Junk Bond Market: ‘I See Dead Companies’

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.

But the essence of the matter is to look past the trigger and focus on a leverage accumulation mechanism. In a previous article I explained that the key transmission of leverage to the Chinese stock market occurred through the shadow margin debt estimated at over four trillion yuan that was extended to millions of day traders that decided to play in a Chinese stock market casino.

Every crisis has a unique conduit that helps to build up leverage. Leading up to 2008, the transmission of leverage to the financial system was done by banks creating off-balance-sheet entities in addition to increasing their legally visible debt. Those entities invested in real estate securities including subprime and the whole system unraveled when those levered bets went south.

Back in the U.S.

So, how is all this connected to the corporate spreads-widening with which we began this post? The connection is that corporate credit is the main driver of the stock market bubble today, just like margin shadow debt is for China.

The Fed’s zero interest rate needs some way to get into the stock market. In the U.S. there is no shadow margin debt system like there is in China. Also, there appears to be no major off-balance-sheet vehicles investing in U.S. assets as there were in 2008.

Corporate credit has been functioning as one of the main conduits of the Fed’s free money to the stock market. Corporations borrow money at historically low interest rates, and then buy back their own shares, artificially driving EPS growth (and executive bonuses). According to data from Birinyi Associates, stock buybacks in 2015 are set to reach $1.2 trillion, shattering the previous record of $863 billion.

When was the previous record established? You guessed it, in 2007.

It’s important to recognize that most of the companies that are borrowing to buy back their stock are not junk rated. These are investment-grade companies. But take a look at the chart that we started with. Corporate AAA spreads have also been climbing. In fact they have gone from 0.6% to 0.88%. The spread is still under 1%, but the trend is troublesome.

Before 2008, the corporate AAA spread crossed the 1% line in the fall of 2007 and never looked back, eventually reaching 6% at its peak. If those spreads cross 1% and keep going, in our opinion that would indicate a very strong early warning signal for a systemic event in the financial markets.

In summary:

• Junk spreads have historically been a very strong early signal for equity markets
• Junk spreads have widened significantly to over 11% driven mostly by energy names, but the spread widening is not limited to energy anymore
• Every crisis has a distinct key leverage transmission mechanism. In China it was the shadow margin debt; prior to the 2008 Lehman collapse crisis in the U.S. it was mostly off-balance-sheet bank entities investing in subprime debt
• The current key leverage transmission mechanism in the United States is the investment grade corporate credit market fueling record stock buybacks
• While junk spreads are an important early indicator, corporate AAA spreads crossing over the 1% line would indicate very serious trouble for the stock market and not just a correction
• To watch the Corporate AAA spread you can use this page from the St. Louis Fed.