There are seemingly always “good reasons” why troubles in a sector of the credit markets are supposed to be ignored – or so people are telling us, every single time. At first it was assumed that the most highly rated tranches of complex structured products would be immune, as the riskier equity tranches would serve as a sufficient buffer for credit losses. A weekly chart of high yield ETF HYG (unadjusted price only chart) – click to enlarge. It also overlooks that energy and commodities-related debt is simply huge and the losses are really beginning to pile up by now. It has turned out in hindsight that when we wrote in detail about the unsound boom in corporate debt last year, the price bubble in junk bonds had actually peaked a mere five trading days earlier. As you can see from the above, excluding all the bad stuff, things still look fine, but the bad stuff looks really bad. Not surprisingly, the credit rating agencies are beginning to increasingly express concern over these developments. To date, the US high-yield credit rating changes of 2015’s fourth quarter show 57 downgrades far exceeding 18 upgrades. The final quarter of 2015 is shaping up to be the second straight quarter of substantially fewer high-yield rating upgrades relative to downgrades.
As long as high-yield downgrades well outnumber upgrades, any extended narrowing by the high-yield bond spread is suspect. In short, if there should be a short term rally in junk, use it to get the hell out of Dodge while you still can.
Expected default rates of high yield borrowers tend to lead credit spreads – click to enlarge. Accordingly, expected default rates are now increasing as well, and have reached levels that were last seen in 2009. Given the surge in the number of downgrades, plunging upgrades, and the likelihood of significantly more defaults, the recent composite high-yield bond spread of 595 bp is unlikely to soon approach its 424 bp average of the two-years-ended June 2015.
Only in the 2001-2003 post technology bubble recession was a higher proportion of HY debt employed for refinancing purposes.
As long as enough new money is provided the show can go on, but obviously, this is highly dependent on investor confidence. Bank credit supply to business is tightening – HY spreads historically tend to follow suit – click to enlarge. What is so remarkable about all this is that it has happened before the Federal Reserve has hiked rates even once from their current zero to 25 bp corridor (in practice, the effective FF rate has been oscillating between 7 and 14 basis points). This is highly unusual and indicates that the end of QE3 must indeed, as we have always argued, be regarded as a significant tightening of monetary policy.
Thus the often heard refrain that the “taper” did not mean a tightening of policy was and remains misguided. The stock market is traditionally the last market to get the memo – this is the case at present as well. In the meantime, the ratio of junk bond prices to equity prices has trended relentlessly downward, something that can be observed with unwavering regularity ahead of major market peaks. The price of junk bond ETF JNK (unadjusted) and the JNK-SPX ratio – stock market participants once again assume that credit market deterioration cannot harm them. In addition, the misguided view that “manufacturing is just not important to the economy”, continues to hold sway as well.
ZIRP, NIRP lead to squandering money on malinvestments in plants, mines, equipment, staff, ending up in overproduction, ending in falling prices- deflation. And yet Martin Wolf this morning avers that high equity prices can be justified by a corporate savings glut.
We and many others have made a valiant effort over the years to explain what actually moves the gold market (as examples see e.g.
Our editor recently stumbled upon an image in one of the more obscure corners of the intertubes which we felt we had to share with our readers. The commitments of traders in gold futures are beginning to look a bit concerning these days – we will explain further below why this is so. Legendary former hedge fund manager Stanley Druckenmiller at the Ira Sohn conference – not an optimist at present, to put it mildly.
The markets are eerily quiet… like an angry man with something on his mind and a shotgun in his hand. DUNMORE EAST, Ireland – We came down the coast from Dublin to check on our new office building. As we keep saying, there really is no point in trying to make people richer by making them poorer – which is what Shinzo Abe and Haruhiko Kuroda have been trying to do for the past several years. Zerohedge recently reported on an interview given by Lithuanian ECB council member Vitas Vasiliauskas, which demonstrates how utterly deluded the central planners in the so-called “capitalist” economies of the West have become. To bring new readers fully into the picture, Northwest Argentina, where we have our ranch, has a revolution going on. Tesla Model 3: the company’s first “mass market” entry so to speak, which is supposed to help the world to reach the nirvana of  “sustainable” transport. Redemptions from stock funds have hit nearly $90 billion this year as portfolio managers and hedge funds struggle to navigate a market that no longer seems driven by radical central bank policy. It has become clear now that the troubles in the oil patch and the junk bond market are beginning to spread beyond their source – just as we have always argued would eventually happen. Recently we said that JNK looked like it may be close to a short term low (we essentially thought it might bounce for a few days or weeks before resuming its downtrend).
