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The Bond Market

An important part of the bond market is the government bond market, because of its size and liquidity. Government bonds are often used to compare other bonds to measure credit risk. Because of the inverse relationship between bond valuation and interest rates (or yields), the bond market is often used to indicate changes in interest rates or the shape of the yield curve, the measure of "cost of funding". The yield on government bonds in low risk countries such as the United States or Germany is thought to indicate a risk-free rate of default.

Ways of Looking at The Bond Market

The risk-free rate of return in the non-theoretical real world is what they call the amount you receive in payment from the United States for owning one of its Treasury bonds or notes. When they say “risk-free,” they mean it as a relative term since nothing in the universe of investments could really be called such a thing. It’s risk-free compared to the rate of return on corporate bonds or bonds from other nations or any other kind of bond, for that matter.

Risk free compared to dividend payments from stocks.

f you want to own the safest of all possible investments then you go with U.S.A. government issues that are the basic concept, according to the expert wisdom on the subject. These bonds and notes trade up and down depending on the level of interest rates. That’s why there’s so much focus on the Federal Reserve Board – the folks who set the most basic “federal funds rate.”

Everything that happens in the bond market depends on the ups and downs of the Fed’s decision.

Here's a look at the daily and weekly price chart of the TLT ETF which tracks the price of the 20-year government and is widely viewed as one of this market's benchmarks:

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TLT ETF daily price chart

The NYSE-traded ETF is no longer trending upward as it was from November through January. That's the upshot here. A close below that green “Ichimoku” cloud might suggest a trend reversal -- but it's not there yet.

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TLT ETF weekly price chart

It's a classic triangle pattern and bonds have broken out over the downtrend line connecting the 2016 peak with the 2017 high. Bond prices had been trading in a specific range between the upper and lower dotted lines on this chart -- then, from October to December of last year, they regained strength. Some of that gain is now being consolidated.

Credit Spreads

What is your time horizon?

Credit spreads have been compressing in recent weeks but are materially wider than one year ago. The market may be nearing new highs but the credit market is pricing in more risk.

RHow Should We Be Thinking About Credit Spreads?

Corporate bond spreads are an important measure of risk, liquidity and general economic/market conditions. Corporate bond spreads or credit spreads represent the yield above an equal maturity Treasury bond or risk-free rate.

For example, if a 10-year Treasury bond is yielding 3% and a 10-year BBB-rated corporate bond is yielding 5%, the credit spread is 2%.

As corporate spreads get wider, that is an indication of tightening liquidity, higher risk in the market place and/or worsening economic conditions. You can measure the corporate spreads for all credit qualities across the spectrum as well as measure the spread between different corporate bonds.

When studying credit spreads, it is important to remember that it is the rate of change that matters, not the nominal level of the spread. As with economic growth, inflation, profit growth or credit spreads, the rate of change is what should be measured.

RAre spreads getting better or worse?

The chart below shows the history of BBB-rated corporate bond spreads.

When studying credit spreads, you have to look at the rate of change across your desired time frame.

We focus on three distinct time periods: the growth rate cycle (12-36 months), the business cycle (5-10 years) and secular economic trends (10+ years). The shortest time frame we study is the trending direction or the rate of change in growth, inflation, or in this case, credit spreads, over a 12-36 month time period.

Below is a chart of BBB-rated corporate spreads for this current economic cycle and you can clearly see three distinct episodes of widening credit spreads that occurred over 12-36 month time periods.

Each widening had rallies within but those moves are very short-term and not what we focus on. Are spreads widening or contracting over the growth rate cycle?

Today, many bulls are joyful with the recent compression in credit spreads over the past 6-8 weeks but whether this move is just part of normal fluctuations within a widening cycle that corresponds to a change in growth remains to be seen.

Leave the 6-8 week moves for the traders.

As economic cycle analysts, we are still in a widening cycle that started at the beginning of 2018 that corresponds to a change in the growth rate cycle that started in November 2017.

US Corporate BBB Option-Adjusted Spread:

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Source: Bank of America Merrill Lynch, EPB Macro Research

When looking at the chart of credit spreads above, you might be thinking that today's widening is not nearly as bad as the 2010-2012 episode and the 2014-2016 episode based on the nominal level of the spread. That is true but again; focus on the rate of change.

