CREDIT CYCLE WARNING: EMERGING MARKET SOVEREIGN BONDS CHEAPER THAN US HIGH YIELD!
- The Federal Reserve is tightening monetary policy.
- U.S. bond yields are rising.
- The European Central Bank is ending quantitative easing.
- Italian yields are soaring.
- Emerging market currencies and bonds are tumbling.
- European credit markets are cracking.
- Fixed income investors around the world are nursing hefty losses.
...... yet the U.S. high yield bond market is acting as some sort of safe haven. How is that possible?
Many factors influence the level of credit spreads. Monetary policy, liquidity, supply relative to demand, and risk sentiment all play a role in determining where credit is priced in the market. The fundamentals of the borrowers, such as corporate leverage, interest coverage and earnings growth, also influence the level of credit spreads. Most of these factors, though, tend to follow the normal economic business cycle. If you know where you are in the business cycle, you can make a good guess as to the direction in which the credit spreads are heading.
The behavior of high yield bonds, sometimes referred to as “junk” bonds, is often a good leading indicator of changes in the credit cycle. As compared to investment grade credit market, the high yield corporate bond market is more sensitive to the health of the economy. The primary concern for high yield investors is the default rate. More companies default in an economic downturn than in an expansion due to constraints in the cash flow and the availability of credit. The question is how close are we to the next downturn?
For the moment, the fundamentals still look good. According to a recent report released by Barclays Bank, corporate leverage, measured by the ratio of total debt to EBITDA, stands at 5.4x and is below peak levels set in 2016. Solid earnings growth, with added assistance from the passage of the recent tax reform, have kept the ratio under control, despite companies increasing their debt load by taking advantage of the low interest rate environment.
Reflecting these strong fundamentals, the high yield market shows very few signs of stress. The Bloomberg Barclays U.S. Corporate High Yield Index, with a spread to U.S. government bonds of 3.29% as of June 13th, is near the lowest levels of the cycle. The premium demanded by investors to compensate for higher defaults is at the lowest level in the last five years. Using spreads as an economic barometer, we are not near a domestic economic downturn. International credit markets, however, are not as benign.
Emerging market credit is weakening. The U.S. high yield market looks rich when compared to emerging market countries that issue USD bonds. The JP Morgan EMBI Global Index (EMBI), which tracks a basket of debt from countries such as Mexico, Russia and Poland, has a negative return of more than 6% so far in 2018 and currently offers a spread of 3.75% over U.S. Treasuries. That is higher than the spread for the junk bond universe. Approximately half of the issuers in the EMBI are investment grade rated and the historical default rate for these credits is much lower than in the U.S. high yield market. The last time emerging market sovereign bonds were cheaper than U.S. junk bonds was in 2005, just before the burst of the housing bubble.
Yet the performance of the junk bond market remains strong. HYG, the iShares high yield corporate bond ETF with over $15 billion in assets under management, has delivered a positive total return year to date of 0.6%, despite an increase in five-year government bond yields of more than 0.60%. Interestingly, the segment of the market with the lowest credit rating of CCC and below, performed the best. CCC-rated bonds have returned 4.8% so far this year compared to –1% for the higher-rated BB bonds.
We can’t say the high yield market is priced “wrong.” After all, the economy is still doing well. The unemployment rate is low, business optimism is at a record level, and both companies and individuals are benefiting from the recent tax reform. What we can say, though, is that credit spreads are probably underestimating the timing of a turn in the credit cycle. While we know the turn is coming, we cannot accurately predict when it will happen. However, the weakness in global credit spreads may be a sign the turn is upon us. Accordingly, keeping an allocation to the high yield market to capture some extra yield could be dangerous at this stage. We should remind ourselves of the old Wall Street adage: bulls make money, bears make money, (high yield) pigs get slaughtered.