To be sure, such a big move lower on vastly expanding volume after what has already been an extended decline often does manage to establish a short to medium term low. As we have often stressed, we see the corporate bond market, and especially its junk component, as the major Achilles heel of the echo bubble. We would also like to remind readers that it is not relevant that the main source of the problems in the high yield market is “just” the oil patch. Financial crises are actually quite often triggered by problems that emerge in a small and supposedly unimportant sector in which a comparatively large amount of unsound credit has piled up. There is a widespread tendency to underestimate these dangers, and one reason for this is the role played by the time element.
WTIC and HYG (with a hat tip to Steve Saville, who recently showed this overlay in the Speculative Investor) – a very close correlation that shows how important the energy sector has become for the junk bond universe – click to enlarge. People who have to do with the financial markets or the economy every day can easily lose perspective on this point. In addition, there are winners, namely the many people and companies that obviously benefit from lower oil prices.
It is moreover undeniable that we are continually receiving warning signs, and yet another one has just been delivered. That means that these investors who want their money back are becoming “beneficiaries of the liquidating trust” without a sense of when they’ll actually get anything back, according to a notice to its shareholders dated Wednesday. A substantial portion of the fund, which had $3.5 billion in assets not long ago, consists of the lowest-rated junk bonds, which have on average plunged almost 13 percent in 2015, their biggest negative return since 2008.


One sure sign that this is a symptom of a very serious underlying problem – the very one numerous people have warned about for many moons – is that regulators are waving it off as a non-problem and have tried their best to “debunk” it.
But the fact that Third Avenue took the significant, relatively uncommon move of locking in its remaining investors shows the level of desperation in the lowest-rated credit right now. Our bet is that our vaunted regulators will be just as wrong about this as they were about sub-prime mortgages. Lately the problems in the commodities and junk bond universe have begun to spill over rather noticeably into other markets. The fact that the stock market has also been affected recently strikes us as particularly important, because it is happening during the seasonally strong period.
However, considering the many other warning signs (such as the market’s horrid internals, the still extant Dow Theory sell signal, the growing divergence between junk bonds and stocks, the enormous complacency revealed by long term positioning and sentiment indicators and the recent ominous decline in margin debt from its peak), one should definitely pay close attention.
And then you have these periods like post GFC (2008), where credit saturation is so high (and bank solvency so low) that in order to keep the pyramid scheme of FRL going, the Fed had to step up and create most of the money for the market by diktat.
Not a chance … If you have ever read what he writes here all the time (apparently he loves Draghi because he makes a hard currency out of the Euro, HA!) you would know he means it. Yes, your comment reveals that all of the anti CB vitriol written here and elsewhere is nonsense. Almost exactly one year ago, we penned several articles on what we believed to be a dangerous bubble in corporate debt. There is no need to rehash all the arguments we made at the time – as a refresher, readers may want to revisit “A Dangerous Boom in Unsound Corporate Debt” and “Comfortable Myths About High Yield Debt” for the details. In fact, there has been a kind of “stealth bear market” in junk bonds for a while already, and it has recently gathered pace in the sector’s worst rated segments.
Curiously, this poor performance doesn’t seem to be getting a lot of attention at the moment. Energy companies make up a much greater proportion of the main high-yield indices than they do the S&P 500. High exposure to energy “is totally distorting numbers for the high-yield market”, says Sabur Moini, high-yield portfolio manager at Payden & Rygel.
We believe this type of “this time it’s different” rationalization may turn out to be flawed.
The fact that the same is the case in this instance as well is not exactly a good reason to be complacent.
In an article we published in early April, entitled “The Era of Return-Free Risk”, we showed a possible Elliott Wave count of the above chart that actually looks quite prescient so far. However, more interesting may be recent developments in the yields on junk bonds that are rated CCC or lower. When an important market acts badly and this fact isn’t causing much concern among market participants and observers, it is usually high time to pay close attention. In the short term junk bonds and the weakest stock market sectors (such as assorted commodity producers) are quite oversold and hence seem overdue for a bounce. Readers may recall how the developing problems in the sub-prime sector of the mortgage credit market were greeted by officials and countless market observers in the beginning in 2007. When that turned out to be wishful thinking, it was argued that the problem would remain “well contained” anyway.
The junk bond market has grown by leaps and bounds during the echo bubble, so a lot of money has become trapped in it. Nevertheless, debt issuance in both junk bonds and leveraged loans subsequently continued at a brisk pace for more than a year or so – this has only begun to change in recent months. In the meantime a sizable gap has opened between the two – debt has continued to grow, but the income that supports it has begun to head in the opposite direction – click to enlarge.