Interestingly, when you look at the effective interest rate, rather than the spread above Treasury yields shows that while the widening of spreads is less today compared to 2015, much less, the interest rate that corporations have to pay is higher than 2015 because Treasury yields have increased across the curve from 2015 through the present.

While credit spreads rose dramatically in 2015, multiples of today's move, the interest rate peaked at 4.50%, roughly the same level as today with less of a move in credit spreads.

This is something to consider. Corporations are experiencing a larger rise in interest expense today with less of a move in credit spreads. Focus on the rate of change. The change in interest rate is larger today than in the last widening episode.

Five things to know about the corporate debt market

Investors are concerned about the deterioration of corporate debt quality, marked by lower credit ratings and a large share of covenant-lite issuance in the loan market.

Credit is typically a non-recessionary asset class and should perform well so long as there is no impending recession, which at the moment looks unlikely. Corporate bonds still add value in portfolios. But changes to the structure of the corporate bond market mean investors should have an understanding of any new risks.

Corporate debt as a share of gross domestic product has risen dramatically through the last decade, and with it, leverage has increased and credit quality declined.

Five key post-crisis changes to the most transparent sector of corporate debt corporate debt

1. The corporate bond market is growing fast

The global debt market has changed dramatically over the last 12 years. In 2006, structured products accounted for 45% of all issued debt. After the global financial crisis (GFC), the fallout from the sub-prime mortgage market, a tighter regulatory framework and an increase in financial institution risk-awareness led to a 50% decline in the issuance of structural products.

Corporate bond issuance rose to fill the gap leading to an evolution in the structure of debt markets, and since 2009 corporate bonds have accounted for 57% of all issuance. The combination of extremely low borrowing costs and yield hungry investors (27% of global government debt yields less than 0%) created the perfect environment for both rising demand and supply. A larger market in itself does not pose an immediate threat, so long as company fundamentals are strong enough to maintain coupon payments and avoid defaults.

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2. The quality of investment grade debt is in decline

Investment grade corporate bonds are like cuts of beef: at the top-end there is the tender filet mignon (AAA-rated bonds), and at the bottom, the still-delicious but tougher rump steak (BAA-rated bonds). When investors buy investment grade bonds, they may think they are getting the prime cuts but actually end up with the rump without being compensated for it.

With low borrowing costs and investors desperate for yield, companies rationally altered their capital structures or financing methods by issuing debt. However, rising leverage and a potentially-weaker credit position have created an overall decline in the quality of corporate bond indices. Between December 2008 and January 2019, the share of the lowest-ranked bonds in global investment grade corporate bond indices has doubled from 24% to 50%. In the high-grade market in Asia Pacific, for example, BBB bonds have risen from 6% of the domestic bond universe to just 23%.

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The deterioration in index quality is a worrying trend, but there are mitigating factors when assessing the overall level of risk. For example, many companies have used the easy funding environment to refinance existing debt at more favorable rates and extend their debt maturity profile. As a result, if rates start to rise and financial conditions tighten, the pressure on funding costs will only be gradually felt.

3. Lenders have less protection

The deterioration in corporate bond market quality is not limited to the top end of the bond market. Other segments of the debt market have been made vulnerable by the dilution and removal of protection for the buyers of bonds.

In 2018, an estimated 87% of leveraged loan issuance was considered to have a lower-than-normal level of protection for bond holders. These types of loans are known as covenant-lite (cov-lite), where investors do not require borrowers to commit to maintain certain financial ratios. Growth in this market has been driven by an increased level of private equity ownership, and their preference to raise capital with more favorable terms for the lender in the leverage loan market.

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The default rate is running below the long-run average, but an untimely end to the credit cycle or an increase in market stress could drive defaults.

4. A debt wall is approaching

Between 2019 and 2022, USD 8.4 trillion of bonds will mature in global corporate debt markets, a record for this economic expansion. This is known as the “maturity wall”, and investors are concerned for two reasons: first, large maturity walls are challenging when interest rates are rising as companies are forced to refinance debt at higher rates at the expense of profitability; and second, the interest coverage ratio, or the number of times a company’s earnings can cover its interest expenses, has fallen from 8.6x in 2012 to 7.3x in 2018, close to the lowest level since 2009.

Taken together, these two factors suggest that spreads could widen if firms face increasing pressure to service their debt.

