There is a claim out there that equities are actually fairly valued because of low interest rates and the underpinning they have provided for discounting future cash flows, even with a weaker post-COVID-19 outlook for the economy. Fair enough.
But for other risky asset classes, such as the high yield bond market, it’s really about whether you are being compensated sufficiently for the risk against default, not about earnings shortfalls, which is the domain of the stock market. And while high yield spreads are a barometer of risk appetite and general financial conditions, it is not the spread that protects an investor in the corporate bond market – especially at the outer limits of credit quality. It is the yield itself that should reflect that risk of future default.
It is true that investors are being given a high degree of comfort from the U.S. Federal Reserve’s incursions into the credit markets, including high yield debt. But while the Fed can provide liquidity, it can’t really protect anyone against insolvency or prevent bad managers of risk and poor business models from going under. Insofar as this is attempted, it merely kicks the can down the road for zombie companies and therefore ensures that excess capacity lingers for longer, reinforcing a deflationary backdrop that proves to be a pervasive squeeze on profits and margins. There is no such thing as a free lunch, even if that is how the markets trade on a “Don’t fight the Fed” mentality.
Back to the high yield market. It is in the danger zone. Again, this is not about spreads, which are only wide by virtue of how low government yields are trading. It is about the yield, or lack thereof. This is a space that is called “high yield” because the yield is supposed to be high to compensate for heightened risks of debt default. It is otherwise known as “speculative grade” or even “junk,” because these are companies with a ton of leverage on their balance sheets relative to their capital base and cash flows.
The speculative grade (12-month) U.S. corporate default rate has climbed to 7.32 per cent as of July 1, up from 6.39 per cent in June. This is a new 10-year high.
There is an unmistakable pattern of rising default rates that started long before the current recession began. A decade ago, when the default rate was this lofty, the high yield coupon was more than 10 per cent. In fact, the level of today’s default rate has historically been associated with an interest rate, on average, of 11 per cent in the high yield sector. Today, that yield sits at 6.1 per cent. That’s why I call it “low yield” now – it does not deserve to be called “high yield” under the current circumstances, unless you think the default rate is suddenly going back down to 3.25 per cent.
Think about that figure: 3.25 per cent is where we normally are three years into an economic recovery – including each of the past three cycles.
One thing is for sure, however – we’re nowhere close to being in the third year of an economic renewal cycle. At best, that would put us in the second half of 2023. So, the high yield market is trading as if the default rate is 3.25 per cent when, in fact, we know that default rate currently sits north of 7 per cent. That is a mispricing of risk, with or without the long arm and deep wallet of the Fed. Also, keep in mind that defaults lag the cycle and at the three prior recessionary highs, the rate averaged 12.7 per cent.
So, the conclusion is: 1) High yield rates “should” be trading closer to 11 per cent than 6.1 per cent to compensate for default risk. And that’s for today’s default rate – we haven’t even hit the peak yet.
2) The high yield market seems to be pricing in a default rate of 3.25 per cent, which is just under half today’s level. Instead of discounting a recessionary default rate, the market is pricing in a default rate we typically see three years into the economic recovery.
3) Maybe the Fed is omnipotent or, perhaps, this is the perception that has driven this unprecedented gap between the current pricing and the underlying fundamentals. The question for high yield bond investors is whether we reach a point where not even all the intervention in the world by the Fed can entice investors to ignore the huge mismatch here on a risk-reward basis.
At what point will investors wake up to the reality that this is not a casino, after all, and there will be a time when true price discovery will bring the market back to balance. To say, “there is no alternative” in the high yield space is akin to saying, “Mr. Lender, I will pay you to take on the risk of this piece of paper instead of me getting paid to assume the risk.”
To be sure, the stock market is way too overpriced for my liking. But the future earnings outlook is a source of debate, and the bulls have stated their case. And I get it. But high yield bonds – come on, the issue is as plain as day. It’s about default risk and not getting the compensation you deserve as an investor.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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David Rosenberg