Junk Bond Market Pricing in Recession?

Many pundits often say something along the lines that the bond market is 6 months ahead of the equity market. I would like to examine why this can be the case and examine some current events that are occurring that may be signaling such a concept.

I would like to try to break this down in simple terms. Bond yields are the compensation an investor receives for lending money. There are a variety of risks that push up interest rates such as inflation risk, exchange rate risk, and liquidity risk, but for the purposes of this post we will focus on default risk. Other listed risks equal, bond yields are primarily based on default risk. One thing many people get confused with is the relationship between price and yield (interest rate). They move in opposite direction because when a bond is less intrinsically valued (demanded), then the yield must adjust higher in order to compensate the investor for the lower perceived intrinsic value. The idea here is if all risks among bonds are equal except for default risk, then bonds of entities with higher default risk will need to offer higher yields in order to attract buyers.

With some basics now out of the way, let us attempt to perform some application to today’s markets. Below you will find a chart showing corporate debt to GDP over time. Knowing that GDP is constantly growing in the long term, and seeing that corporate debt as a percentage of GDP is at all time highs, we can conclude that corporate debt is at all time highs.

Below you will find a chart showing that nearly half of investment-grade bonds are rated BBB. Bonds are either investment-grade or junk in the most general of ratings. So what does that mean? BBB signifies lower medium grade within the investment grade market. This is the lowest grade within the investment grade section. Many funds buy these bonds simply because their mandate forces them to buy any investment grade bonds. The issue is that if these bonds were to downgrade, then those particular funds would be forced to sell to comply with their investment policy. If those funds were to cease buying these bonds due to a downgrade, then yields would surely rise due to less demand for those bonds and the admittance of the rating agencies that these bonds are at more default risk than their prior BBB rating would have portrayed. Holders of BBB bonds would lose due to having to take any price in order to get out of the downgraded position, investors in company stock of those downgraded BBB bonds would lose due to increased borrowing costs eating in to future earnings, and the junk bond market would get hit with over supply.

So one question to ask is how accurate are the ratings? Jeffrey Gundlach is known as the “Bond King” on Wall Street. He spoke last night and said that “By historic standards 62% of BBB rated bonds should be considered junk status right now but are not.”

So what? There will come a time when the rating agencies have no other choice, but to downgrade some of these “BBB” bonds. This could simply be due to the fact that over the past few years interest rates have been steadily climbing, but more importantly than the climb is the percent change in the climb. Companies will eventually have debt coming due, which was previously locked in at much lower rates, and when that occurs companies that over-binged on cheap credit for the past decade will be in for a rude awakening when they have to refinance at higher rates. Below you will find that this time called “eventually” is now. Through 2022, the amount of debt coming due to many S&P 500 companies will be rising year over year. In a rising interest rate environment, this is a no bueno situation keeping the above logic in mind. One last note is to consider all the companies that are likely on the brink of downgrade based on Gundlach’s comment…do you really think that they will remain investment grade if an inevitable recession were to occur?

The below situation of PG&E being downgraded due to liability from the California fires is entertaining to mull over. My takeaway is that rating agencies will not issue downgrades until it would become obscene if they did not. The point is that when recession eventually hits profitability of debt-riddled companies, then ratings will finally come down.

Let’s imagine that a glut of BBB bonds hit the junk bond market via downgrade. Since, there is only so much demand for junk bonds, then all things equal junk bond yields will have to rise in order to absorb the larger supply. Below you will see that junk bond yields began a significant rise back in September. One way to read that is to presume that such a glut of future junk bonds hitting the market is beginning to be priced into the junk bond market. Therefore, junk bond investors are preparing themselves for such an event. Also, Lisa Abramowicz is on the mark here as she speaks to the volatility growing within the junk bond space, which means a diminishing amount of liquidity due to junk bond investors being more apt to stay on the sideline during this uncertainty.

In conclusion, I think it is possible that the junk bond market is pricing in recession based on the over 50% rise in junk bond yields since September. I will continue to watch how things develop and keep you updated as best I can.