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The expansion-long hunt for yield has created natural demand for corporate bonds helping to keep interest rates low. This should help ease the pressures of the approaching maturity wall. Nonetheless, investors should remain cautious given current cycle positioning.

5. Much of the debt has not been used for investment

In a perfect world, the money raised from issuing debt would be allocated to inward investment, including research and development and boosting productivity as a means to grow profits. For many investors, the use of corporate debt has been a point of focus. As it turns out, over the course of this cycle, debt not used for refinancing has been put toward mergers and acquisitions (M&A) activity, share buybacks and dividends.

In general, firms generally have the financial flexibility and a commitment to preserving their investment grade rating. However, the use of the debt is just as important as its quality. A company issuing debt to artificially increase its intrinsic value could be raising leverage without the ability to repay borrowers.

Investment Implications

As investors have been starved of income throughout this expansion, the corporate world has responded by issuing an increasing amount of debt of lower quality. This is something that many investors have been willing to overlook. With renewed fears about the end of the credit cycle, the risks of, what this dynamic may mean for markets, is becoming increasingly prominent.

Part of having a resilient portfolio is understanding what you own and being aware of where the risks lie; or being adequately compensated for that risk. The falling quality of the corporate debt market means that in the next downturn, corporate debt markets are likely to be more positively correlated with equity market performance, providing very little protection for investors.

Asia's Dollar Bond Market Hasn't Been This Hot for Years

Bond orders ratio surged last month to most since January 2016. Investors are scooping up China property, longer dated-notes Investors have never been so gung-ho about Asian dollar bonds.

Bond orders soared to 6.7 times their issuance sizes in February, unprecedented since Bloomberg started compiling the data in 2016 using available deal statistics. The demand rose just as note sales in the region (excluding Japan) hit a record $64.5 billion this year.

The robust rally is a sign of how investors have moved on from the worst performance in a decade last year for Asia’s corporate notes. With risk back on now, the market’s enjoying its best start in seven years, spurred by the dovish signals from the Federal Reserve and China’s policy loosening. While the rally has had more legs behind it, it may not match the kind of intensity seen recently.

Skyrocketing Demand

The order-book ratio for Asia USD bonds sold in Feb. soar to most since at least 2016.

(Data compiled by Bloomberg using available deal statistics)

Investors are now looking for carry after being underweight risks due to the market volatility last year. The tone should remain constructive in the near term while the pace of bond price appreciation should moderate. Nowhere is the demand more pronounced than in Chinese property developers. The amount of orders for their bonds compared with the actual deal sizes hit 7.6 times in February.

Strong Support

China builder dollar bond sales jump this quarter on risk appetite. We have seen real money buyers return in strength for property names, some of which took a break from the battered high yield market since November last year.

Dollar-debt sales by Chinese builders have been on a tear with issuance surging to a record $22.7 billion this year, aided by a blistering jump in junk-rated offerings. We expect continued supply from developers ahead.

Longer the Merrier

Asia dollar bonds maturing in five to less than 10 years are the most popular. Data compiled by Bloomberg using available deal statistics.

One notable theme recently is investors are piling into notes with longer tenors amid dampened expectations of interest-rate hikes this year. Bonds maturing beyond five years are outperforming the short end of the curve. Dollar debentures due in five to seven years have been racking up returns of 4 percent so far this year, compared with the 1.7 percent gains for notes of one to three years.

Having access to longer tenors gives borrowers greater flexibility to manage their debt profiles to avoid maturity walls from building up.

Longer-dated new issues have also proven to be more volatile when sentiment turned, especially for high yield credits. Overall market sentiment may be negatively impacted if trade conflicts are not resolved, or if the Chinese government does not loosen enough to turn around the economy.

Is there a Corporate Debt Crisis?

Corporate debt has increased substantially. Share buyback programs have been financed by debt. A credit crunch could cause systemic dysfunction. The shale oil Ponzi scheme is part of the problem.

The amount of corporate debt has increased substantially in the last decade.

The graph below shows how leveraged loans have more than doubled since 2006. This is not a financially healthy situation.

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What is really alarming is that there is a high-percentage of covenant lite loans. If the share of covenant-lite loans in 2006 was around 10%, this became 80% in 2018.

