The shudder in US credit
As oil prices tumble and the first US interest rate hike for eight years comes into view, bond investors in the high-yield segment are taking flight. The market was given a foretaste of what a disorderly unwinding of an over-bought US corporate bond market may look like late last week, when two high-yield bond funds suspended redemptions.
The worry is that these tremors become an earthquake, making it more costly for all companies to refinance themselves. Such a cycle of contagion could tip both the US economy and equity market into a proper downturn. To our mind, this risk is probably overblown.
First, it should be recognised that there has been no “meltdown” in the credit space. To be sure, spreads and yields have generally risen since April, but outside of the high-yield commodity sector, the moves have so far conformed to “normal” patterns given the point in the economic cycle.
While yields on sub-investment grade energy bonds have risen by another 700bp since May (when the current move in bond markets really got started), the rest of the high-yield bond index has seen yields rise a significantly lower 200bp, and the overall cost of borrowing for US companies of all shades is up by 75-100bp. The market is still distinguishing between varying risks and not yet in a generalised panic.
A strong argument can also be made that contagion risk has lessened compared to past panics. Banking sector reforms that followed the 2008-09 crises mean that banks are less involved in market-making activity (the share of corporate bonds held by banks has halved since 2008; this means less leverage). And with bank balance sheets not so exposed, bond market tremors are less likely to spark riskaverse responses by those institutions and with it a contraction of the US money supply.
This does not mean contagion risk has gone to zero. A new risk has emerged with a possible wave of redemptions from bond funds resulting in price gapping.
Open-ended mutual funds lack the leverage of banks, but they share some similarities in that they have an inherent maturity mismatch — such funds typically promise daily liquidity, while owning less-liquid long-term assets. A run on these funds would create a wave of forced selling, especially as the holding of liquid assets (cash, US treasuries…) amounts to just 5% of assets.
And since investment banks play a greatly diminished market-making role, these sellers may struggle to find buyers in any orderly fashion. In such a scenario, fund managers will offload what they can, not what they “should”—the result would be an indiscriminate rise in credit spreads and interest rates.
This risk is real, and worth monitoring. In fact, if the US is to face a recession in 2016, this is the most likely transmission mechanism. Yet in our view it remains a tail risk. We estimate that corporate borrowing costs would need to rise by about 200bp from here to usher in recession (twice the increase seen since May, see chart). This would eliminate the positive spread between the cost of capital and its current rate of return.
With less leverage in the system, and with yields on longterm corporate bonds so far above the return offered on money market funds, we think such big moves in yields are unlikely.
To be sure, it would not surprise us to see bond yields rise by a further 100bp in the next few weeks or months (whether on the back of rising government yields or wider credit spreads). But we would expect this to attract domestic and international buyers, capping the rise before it triggered a recession. Tail risks notwithstanding, the US is most likely marching toward a recession sometime in 2017 or thereafter, not jumping into one after the Federal Reserve’s first rate hike.