Surging borrowing costs for companies with speculative-grade credit ratings have some market watchers warning that the US economy is heading into a recession.
The debt issued by these companies, which are also know as high-yield bonds or junk bonds, have experienced a surge in spreads. In other words, the interest rates these companies are paying to finance their operations are spiking, making it more challenging to refinance while pushing more companies toward default.
While much of the pain is occurring in the high-yield energy bond market, it nevertheless signals tighter financial conditions are coming.
“This is not just an energy story, but a broader conversation about the credit cycle and our place in it,” UBS’s Steven Caprio said.
Caprio thinks the US economy is heading for a period of tighter, more expensive money. He observed that what happens in nonbank lending markets like the bond markets lead what happens in bank lending.
He homed in on a segment of the junk bond market.
“Our analysis suggests it is actually the lowest of low quality issuers (B-rated and below) that provides the first leading signal that credit stress may lie ahead, as Figure 3 illustrates,” Caprio wrote. “Worryingly, this chart is flashing red. While BB net issuance has held in quite well, B-rated and lower net issuance has plunged in a replay of late 2007, as investors cut back in the face of growing default risk and rising illiquidity.“
“And stripping out the energy sector from this chart makes no difference; ex-energy low-rated issuance is drying up too,” he added.
What’s happening in this “lowest of the low” corner of the argument is just a preview of what banks are going to do when businesses and consumers come asking for loans.
As a proxy for bank lending, Caprio points to the percentage of banks tightening lending standards according to the Fed’s Senior Loan Officers Survey (SLOS), something UBS chief economist Maury Harris has long argued this measure is a reliable indicator of job creation.
“The implication of this model is that bank lending will tighten from a healthy 6% of banks easing standards in Q2’15 to 14% of banks tightening standards in Q3 ’15,” he explained. “This would be a significant move; these levels would imply HY defaults near 4.8% by Q3’16, even without accounting for specific stresses impacting the energy and materials sectors.”
“In sum, we believe that non-bank lending standards illustrate an overall tightness in US financial conditions that signal a downside growth risk to the US economy,” Caprio said. “While bank lending standards are healthy, we ultimately believe this misdiagnoses the pulse of the corporate credit cycle. Nearly all of the additional financing provided to nonfinancial corporates has come from non-bank sources, post-crisis. And expecting the banking system to meaningfully pick up the baton from a non- bank slowdown is unrealistic in today’s highly regulated environment. In short, non-bank liquidity has been the main driver of the corporate credit cycle post-crisis, and there are now early signs that it is evaporating.”
In one sentence: “This signals a downside growth risk to the US economy.”