The corporate bond market: A case of Icarus syndrome?
An essential part of the bond market, and one that has played key roles in numerous financial crises and recoveries, is corporate debt. My hope that among the most lasting concepts readers glean from this book is the extreme criticality of credit spreads. Once again, these reflect the difference between what corporate borrowers pay in terms of interest on their debt and what the government pays on treasuries. When that gap, or spread, widens significantly, it almost always means corporate bond prices are under downward pressure.
Often during these episodes, the price declines can be severe, as seen with the debt shown above involving Enterprise Products (arguably, but not much, the strongest of the independent energy infrastructure operators). When conditions improve, the rallies can be extraordinary, as the Enterprise bond chart above clearly shows. Rapidly declining (aka, narrowing) credit spreads are like mixing Red Bull with a double espresso when it comes to hyper-stimulating a bull market in both stocks and bonds.
The ultimate proof of the vital nature of credit spreads occurred, as described in Chapter 2, when the Fed announced it was buying corporate bonds during the worst of the virus crisis. As also noted earlier, it was this disclosure that ended the shortest bear market and recession of all time. While it wasn’t the only catalyst, in my view it was the most powerful one… by far.
During the pandemic’s sheer panic phase, in the first few weeks of March of 2020, credit spreads blew out, as they nearly always do during high-stress times. But, unlike 2008-2009, the Fed prevented it from being a drawn out, death-by-a-thousand cuts affair (which is what the Global Financial Crisis experience felt like — take it from someone who bled plenty back then!). As with stocks and the economy, the corporate bond market rally and the tightly linked spread contraction were breathtaking.
Figure 10
As a result of this screaming rally in corporate bonds, spreads are now extremely tight. Thus, not only are rates at historic lows relative to inflation, credit spreads are, as well. (In early 2022, spreads were on the rise but remain at non-threatening levels.) On the former, never has the yield on the 10-year T-note been 4 ½% below the CPI increase on Social Security.
Similarly, 2021 saw the economy’s nominal growth rate (again, real growth plus inflation, as explained in the Glossary) exceed the yield on the 10-year treasury by the widest margin on record.[iv] Most significantly, this had the effect of reducing the U.S. government’s debt-to-GDP by 13 full percentage points in a year, from 135% to 122%. In my view, this is precisely what the powers-that-be wanted to bring about — and still do. It’s basically a stealth form of default with bondholders taking a severe hit in terms of lost purchasing power. (This punitive action toward U.S. government debt owners is likely in its early stages.)
Related to how compressed both rates and spreads were in 2021’s fourth quarter, this is the first time less-than-investment-grade corporate bonds (junk), the ultimate spread vehicles, traded with negative real yields. In other words, it’s another example of a bond market that increasingly offers copious amounts of risk and precious little in the way of reward.
Accordingly, in the next crisis — one that could be precipitated, say, by millions of investors having an epiphany that rising inflation is becoming a persistent problem — corporate bond investors could lose twice: First, due to a big jump in rates and, second, as a function of materially widening credit spreads.
While not all stock market convulsions have been caused by spiking credit spreads, I’ve never seen a serious spread-widening episode that hasn’t triggered an equity downdraft. Typically, the more severe the spread widening, the more painful the correction in stocks. Consequently, even if you don’t give two hoots about bonds, because you’re an equity gal or guy, you should be aware of this aspect.
Besides unusually tight spreads and the putting green level of interest rates, there were also unmistakable signs of complacency and frothiness in the more esoteric realms of the non-government bond market in the fourth quarter of 2021. The currently highly popular Collateralized Loan Obligation (CLO) market is almost a carbon copy (yes, I know I’m dating myself, perhaps carbon-dating myself) of the Collateralized Debt Obligation (CDO) space. It was these not-so-secure securities that nearly destroyed the planet’s financial system a dozen years ago.
Regardless, the ducks were loudly quacking again in late 2021 to be fed more yield products, with CLOs being hoovered up like spilled popcorn in a theater after a Spider-Man: No Way Home showing. This is notwithstanding that CLO yields were pathetically low and their credit risks disturbingly high.