Thus far, the US high-yield credit rating revisions of 2015’s final quarter hint of the fewest upgrades relative to downgrades since 2009’s recessionary second quarter. In addition, the accompanying revisions of investment-grade ratings include 11 downgrades and only one upgrade.
All credit agencies put this expected rate at a new low for the move in 2014, not unreasonably arguing that because companies have issued so much debt, they are currently flush with cash and can postpone their refinancing plans if necessary.
Obviously, with demand for HY debt extremely high, even bad credits have little problem refinancing their debt.
In the time period 2009 to 2013, between 53% and 64% of all high yield debt issuance proceeds globally were used for refinancing purposes.
While the agency is uncertain of the precise cause-effect vector at work, this is how credit booms usually end: lenders begin to become nervous about their exposure and stop extending credit to dubious borrowers. Once an economy is hooked on an ever accelerating expansion of money and credit, any slowdown of said expansion will eventually trip the boom up.
As mentioned above, there is no shortage of rationalizations when segments of the credit markets come under pressure, and there is no shortage of rationalizations with respect to the stock market’s increasingly deteriorating internals either. Our hunch is that it won’t make things easier for assorted credit and liquidity junkies. After all, the “it’s different this time” notion is holding sway every time – and it has a tendency to sound increasingly delusional the longer the stock market remains superficially strong.
Meanwhile, the foundation of the economy continues to look rotten (the newest round of Fed surveys has begun with another bomb and other manufacturing-related data continue to disappoint as well). We are happy to report that we have reached our turn-of-the-year funding goal and want to extend a special thank you to all of you who have chipped in.
Switzerland is the first country worldwide to put the idea of an Unconditional Basic Income to a vote and the outcome of this referendum will set a strong precedent and establish a landmark in the evolution of this debate. Not surprisingly, they have so to speak only succeeded in achieving the second part of the equation: they have certainly managed to impoverish their fellow Japanese citizens. His statements are nothing short of bizarre (“we are magic guys!”) – although he is of course correct when he states that a central bank can never “run out of ammunition”. There are however exceptions to this “rule” – namely when something important breaks in the system and a sudden general rush toward liquidity begins. One of its characteristics is that there are many instruments, such as ETFs and assorted bond funds, the prices of which are keying off these bonds and which are at least superficially far more liquid than their underlying assets.
Once the boom in the most exposed sector ends, it at first always looks as if the consequences were manageable, because it takes a long time for really serious effects to become obvious. For instance, more than a year has passed since some observers have first pointed out that the decline in the oil price might cause serious trouble. We suspect however that the winners in a sense have their own time line, one that is to some extent independent of that of the losers. Before the positive effects have a chance to assert themselves sufficiently to matter, the negative effects are likely to play out. Instead of continuing to sell distressed-debt holdings at incredibly low prices, the asset manager decided to make a drastic move that will inevitably kill some of its future business. The Third Avenue fund was aiming to provide huge returns to investors by buying incredibly risky debt when it started in 2009. As investors demanded their money back because of falling prices, the firm was forced to liquidate its holdings, pushing the prices lower on the lowest-rated notes and spurring even more redemption requests. More casualties can be expected, and they will continue to weigh down prices of highly speculative assets.


We believe that the recent plunge in the South African Rand – triggered by president Jacob Zuma firing his minister of finance and replacing him with a relatively unknown lawmaker – shows that the markets are really on edge by now. If you look at the years 2000 and 2007, you will notice the same phenomenon: the stock market started weakening precisely during the time when it is normally expected to be at its strongest. We would argue that if this recent unseasonal weakness persists, it could well be the final nail in the coffin. The boom in both prices and bond issuance was primarily driven by the desperate “hunt for yield” of investors starved of interest-income by the inane ZIRP and NIRP policies enacted by major central banks all over the developed world.
So far, the potential dangers we identified at the time haven’t become fully manifest yet, but there are now signs that this may be about to change. If one looks at a weekly chart of the junk bond ETF JNK (which is depicted excluding coupon payments below – note that one must be careful with charts of bond ETFs, which are often adjusted for payouts and shown as “total return” charts), one could perhaps still argue that it is merely undergoing a drawn-out correction. Only a recent article in the FT briefly discusses it, in an attempt to divine whether it represents a bad omen for equities.
It is a bit like saying in mid 2007 that “only high yield bonds of sub-prime mortgage lenders are performing badly” and hence there is no reason for concern. Whenever liquidity problems in certain risk asset classes begin to become acute, they tend to spread and eventually will affect otherwise uncorrelated sectors as well – mainly because forced selling to service margin calls usually involves selling whatever one can sell. The breakout that hasn’t happened in the Master Index II just yet, has definitely already occurred in the lowest rated high yield segments.
