U.S. corporate credit, particularly high yield, is showing some very troublesome signs. One could say that it looks to be on the verge of a breakdown.
Junk spreads (the red series that is plotted on the y-axis in the chart belwo) have risen to over 11% from less than 8% at the beginning of 2014.
Junk Credit Spreads (left y-axis) & AAA Corporate Credit Spreads (right y-axis)
However, U.S. equities are not showing the same kind of stress in the VIX (this article was written on Wednesday of last week and it has since started to show significant stress). Since these are claims on the same financial assets, something has to give. Either corporate spreads have to tighten (or at least stop widening) or equities have to fall. By a lot. Corporate credit has always had a special role in the financial markets, particularly when it comes to early warning of equity problems. However, in today’s financial system it is more critical than ever.
Junk Bonds Give Up The Ghost
Corporate credit has always been the early signal for the stock market. Bond king Jeff Gundlach expressively, if somewhat grimly, suggested in a January 2015 interview: “Historically, when junk bonds give up the ghost and Treasuries remain firm, it is a signal that something is not right…It is almost as if the Treasury market and the junk bond market are projecting that the Fed raising interest rates will cause a recession.”
Junk spread is essentially the amount of money investors want to pay in order to take the risk of investing in “CCC” or lower entities. It has always been a great measure of the degree to which investors want to take risk. And it is showing some worrisome signs, as the chart above indicates.
Before considering what the corporate credit turmoil means, let’s take a detour around the world to China.
Most market observers were shocked by a recent series of ‘Black Swans’ coming out of China. First, a tremendous market crash that was temporarily stopped by the government literally threatening to arrest short sellers. That didn’t work out and equity markets in China are in a tailspin again. Then a yuan devaluation that sent shockwaves through the financial system by disrupting a yuan carry trade. That carry trade essentially had traders borrowing in currencies that have low interest rates (U.S., Japan) and then buying yuan in order to buy yuan-denominated assets to reap a higher yield offered by those assets. Clearly, devaluation of the yuan causes losses for such a strategy and those trades are being unwound in a hurry.
China, and How Financial Crises Come About
All financial crises have similar mechanisms in play. During good times financial players accumulate too much leverage. Then some trigger event hits and those players are exposed. Many people focus on the trigger event and since there can be an infinite number of triggers, they will ascribe a crisis to a Black Swan, a completely unpredictable event.