A dark corner of the bond market is sending a warning sign about the economy.
"If our analysis is correct, today's elevated level of US investment-grade and high-yield credit spreads will persist, and default rates may rise materially through 2016," UBS's Stephen Caprio said on Wednesday. "The implication for the US economy is that wide credit spreads and ascending downgrade and default risks will increase borrowing costs for US corporates. This signals a downside growth risk to the US economy."
This story is not just about junk bonds. It's about the junkiest of junk bonds and what they're predicting for bank lending, which is critical for job creation.
Let's take a breath and unpack this for a second.
What are junk bonds and why are spreads are blowing out?
Market-watchers have pointed to the recent spike in high-yield bond spreads and noted that this is the kind of move that happens as an economy goes into recession.
The high-yield bond market is particularly sensitive to economic cycles. Commonly referred to as junk bonds, these debt securities are issued by companies with low credit quality. Because of the higher risks that come with lending to such companies, they have to offer higher yields than those of their investment-grade peers. When spreads increase, it's costing more for these junk corporates to borrow.
"US high yield credit has faced one headwind after the next — from significant distress in Energy, to risks of weakening global growth, to significant uncertainty around Fed rate hikes," Morgan Stanley's Adam Richmond said on Friday. "As a result, HY just posted the weakest four-month stretch (Jun-Sep) since the end of 2008, -7.03% in total return. This selloff has driven very negative sentiment, as nothing brings the bears out of hiding more so than low prices, feeding into panicky price action in markets."
"The simple point — it doesn't happen often — only shortly before recessions or during major growth scares," Richmond said.
Now, the first caveat everyone points to is high-yield energy, which has been getting slammed by the effects of low oil prices. Indeed, if you take the energy companies out of the picture, spreads in the rest of the junk bond market are much more subdued.
But UBS's Caprio sees a bit more to the story.
"This is not just an energy story, but a broader conversation about the credit cycle and our place in it," he said.
The 'lowest of low quality issuers' are sending a warning sign
Caprio thinks we're heading for a period of tighter, more expensive money. In a note to clients on Wednesday, Caprio 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.
Caprio goes into great detail regarding what's going on here and what the implications are. But we'll fast forward to the nut of the argument.
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). (UBS chief economist Maury Harris has long argued this measure is a reliable indicator of job creation.)
Caprio observed that market activity in bonds B-rated and lower — a proxy for nonbank lending — predicts where the SLOS is going. From Caprio (emphasis added):
"What do our non-bank measures tell us about the future level of bank lending, and ultimately credit spreads and defaults, per our model framework? Utilizing quarterly data back to 2001, we build a model that predicts SLOS based on the level of the CMI index and low-quality HY bond net issuance (Figure 10). The fit is good (R-squared of 68%) as we expected, highlighting that bank and non-bank liquidity evolve similarly through time. However, we would note that our non-bank liquidity measure generally leads our bank liquidity measure by one quarter. The exception is during the financial crisis, where the banking sector was clearly the epicentre of the problem. 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. 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 ...
Here's what that relationship looks like.
While all that sounds bleak, Caprio thinks it could be a lot worse.
"On the positive side though, we believe further spread widening would only be warranted with a systemic-type event, likely originating from even lower commodity prices, a renewed strengthening of the dollar, or a further deterioration in EM growth," Caprio said.
Still, Caprio's base case is for tighter financial conditions.
"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."
To close, we'll note that tighter financial conditions make it less likely that the Federal Reserve will tighten monetary policy imminently. This may alleviate some of the concerns above. Or maybe it just won't exacerbate them.
