November 21, 2018
One of the warning signs of trouble for the economy and the general stock market comes from the credit markets. Credit is the lifeblood of the economy and is crucial for businesses and households to continue to spend. In turn, it drives company revenues and business expansion.
Cut off credit, and spending will be imperiled. And so, in the past months’ issues of Profitable Investing, one of the risks that I’ve been keeping a close eye on is the credit markets.
Right now, corporate non-financial debt in the US as a percentage of the gross domestic product (GDP) has been strongly on the rise to a current 45.60%, nearly a post-war record. For households, in the third quarter of this year, debt was up for the 17th consecutive quarter to a high of $13.52 trillion, which is 20% higher than in 2013.
This is a lot of credit that has been working to fuel economic growth and the stock market’s underlying earnings growth.
But is this running into a problem?
One of the distressing facets of corporate credit is in the leveraged loan market. These are private loans that are either placed directly with banks, private equity and other fund companies or are pooled and packaged into collateralized loan obligations (CLOs), which then trade over the counter.
2017 saw a record placement of additional loans, amounting to $788 billion. The US makes up 70% of the overall market for these typically lower-credit-rated loans.
All of this debt has been finding eager homes at the institutions and funds buying them up. But since October, the yields have been climbing rapidly. For less-than-investment-grade (“junk”) debt, the yield is now up to 7.23%. This is now back at levels last seen in July of 2016, but thankfully still below recent highs in February 2016, when the average yield was over 10%.
BB-rated debt is now at an average of 7.22%, and CCC-rated debt is averaging 10.89%, both up significantly from the start of October.
One of the warning signs for trouble just kicked in—the credit default swap (CDS) market saw a dramatic move since October 1. CDSs are like insurance options on individual bonds or on bond indexes or other derived securities. Owners of bonds can buy CDSs, which pay them if bonds default. Sellers of CDSs make bets (or investments) much like insurers, betting that bonds won’t default at levels to make the CDSs bad deals.
One of the broad measures for the CDS market is the Markit CDX North American High Yield Index. This index had been puttering along until October 1, after which time the index has made a significant plunge from 107.57 to a current 103.33. This might not appear to be a big deal, but in the bond market a move like this is very significant. This index tracks the performance of the underlying synthetic CDS long positions represented by the index. The result is that as the index remains steady to higher, the CDS market is steady to positive. When it falls, as it has done quickly and decisively since the start of October, it means the underlying CDS positions are rising in risk and falling in performance for the institutional investors being long the risk.
Now, I’m not ringing the alarm bell, but I am letting you know that I’m continuing to keep an eye on these conditions and will let you know when it (or any other indicator) has tipped enough to warrant raising cash or becoming more defensive in the allocations in the model portfolios.
One bit of better news comes from the bond rating agency Fitch. The agency recently issued a forecast for default rates for US corporate bonds for 2019. It is forecasting that default rates will fall to 1.50% from the rate of just less than 2.50% that we’re expected to end up with for this year. That would make it the lowest since 2013.
So, while there are cracks in credit, for now companies are expected to make their payments.
However, there are some outliers that could be ready to shake up the general stock market. General Electric (GE) is in precarious shape. Its debt is currently at 209.50% of what’s left of its equity. A default would be epic news for the stock market and would be cause for another round of selling of the S&P 500 and would be headline news for the markets.
Ford Motor (F) is another classic American business that’s also in jeopardy. Its debt to equity is at 442.20%, and its management is flailing to right the ship.
Neither, in and of themselves, will upend the overall debt market, but either would put other debtors under closer scrutiny. And what we all learned in 2007 is that it only takes a few companies—and they don’t even have to be large or well-known—to set off ripples that can result in waves.
That said, with the general stock market heading down for the start of the week, I want to continue to point out some havens out there that you should be buying and owning, as I did at length in the December issue just posted on the Profitable Investing website.
One haven to note for investors seeking a parking place for capital while the general stock market churns is developing in the shorter end of the US Treasury market. The two-year Treasury yield is now sitting at 2.79%. This is now an attractive yield against the general average for the S&P 500, which is sitting at 2.00%. And even as I see shorter rates potentially edging higher, the two-year has minimal duration, meaning prices don’t move down much against yield rising.
In addition, as the two-year is held, it continues to shorten day by day in maturity, shortening duration risk further and further. This makes this area of the Treasury market appealing as a parking place for cash, given the churn in the S&P 500.
All brokerages can provide access to two-year Treasuries at a low fee. And you don’t have to completely nail the exact date as there are many older Treasuries in the market that are just rolling down the yield curve as they move closer and closer to their eventual maturity.
For investors seeking synthetic alternatives, there are two ETFs worth taking a look at: the Vanguard Short-Term Treasury ETF (VHSH) and the SPDR Portfolio Short-Term Treasury ETF (SPTS).
Both of these ETFs have Treasuries maturing from under one year to out to just beyond two years, and they tend to rebalance their holdings on a monthly basis. This means that compared to owning Treasury notes directly, the ETFs will have lower yields and will reflect the ups and downs in the very short end of the Treasury yield curve market.
But again, both would make for good parking places for the current stock market conditions and would also insulate you from credit market risks.