Too Much Junk

Monday 11/23/15

     This week I want to take a look at the junk bond market and some of the reasons that investors are starting to get nervous. Junk bonds have been showing weakness in recent months, figure 1 shows the junk bond ETF HYG. It is important to note that although stocks have recovered most of their losses since the sell-off in September, junk bonds have not rebounded. It is also interesting to compare the investment grade ETF LQD. Figure 2 shows SPY, LQD and HYG. As you can see, junk bonds have underperformed riskier stocks and less risky investment grade bonds in recent months. This is somewhat concerning because as Oleg Melentyev of Deutsche Bank points out, “…the only two times we had [junk bonds vs. stocks and high yield vs. investment grade 12-month differential] being negative were, again, early 2000 and late 2007.” I don’t want to suggest that we are in the exact same situation as 2000 or 2007, but I also do not think this is something that should be ignored.

     Most of the weakness in junk bonds can be attributed to commodities. Energy exploration companies were able to issue a lot of debt in the last several years as oil was at or near $100/bbl and new technologies related to fracking were spurring investors to take risks. Many of these companies have now become a victim of their own success as oil production has surged and oil prices have collapsed. Many of these companies were not profitable when oil was $100/bbl and now with oil around $40/bbl many are beginning to declare bankruptcy (I discussed this problem back in October 2014). Even if oil prices double in the next year, many energy companies will still be unprofitable, so for that reason I am not very optimistic when it comes to these companies.

     It isn’t just oil companies that are having difficulty, it is also metals and mining companies, especially coal companies. I have discussed the headwinds facing coal here. China, which had been supporting commodities prices for decades is no longer a driver of demand. Chinese demand for commodities will not return to how it was because of debt constraints and the government’s desire to rebalance its economy. Figure 3 shows the ETN DJP which tracks the performance of the Bloomberg commodity index, the index is now at its lowest level since 1999.

     Since most of the weakness in junk bonds are in the metals, mining and energy spaces many have suggested that the problem is contained. However, these arguments were also made in 2008 when people warned about housing. Most members of the fed were aware of problems in housing, but weren’t able to see how that could lead to contagion. I certainly don’t mean to suggest that this situation is the same, but there are some similarities. It now seems like the fed is determined to raise rates very soon, which could mean that the era of cheap credit is coming to an end, which could also make it difficult to continually refinance bad loans to highly indebted companies. The fed typically raises interest rates when the economy is very strong and inflation is picking up. Neither of those seem to be a problem at the moment and it also appears that we may currently be in an earnings recession. It is for these reasons that I’m not convinced by the argument that stocks historically don’t peak when the fed first raises rates. Now is probably not the time to panic, but it is a good time to exercise more caution than usual and to avoid getting involved in illiquid securities.