The Federal Reserve stepped in to save the collapsing stock and credit markets earlier this year…
It lowered interest rates to practically zero and promised to buy corporate bonds for the first time ever. And for the time being, it has worked. The stock market has since hit an all-time high. The Fed has prevented credit from drying up. U.S. companies have issued record numbers of bonds since March.
More than 80% of the bonds issued have been investment-grade bonds. And these actions have kept money flowing into junk bonds as well.
But don’t let the relative calm in the markets today deceive you.
As I covered yesterday, the Fed’s actions are just extending the day of reckoning for many companies. The storm is far from over. And investors who aren’t prepared for what’s ahead could be wiped out.
The March spike in fear was just a warning tremor. A massive new credit crisis is fast approaching… And when it’s all said and done, it could be much worse than the last financial crisis.
Let me show you why…
This has to do with something called the “high-yield credit spread.” It’s the difference between the average yield of so-called “junk” bonds and the yield of similar-duration U.S. Treasury notes. The size of the spread is a good way to gauge fear in the credit markets.
Right now, we’re seeing a lull in fear. Today, the high-yield spread is around 430 basis points. (100 basis points is one percentage point). In other words, high-yield bonds yield just 4.3% more than Treasurys… much lower than the long-term average spread of around 600 basis points. And much lower than the 1,000 basis points back in March.
Junk bonds yield more than Treasurys because they carry more risk. Unlike the U.S. government, companies can go bankrupt. That’s why the size of the spread is tied to another measure – the default rate. It’s the rate at which companies default on their debts.
This chart shows the U.S. high-yield credit spread (light blue line) and the default rate (black line) over the past 20 years. There’s a lot to look at here, but I’ll break it down piece by piece…
First, pay attention to how tiny the recent spikes in the high-yield credit spread in 2016 and 2020 were in relation to the last financial crisis. The recent spike in March looks like a blip compared to what happened in 2008, when the spread skyrocketed to nearly 2,000 basis points.
That’s why I believe the recent spike in March was just a tremor.
You see, corporate debt is much, much higher today… reaching an all-time high of $11 trillion during the pandemic. Back in 2008, corporate debt was only $6.6 trillion. And the credit quality of this debt is much worse than it was leading up to the last financial crisis.
Next, look at the correlation between the default rate and the high-yield credit spread. They normally move together. The high-yield spread rises first, and the default rate follows. That makes sense… Investors see trouble coming before companies begin defaulting.
But that isn’t happening today…
The default rate has been steadily rising to its current level of around 6%. That means 6% of all U.S. corporate borrowers have defaulted over the past year. But as you can see, despite the rising default rate, the high-yield credit spread has fallen in recent months.
This situation simply can’t last…
These two metrics typically move together over time. As I shared yesterday, we know the default rate is heading much higher. And when the default rate soars, investors will panic.
So eventually, the high-yield credit spread will follow the default rate higher.
The dotted black line in the previous chart is S&P’s base-case forecast for the default rate over the next year. The dotted red line is the credit-ratings agency’s “pessimistic” forecast.
S&P is predicting that the default rate will rise to 12.5% by next June… That would be the highest default rate since the Great Depression in 1932.
But the thing is… I expect it will be even worse. It’s likely to be closer to S&P’s pessimistic forecast of 15.5%, which assumes a second wave of COVID-19 will crop up soon. With the number of cases rising again in the U.S., it may already be upon us.
A 12.5% default rate means another 240 companies would go bankrupt over the next year. A 15.5% rate means more than 300 companies would go under. By my estimates, that will translate into somewhere between $70 billion and $250 billion in defaulted debt – and billions of dollars of credit losses for investors.
Back in March, it was easy for investors to move past their fears. The default rate was only around 3%, and folks weren’t sitting on large credit losses. But the next time it spikes, the credit losses will be much higher.
The Fed can’t do much to stop the default rate from soaring. It will try, of course… once again throwing the “kitchen sink” at the problem. But that will just lead to a longer period of higher defaults.
And when it comes down to it, the Fed is not going to bail out most junk-rated businesses. It might bail out a large automaker and an airline or two to preserve jobs and keep the unions happy… but most businesses low on the credit spectrum will simply be out of luck.
Today, high-yield bonds only yield an average of around 5%. Investors are oblivious to the danger… They don’t realize that a 5% yield is not nearly enough to compensate them for the risk of the coming credit losses.
But if you’re reading this today… you know better.
Good investing,
— Mike DiBiase
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Source: Daily Wealth