Capital market are dominated by two assets: stocks deemed to be more risky and so called safe bonds. When economy grows, capital flows into stock markets and increase their prices. When economy is going down capital flight is towards government bonds. Generally last century these two assets were negatively correlated with each other. When stocks rose, bonds were cheaper and vice versa.

One specific type of a bond moving defying norm described above are CCC-rated corporate bonds – junk bonds. Rating (level of issuers’ credibility) is given by three biggest companies: Moodys, S&P and Fitch. Lowest rating bonds – CCC – are considered highly volatile and prone to speculation. Investors must understand that there is high risk of insolvency of issuer. Throughout 1970-2012 factor of insolvency of 10-year junk bonds was 12,5%. Risk is significant but this is rewarded by higher premiums.

In calm times yield of junk corporate bonds stayed between 7—10%. Their profitability rose sharply when investors felt any sort of insecurity or excessive risk and were selling bonds quicker than shares.

Above graph tracks S&P 500 index (yellow), yield of junk bonds (blue). Due to 2008 panic you can see their profitability sky rocketed from 10% to 42% in just few months. Price of bonds was massacred. Literally.

I decided to write this article not only to touch junk bonds but also quick fall of their price (climb of their yield), as those kind of occurrences in the past signaled incoming sale in the stock markets.

Lets take a look at some hard data:

In the last 16 months, yield of corporate debt with junk rating rose form 6,3% to 15% now. This means nominal increase of profitability of 130%.

Similar movement happened few months before NASDAQ bubble burst in 2000. Yield climbed from 11,6% to 22% (growth of 89%). Back then we had higher interest rates than we have now but change percentage wise is comparable.

Another example is 2008 when before stock exchange crash, yield hike was equal to 111% (from 4,2% to 8,9%).

To be objective one fact needs to be considered. In 2012 we could see analogous - growth from 7,4% to 15,4% but afterwards situation normalized.

Source: Myrmikan Research

Shale industry debt.

Condition of the corporate debt is very complicated also due to shale sector. In the “Shale producers on the brink of going bust” I highlighted that as much as 83% of shale oil and gas companies’ income is used to pay back their debt. Three years ago this factor was at only 40%.

Corporate debt.

After 8 years from last financial crisis the amount of corporate debt (excluding financial institutions) has doubled. Comparing level of indebtedness in USD is unreliable as dollar is heavy inflated.

We do better job when using ratio of debt to the US GDP. During last two cycles slump in the stock markets started when the level of corporate debt crossed barrier of 42%. Today this level is 45%.

Source: inflation.us

Summary

Situation in junk corporate debt market suggests serious problems. It also confirms the lowest engagement of the biggest investment banks. While having very limited position in junk debt markets the biggest institutions in the US eagerly broker new bond issues.

The most important fact here is that in recent months yield of this debt significantly grew. Previously this was an omen of a slump in global stock exchanges.

This time we can say that things are different. Central banks are manipulating market through QE, zero interest rates or direct shares and bond purchase. Central banks’ power now is limited. Take that into consideration when analysing stock markets.

 

Trader21