There’s a huge bubble at the bottom of the bond market, and when it pops it could put $1 trillion at risk.
“In short, we believe there is a corporate credit bubble in speculative grade credit. And the structural downside risks for high yield bonds and loans are material, with non-negligible downside risks to growth,” wrote UBS’ Matthew Mish in a note to clients.
Mish argues that below the surface of corporate bonds, all the way down at the bottom-most levels of junk, there is a bubble forming.
“We believe roughly 40% of all issuers are of the lowest quality, and roughly $1tn which will end up ‘distressed debt’ in this cycle,” wrote Mish. “Much of the debt was bought to pick-up yield linearly, but the default risk is exponential.”
So how did we get here? Mish believes there are 3 circumstances that have inflated the bubble:
- Central banks support allowed zombie companies to stay afloat, carrying over larger debt loads and then adding even more of it on top of unproductive firms.
- Low-yields in Treasuries forced pension funds and other investors with nominal return targets towards more speculative debt in order to meet those goals. “Investors were herded into lower-quality credit risk for a yield pick-up of a couple hundred basis points,” wrote Mish
- The heightened demand from these funds for high yields creating an ease of access for speculative grade issuers to find a market for their debt. “The proportion of triple C rated issuers in its speculative grade universe (bonds and loans) reached a new record to start 2016; 1,356 out of 3,181 issuers or about 42% of the total,” said Mish.
The next question, wrote Mish, is where do we go now?
On the bull side, the recent widening of credit spreads is simply a case of the debt market “deteriorating incrementally, and from a relatively healthy position.”
Then there’s the bear side that the bubble has formed and widening spreads and defaults, especially in higher yields, are sign of a coming disaster wrote Mish.
In his mind, Mish is heavily leaning towards the bears. For one thing, bubbles such as the one in high-yield credit have to burst eventually, so at the very least the clock is ticking.
Additionally, according to Mish, the current state of the credit market is looking like time is close to up before it bursts.
“Commodity-related stress will push default rates up towards 5-6%, without assuming much increase in non-commodity defaults,” said the note.
“But the broader speculative grade universe is highly leveraged — particularly the lower quality segment (many single Bs, nearly all triple Cs), which, by definition, leaves them more exposed to peaking profit margins, rising interest costs and a slowdown in US growth.”
This last point is overlooked, said Mish, since most analysts look at just the leverage of the market aggregate. However, 10% of the companies in the S&P 500 hold 70% of the cash, so the lower quality names where the bubble has formed are worse off than it looks.
“Simply put, lower quality firms have been structurally increasing debt faster than earnings as interest rates have declined,” said Mish.
When the $1 trillion bubble bursts it may just be in the speculative market, but it will have wide ranging effects on all corporate credit. Seizing up the wheels of issuance and widening spreads, which could then weigh on economic activity and eventually US growth.
“While this bubble and possible mini-bubbles may not pop this month, we believe their existence justifies our structurally bearish view on corporate credit and preference for higher-quality securities,” concluded Mish.