House!

Are we looking at the wrong things in our financial market outlooks?

If you’ve ever had the misfortune to play soccer at really, really low levels, say pub soccer or summer league, there may have been occasions when just as you’re setting up and steadying yourself to take that elegantly curved shot that will skim over the oncoming full-back and nestle in the top corner of the net, you’ll hear a cry of “House!” from one of your teammates.
It translates as Watch your house! or Mind your house!

What it means is that while your focussing on your shot, wind speed, and the players in front of you, there’s a six-foot muck-spreader, bombing towards you from behind, whose only shred of thought in his Neanderthal brain is to break your legs.

Last week, the Federal Reserve Bank of New York shouted “House!”

The FRBNY is one of the 12 districts that make up the US Federal Reserve or Central Bank, and while most market commentators look at GDP and earnings and interest rates, in this call the New York Bank is highlighting financial risk – serious risk.

And the source of this risk is the corporate bond market.

US companies rely much more on the bond market for raising money than their European counterparts. The size of the US Corporate Bond market is currently over $9.2 trillion! We know that US companies have been on a borrowing binge and that a lot of this debt has been used for share buy-backs rather than “real” capital investment.

The risk to financial stability comes from how this corporate bond landscape has changed.

Basically investment grade bonds ,that is those of better quality than High Yield (or Junk as it used to be called) ) have seen a significant deterioration in their characteristics. This work echoes research by the Federal Reserve itself showing that the most rapid increases in debt have been among the riskiest firms!

Within Investment Grade the number of higher rated firms has reduced – today there are only two firms rated AAA, the top of the pile; Johnson & Johnson and Microsoft. And it’s in the lower rated sector within Investment Grade where the bulk of the borrowing since 2016 has taken place – even more than in High Yield. And this increased amount of debt has been at longer maturities – around 4 years as opposed to 1 year at start of decade.
This increased borrowing has had an impact on the quality of these bonds. Leverage, – that is debt compared to assets- has increased. According to the New York Fed, investment grade debt (because of higher leverage) is now as risky, if not riskier, as the supposedly poorer quality high yield sector.

In sum, a large component of the corporate bond market is now riskier – poorer quality and longer term- than many might have assumed, but is still getting a reasonable rating.

This is manageable if rates stay low, which is probably reasonable.

The real risk is if we do see an economic downturn with its impact on revenues and ability to pay, the consequent outcome of poorer returns, higher default rates and ratings downgrades constitute a serious threat to financial stability. Ratings downgrades could lead to some degree of forced selling.

This level of debt does not imply a recession but says that if there is one it may be scarier and more severe than some think.
And remember, corporate bond markets have often played a role as an early warning signals for assets overall