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Another source of worry is that the ratio of debt to EBIDTA has risen, and that means that companies have taken on more debt than they should have. A 5.25 ratio is rather high.

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Another aspect of the problem is that company ratings have been falling as debt increases. A BBB- rating is barely above junk status. There is thus an inverse relationship between debt and ratings. The higher company debt goes, the lower the ratings go.

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U.S. corporate debt has risen from $40 trillion to $70 trillion since the top of the last bubble in 2007. That’s 63% in 10 years. It has risen 135% since 2000.

Of course, many of these bonds are simply financial engineering to buy back stock to increase earnings per share. Low long-term interest rates, thanks to QE, have allowed companies to do this cheaply.

The problem is these long-term rates have been rising since just July 2016. They’ve gone from 1.38% to 3.10%. That’s an increase of 172 basis points in the risk-free 10-year Treasury bond. That naturally reverberates up through the risk spectrum from investment grade corporate bonds to junk bonds.

It is important to understand that companies have concentrated on financial engineering to boost stock prices by implementing share buyback programs that have been financed by debt. The capital has not been invested in R & D (Research and Development) or in Capex (Capital Expenditure) in order to strengthen the company and make it more resistant to a crisis or recession. Capital has been grossly misallocated, and the economy is basically weaker than it should be and therefore more prone to suffer disastrously when there is an economic downturn.

What is more is that the share buyback programs have taken place when the market is extremely overvalued and share prices are very high. Companies seem to like buying HIGH and do not worry about selling LOW.

Total corporate debt has swelled from nearly $4.9 trillion in 2007 as the Great Recession was just starting to break out to nearly $9.1 trillion halfway through 2018, quietly surging 86 percent, according to Securities Industry and Financial Markets Association data. Other than a few hiccups and some fairly substantial turbulence in the energy sector in late-2015 and 2016, the market has performed well.

In fact, Fitch Ratings forecasts bond defaults for 2019 at the lowest since 2013, with leveraged loans at the lowest since 2011. In terms of the systemic risk, at the moment it's not there.

But, then there is the shale oil Ponzi scheme to be considered in the context of corporate debt. Even with an oil price over $60 small and medium-sized producers are still going to have to cope with negative cash flows. As the oil majors crowd into shale oil, they too will find that the rate of well depletion is so high that continually more capital is required to keep production at a high level. The amount of debt owed by the shale oil producers is extremely high.

At a certain point investors are going to stop financing operations that are cash burners just as investors have begun to tire of the hype over Tesla automobiles.

Given such a situation with such high debt levels, a tightening of credit could swiftly bring about a systemic crisis. Fear of widespread defaults could cause investors and banks to be unwilling to finance zombie companies and those with negative cash flow. An economic slowdown could crimp company profits and slow down the rate of corporate share buybacks, which in turn could result in a stock market downturn in as much as share buybacks are a main support of high stock market share prices.

April Yield Curve Update: Backing Off

The trend in yield curve spreads continues to be negative, though the rate of change has slowed considerably. The note and bill yields have become detached.

The changes in the spread are being driven by the notes, the rates least in the Fed's control.The 6-Month Spike indicates investors believe rates will hold steady and then fall 6 months from now.

Models based around the yield curve are starting to predict recessions coming sooner rather than later. The earliest seems to be the Q1 of 2020.

The price of consumer and corporate risk had been rising, but 2019 has seen a reversal of that.

Six Months of Flattening

We’ve been publishing on the yield curve since November, and in that time, the curve has undergone some changes.

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For some time, the most obvious feature of the curve was the 2-Year Elbow, seen here at 2.91% on the red line from November. The curve had that basic shape for most of 2018, until the very end. Then the 2-5 inverted, then the 1-Year Spike formed, and now we see that the 6-Month Spike has formed, with it flat or inverted all the way to the 7-Year. Currently (blue line), the 6-Month to 3-Year spread is -10 bps. We don’t need to fit a line to show you how much the curve has flattened.

But, we’ve also included the peak of the ferocious debt rally at the end of March (green line). The 6-month to 10-year spread was -7 bps and the 6-month to 3-year was a whopping -40 bps.

As you can see, by mid April the spreads have backed off that considerably, pretty much back to where we were a month ago.

Many considerations here for investors as well as issuers going forward. A growing global economy will go a long way to mitigate bond market concerns.

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