" Us, the bond market will start to doubt whether other heavily indebted companies will be able to refinance their debt.
That's when we'll see panic flow into the bond market.
If that happens, many good companies' bonds will be sold off with the bad ones... This will lead us to many prime opportunities to purchase good distressed debt at bargain prices. We'll be watching closely.
Of course, as we've seen time and again during this bull market, 'inevitable' doesn't mean 'imminent'...
There's no telling when these problems may finally "matter" to the credit markets... And it could be even longer still until they spill over into equities.
In other words, for now, the "Melt Up" continues.
New 52-week highs (as of 9/25/17): Celgene (CELG), CME Group (CME), Huntington Ingalls Industries (HII), iShares Core S&P Small-Cap Fund (IJR), and Monsanto (MON).
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Regards,
Justin Brill Baltimore, Maryland September 26, 2017