Moreover, bond covenants meant to protect fixed-income investors had once again become exceedingly lax (favoring the borrower over the lender), as was the case leading up to the Global Financial Crisis. The term “bond” is supposed to mean exactly that: an explicit and enforceable contract between the issuer and the investor. Yet, as happens regularly when there is yield starvation — and, as I write these words, there is a mass yield famine afflicting fixed-income land — borrowers are in the driver’s seat. And, when that happens, they never fail to drive some brutally hard bargains, such as being allowed to skip interest payments without having to declare bankruptcy.
Returning to junk bonds, Michael Lewitt, the bubble-busting author of the Credit Strategist, wrote in his October 1st, 2021, issue: “Even though these instruments are called ‘bonds’, they offer few if any of the traditional protections traditionally associated with bonds. So in addition to offering negative real yields, they offer no covenants and limited liquidity.”
His last point is an important one, particularly with the wild popularity in recent years of junk bond ETFs. These allow investors to instantly buy and sell these securities which own around 1000 different underlying “high yield” bonds. The problem is that many of these trade by, as they say, appointment only.
In bull markets, that’s a no-worries situation, particularly when there are trillions in excess liquidity sloshing through the financial system. But when the inevitable ebb tide sets in, this creates the potential for severe price hits should investors decide to exit en masse, and in a hurry, as they so often do during turbulent periods. Because many of the underlying bonds are extremely illiquid, prices need to be deeply discounted in order to clear markets during a panic. You can see what it looked like for HYG and JNK, the two-leading junk bond ETFs, during March 2020.
Figure 11
Yet, despite negative after-inflation yields, junk bond buyers were ravenous as they absorbed record amounts of issuance, as 2021 drew to a close. Clearly, the prospects of losing money to inflation, the always substantial risk of default with most junk bonds, the liquidity problems, and the paucity of covenant protections, fazed investors not in the least.
It would be remiss on my part if I failed to point out that the unparalleled bond bubble played a starring role in the government debt saga. Pre-Covid, a decade of negligible, cum negative, interest rates enabled developed nations to pile up sovereign IOUs to levels not seen since WWII. Post-Covid, of course, the amount of governmental indebtedness reached almost incomprehensible proportions. With throw-away interest rates, though, what’s the big deal? As you can see, interest costs as a percentage of the size of the Big Seven (G7) economies is a yawner.
Figure 12
Figure 13
It’s the same in the corporate world, as well, with accumulated debt amounting to $11 trillion or 49% of GDP, an all-time high. Yet, as you can see below, debt service for U.S. corporations is a breeze.
Figure 14
As extensively covered in Chapter 6 on MMT, this logic-defying controversial economic thesis has taken the enabling to an entirely new, and totally shocking, level. Politicians have discovered their dream machine and they are dreaming in fantastical ways that put Hollywood to shame. The multi-trillion question is if this will eventually turn into a nightmare, as have all prior full-blown MMTs (Japan is the lone exception and it did MMT-lite).
With an increasingly stubborn inflation trend dominating 2021 — and into 2022, as well — thereby undercutting the Fed’s transitory assertions, senior officials such as Jay Powell must have been sleeping very fitfully. As noted in the MMT chapter, inflation has consistently flipped the free-money fueled booms into busts. A central element of this denouement is a cost of capital, or interest rate, that is far too low (per the foregoing 250-year-old comments by Adam Smith). When this happens, asset bubbles are inevitable. Based on rates being the lowest ever and becoming rapidly more negative in real terms as inflation predictably took off in 2021, it’s no surprise we are witnessing the type of orgiastic speculation documented in Chapter 10.
Ludicrously low interest rates also lead to obscene misallocations of capital, like the stripper in The Big Short who was able to buy seven overpriced homes due to reckless lending practices. Capital misallocation is just a fancier name for a bubble. As we’ve seen in overwhelming detail, in late 2021 bubbles were as pervasive as liars in Washington, D.C. When future generations seek to do a forensic analysis of this evolving (devolving?) disaster, they will need to look no further than the Biggest Bubble Inside The Biggest Bubble In Recorded History. As you know by now, that would be the bond market.
[iv] There may have been one other very brief episode in the early 1950s.