Why the stock market puzzle has not spread to the credit market

W.Retrieved July 2007, Fund manager and bubble spotter Jeremy Grantham compares the stockmarket to a brontosaurus. Although the credit market was collapsing around him, the share price remained steady. The giant sauropod seemed to be bitten on the tail, but the message was still “going to the long spine, one vertebra at a time” to his tiny brain. It took time to arrive: America S.AndP The 500 index did not reach its peak for another 20 months.

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So far this year the story is different. Equities, especially the more speculative, have had a brutal start in 2022 The technology-heavy Nasdaq Composite Index fell nearly 16% in January, before moving slightly to ৷ The ARK Innovation Fund, a vehicle dedicated to young, high-risk technology stocks, fell 20% last month and is down 53% from its peak in early 2021. However, the wild parts of the credit market are relatively quiet Bank of America Us The high-yield index, a popular barometer for the price of “junk” bonds issued by low-credit borrowers, has fallen just 2.4% since the end of December.

Less surprising than you might think. A stock price is derived from a flow of potential income that extends into the future. In contrast, the value of a bond depends on the issuer’s ability to pay interest until the security matures and then to find cash to pay the principal (possibly by issuing another bond). This makes bondholders less star-eyed than shareholders. If a firm wants to change the world, great – but it’s best to avoid breaking up for a few years. So the bond market tends to be less sensitive to sentiment and price changes. In other words, 2007 was the exception, not the rule.

Moreover, the creditworthiness of junk bonds as a department improved during the epidemic. The disadvantages of 2020 have accelerated the growth of the “fallen angels”: companies like Kraft Heinz, which were previously given investment-grade rates but were later downgraded. Such issuers sit at the safest end of the junk market.

However, there are good reasons for investors to be cautious. One is that the push for monetary policy tightening may still be feeding. A record amount of junk bonds will need to be refinanced in the last two years. Such issues amount to সং 869bn, or about half of the outstanding stock of junk bonds, for American companies, according to data provider Refinitive. The main goal of the Federal Reserve was to buy epidemic-induced bonds so that firms would not be overwhelmed by the lack of debt. But its asset purchase is about to end. Borrowers either have to repay the loan or refinance in a market where there is no more liquidity.

More fundamentally, investing in high-yield loans has changed as interest rates have fallen. Michael Milken, an American investment banker, pioneered the use of junk bonds in the 1980s, arguing that their yields were high enough to compensate investors for odd defaults. In that decade, he was right: the junk yield averaged 14.5% and the issuers defaulted only 2.2% per year. But the phrase “high yield” has lost its meaning. Although the central-bank rate hike is on the card, yields are still bleak. In the US and Europe, average junk-bond yields are 5.1% and 3.3%, well below inflation. The resilience of the credit market is a measure of the belief that even the most risky borrowers are less likely to go bankrupt. Yet when yields are in low single digits, it takes a few defaults to break the investment case.

And the financial health of the borrowers who default can be bad, resulting in more losses to the lenders. Lender protection has weakened over the past decade, as yield-hungry investors have been chasing returns at any cost. The maintenance agreement, which allows lenders to forfeit the wheel if the financial condition of the borrower deteriorates, has long been absent from bonds (and has largely disappeared from personal loans as well). Incarnation agreements, which limit borrowers’ ability to make new loans or pay dividends, have lost their teeth.

Its proponents may point out that bond investors have some interesting options for junk loans. Yields are still low in treasuries; Financial markets expect the Fed’s benchmark rate to not exceed 1.8%. But the value of the credit market is for a world where bad surprises don’t happen and liquidity flows forever. These hypotheses increasingly seem to be related to Brontosaurus.

Read more about financial markets from our columnist Buttonwood:

Why it is difficult to eliminate debt bias on equity (January 22)
Rapid transformation of finance, as seen by an experienced broker (January 15)
Why Gold has lost some of its investment appeal (January 8)

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This article is published under the title “Sting in the Tail” in the Finance and Economics section of the print edition.

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