Yields of this segment have already surpassed the peak of late 2014 and have recently advanced to the next short term resistance level – click to enlarge. In short, we disagree with the conclusion presented in the FT – we believe this is indeed a warning sign for other risk assets such as equities.
We should perhaps point out that in spite of this sectoral concentration, problems have recently begun to emerge in other industries as well (a list of recent victims can be found at Wolfstreet). This will in turn eventually make refinancing conditions more difficult for all sorts of industries. Many low-rated borrowers need to continually refinance their debt, otherwise they will simply fold. Note bene, this has happened with administered interest rates stuck at zero over the entire time period! In other words, we are observing a feedback loop here: on the one hand, investors are emboldened by low default rates to keep refinancing HY borrowers, on the other hand it is precisely because they keep refinancing them that default rates remain so low. It doesn’t take a big leap of the imagination to see that problems could arise if investors should begin to balk. We also have confirmation of a tightening monetary backdrop from the narrow money supply aggregate M1, the annualized growth rate of which has been immersed in a relentless downtrend since peaking at nearly 25% in 2011. On the other hand, one can probably be fairly certain that it won’t actually become a “cycle”. It is no consolation that the service sector’s performance is still holding up better.
This message has been often repeated, but nothing really serious has happened so far – after all, the stock market is not too far off an all time high!
It chose to prevent investors from leaving its Third Avenue Focused Credit Fund, a $788 million mutual fund that it has decided to liquidate. But when this debt turned out to have actual risks, the fund couldn’t sufficiently exit its positions to meet investor withdrawals. In “normal” times this type of news may have triggered a small one day wobble in the currency.
Admittedly the current decline is still young and may yet be reversed, so the signal is not yet definitive.
This reinforces the suggestion that the diverging paths of equities and junk bonds are a result of energy company woes rather than broad market fundamentals.
If the market segment doing especially poorly were a tiny one, it probably wouldn’t worth worrying about. Although we regard such wave counts as having more descriptive than predictive qualities, the method sometimes yields good results, especially when the fractal shape of a price chart appears very obvious and one has good reason to suspect that market fundamentals will develop in a manner consistent with the forecast derived from it. Let us not forget that the poor performance of junk bonds also ties in with the recently discussed weakening of stock market internals and the soft data on US gross industrial output reported in Q1.
Also, keep in mind that if a bounce that “should” happen at this juncture doesn’t happen, it would very likely mean that said fireworks have been brought forward. Once liquidity for refinancing dries up – and this is what growing losses in a big market segment will inexorably lead to – it will be game over.
The better rated junk yielded 5.16% at the 2014 low, and yields 8% as of today, adding more that 280 basis points in bad juju since then. Indeed, the recent surge in defaults and default expectations has been marked by issuance in the most vulnerable segments of the corporate bond market grinding to a halt (see the Fitch comment above: HY issuance by energy and metals and mining companies in October stood at zero – the dip buyers are finally taking a break).
Anyone who has observed the markets for a bit longer than today’s 20-something hotshot traders has heard it all before – several times. It should also be noted that every boom ends with capital goods and other higher stage industries affected first and the most.
As a general remark, according to usually well informed circles, exercising the donation button in between funding drives is definitely legal and highly appreciated as well. Malinvestment during a boom is always concentrated in certain sectors (in the recent echo boom the situation has been more diffuse than it was during the real estate bubble, but the oil patch is certainly one of the most important focal points of malinvestment and unsound credit in the current bubble era). Those policy makers may very well be right in that a fund’s liquidation won’t lead to a systemic meltdown and will simply be another casualty of a difficult year for investors.
CBs care only for nominal GDP (not real), so that debts can be serviced and there are no runs on fundamentally bankrupt banking institutions, which FRL lenders (which is institutionalized fraud) constantly are.
It has already put in two consecutive lower highs and lower lows and has declined quite a bit from its peak. They always begin to fray in a specific market sector, and often it is indeed a big segment of the market, as the sector most likely to get into trouble first is usually the one that has seen the biggest capital malinvestment excesses during the boom. However, the segment that is currently in trouble is in fact the junk bond market’s largest. The advance has already put in a higher low and continues to sport an “impulsive” look – click to enlarge.
These yields are comparable to the woeful situation in 2011, when the euro area debt crisis was nearing its peak – click to enlarge. The corporate credit bubble has become too large, while the cash flows supporting it are beginning to crater.
The sharp deterioration in credit-land is however one of the starkest warnings for risk assets yet. This is simply consumption, the price of which has moreover been distorted by government intervention.



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