• On the 3rd of July, the S&P500 index closed at an all-time high 2,996 points. But are equities that expensive? read here

Search for Yield and the Ballooning Bond Market

21062018_yield

Search for Yield and the Ballooning Bond Market

The size of the corporate bond market has grown extraordinarily subsequent to the 2008 / 2009 financial crisis, adding ~$4.5 trillion worth of Investment Grade (BBB rated and above) and High Yield debt (BB rated and below) representing an increase of ~150%. Of particular note is the split between BBB (lowest rated Investment Grade debt) and High Yield (junk rated debt). From the chart below it is clear to see there has been an explosion in BBB paper (Investment Grade) largely driven by unprecedented stimulus from central banks, falling credit standards by rating agencies and the market’s relentless search for yield.

Corporate Debt Split by Credit Rating ($ trillion)

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Historically speaking the spread on High Yield debt coupled with leverage levels in the economy (debt as a  per cent of GDP), have been excellent recession and market dislocation indicators. However, in the current cycle High Yield spreads remain stubbornly low despite record high leverage levels in the economy, a paradoxical situation.

Recessions, Leverage and High Yield Spreads Historically Correlated

 

Screen Shot 2018-06-21 at 9.02.52 am

Circling back to the dynamic discussed in the first paragraph around sharply increasing exuberance in the corporate debt market. If we look at the total return on Investment Grade debt relative to High Yield, we see a staggering trend emerging. Investment Grade returns are sharply underperforming returns in the High Yield market, which means spreads are widening much faster on Investment Grade debt than High Yield. We believe this is likely an indicator that many companies that would have historically been classified as High Yield are now classified as Investment Grade and have been able to raise capital more cheaply than what would have otherwise been possible. As we move deeper into the later stages of the cycle, the market is now repricing these companies and we are seeing signals flash in the bond market. Which perhaps indicates the chart above would be flashing red for a looming correction if we included the lowest rated (weakest) Investment Grade companies that perhaps should have been High Yield all along.

 

Investment Grade vs High Yield Total Return (i.e. Coupon + Change in Bond Price)

Screen Shot 2018-06-21 at 9.18.51 am

As balance sheets, valuations and the economy continue to stretch we may be seeing the beginning of an unwind. Here at Montgomery Global, we are laser focused on avoiding companies that have synthetically benefited from credit markets that have allowed weak businesses to borrow debt at inorganically cheap rates, lowering their cost of capital and thus elevating stock prices beyond what underlying fundamentals can support.

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Amit joined MGIM in April 2018 as a Senior Research Analyst after spending seven years as a credit analyst at Credit Agricole and Citigroup, based in New York. Prior to this, Amit was an investment banker with Citigroup for five years in New York and Sydney, focusing on Media and Telecoms; Metals and Mining; and Consumer Products.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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4 Comments

  1. andrew ronan
    :

    Great article Amit, but I’m wondering if this kind of analysis is even relevant anymore, I mean if these markets start blowing up won’t central banks be forced to buy them all ? after all, what are the alternatives, do nothing and let all of Zerohedges end of world predictions materialise.
    They may as well rate them all AAA plus and be done with it.
    It seems the most useful analysis today would involve paying off central bankers in order to front run their buy orders.
    Markets are virtually extinct, how can you value anything? If what you value it against can be created from thin air?
    There is not a single company that has not benefited from QE, ZIRP, NIRP, and all the other thin air money creation policies that have pushed up demand for everything, and if and when the tide turns all boats will sink just as they all rose when it came in.
    Its really all about central banks and not much else it seems.
    I think those China men have out smarted us all in the long term with their print money and buy as many of the worlds productive hard assets as possible policy, it’s a no brainer when you think about it.

    • andrew ronan
      :

      A correction to the above,
      There are many companies that have been obviously damaged and destroyed by QE etc, these I guess include most of Amazons and co’s victims, but even these companies will be damaged further by the removal of QE Through the turning tide effect, if it ever really happens. It looks like central banks are just taking turns in pouring money into markets, as Nomi Prins has recently suggested, under the pretence of pulling QE.

  2. Very Zerohedge-esque article Amit. I love it ! For what it’s worth, for me it is great to see an article like this from the Monti Funds blog as it lends credibility to what might otherwise be discarded as “doom porn” on Zerohedge. Also FWIW, the following line gives me great confidence in my investment in Montaka : “Here at Montgomery Global, we are laser focused on avoiding companies that have synthetically benefited from credit markets” . This type of analysis and unique opinion is what separates the Montgomery Funds from most others in my eyes.

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