High Yield Debt Surges Higher Which Favors the Bulls

Following high yield debt is an excellent way to time market swings. A high yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade. These bonds have a higher risk of default and so they pay a higher yield than better quality bonds. Bonds rated below BBB− are called speculative grade bonds, or “junk” bonds, and fall into the category of high yield debt.

Recessions increase the possibility of default in speculative-grade bonds.

The number of companies issuing high yield debt is abnormally high for August. What is happening is that investors are anticipating higher rates from the Federal Reserve and so the higher yields of safer investment grade bonds start to come into greater competition with junk bonds. It’s the crowding out effect.

Tesla and other debt heavy corporations are front-running the crowding out effect by issuing as much junk bonds as they can before more interest rate hikes occur. You can read about rising junk bond issuance here.

Recently we have seen some government bonds downgraded to junk bond status like what’s happened recently in Illinois.

You have to be careful not to equate junk bonds in foreign countries with those issued in the US. In emerging markets like China and Vietnam, bonds have become increasingly important as financing options because access to traditional bank credits is limited, especially if borrowers are non-state corporations.

High Yield Debt Chart

Junk bonds act as a barometer for risk on versus risk off. In a risk on environment, investors chase after maximum yield and so they buy high yield debt. Junk bond investors are not too worried about a recession or default on their junk bonds. In a risk off environment, investors sell out of high yield debt and move to safer, lower yielding assets.

When non-investment-grade bonds spike up or down, the S&P 500 has a tendency to follow within 3 to 5 days.

high yield debt

Last week the high yield debt chart (HYG) spiked higher which is a bullish signal for the S&P 500 over the next 3 to 5 day period.

Corporate Bond Yields Spread Falling… Another Bullish Indicator

Corporate bond yields spreads are falling which suggests there is a low default risk. Using Fred and Moody’s we can chart the spread between lowest investment grade (Baa) and equivalent 10-year Treasury yields.

Corporate Bond Yields Spread Chart

Corporate bond spreads are at there lowest point since 2008. This suggests that markets are pricing in a very low risk of default which is bullish for the economy.

BAA Corporate Bond Yield

Corporate Yield of a Moody’s Graded Bond. For instance, a Seasoned AAA Corporate Bond of 30 Year is the yield return of bonds graded AAA by Moody’s with a maturity of 30 years. Bonds less than specified timetables are dropped along with bonds with redemption and rating risks.

Moody’s BAA corporate bond yields are instruments based on bonds with maturities of 20 years and above. For instance, a seasoned BAA corporate bond of 30 Year is the yield return of bonds graded BAA by Moody’s with a maturity of 30 years. Bonds less than the specified timetables are dropped along with bonds with redemption and rating risks.

The credit ratings of AAA and BAA are the two ends of the ratings spectrum for investment-grade corporate bonds as provided by the Moody’s rating agency. The yield difference between bonds with these ratings has historically indicated whether the economy was in a period of recession or expansion.

The credit-rating agencies Moody’s and Standard & Poor’s provide credit ratings on bond issuers and their bonds to give investors an idea of the investment reliability of the bonds, concerning the payment of interest and principal. AAA is the highest bond rating and indicates the safest bonds for investors. Bonds rated below BAA — BBB from Standard & Poor’s — are considered to be non-investment grade. That makes the BAA rating the lowest investment grade rating. The lower the credit rating, the higher the yield a bond will pay.

The corporate bond yields spread chart above shows riskier BAA rated bonds (lowest investment grade rating), versus 10-year Treasury yields. In periods of higher default risk, the plot rises. The plot falls in periods of lower default risk.

U.S. Treasury yields are falling because of low inflation. With inflation so low, the Federal Reserve will likely not raise interest rates again until 2018. Remember, the main reason the Fed raises interest rates is to combat inflation in an over-heated economy. Clearly we do not have that.

Tax cuts and a $1 trillion infrastructure spending program would push inflation higher.

With Congress failing to repeal and replace ObamaCare, it is pushing the Trump Administration’s tax cuts and infrastructure jobs program out further. Inflation is staying low for longer as a result.

The Federal Reserve now is in a position where they do not need to raise rates to combat inflation. As a result, the Fed funds futures rate has dropped and is now showing about a 40 percent chance of a rate hike in December 2017.

Next week when the Fed meets, we could get clarification on when they will begin unwinding their $4.5 trillion balance sheet.

If you have an opinion on what the drop in corporate bond spreads means, please add your comment below.

Illinois Debt Clock Ticking Down To Junk Bond Status Credit Rating

The Illinois debt clock is ticking. Unless the Governor and the General Assembly set a budget in place by June 30, 2017, and a correctly balanced budget, Wall Street ratings agencies are expected to quickly downgrade the state’s credit to junk status.
Continue reading “Illinois Debt Clock Ticking Down To Junk Bond Status Credit Rating”

Deadly Parasitic Derivative Collapse Spreading Through Global Markets

Deutsche Bank may be on the verge of collapse. Last week Deutsche Bank reported Q2 2016 earnings of 20 million euros which is a 98% drop in earnings year-over-year.

In 2015, Deutsche Bank announced its first full year of loss since the 2008 recession.

Deutsche Bank’s stock is down -60% over the last year meaning that the bank is close to collapse.

Deutsche Bank’s shares now trade for two-thirds less than their tangible book value, a steeper discount than even during the depths of the financial crisis.

Beyond Germany, few stock traders care if Deutsche Bank collapses. The problem with Deutsche Bank collapsing is its enormous derivatives portfolio valued at 42 trillion euros! To put in perspective, the entire EU (all 28 member states) has an estimated GDP value of 14.3 trillion. Deutsche Bank’s 42 trillion euro derivatives portfolio is about three times the size of the entire EU!

One might think that with such a high exposure to the derivatives market, Deutsche Bank would have already collapsed. The reason Deutsche Bank has not collapsed is because of something called netting. For every derivative position Deutsche Bank holds, they hold another position in the opposite direction, so they roughly cancel each other out. At least that’s what Deutsche Bank is reporting that they are doing. Whether that is true or not remains to be seen. Why would anyone hedge their longs with shorts in a 1:1 ratio? You would never make any money from trading, and you would slowly lose on slippage. The OCC tracks netting on U.S. banks and does, in fact, show that even with netting, net current credit exposure (NCCE) has been rising rapidly since 2014.

When Deutsche Bank collapses, it is going to be the explosion heard around the world, and it will be a disaster many times greater than the collapse of Lehman Brothers in 2008.

US Derivatives Exposure

The big U.S. banks have higher exposures to derivatives than Deutsche Bank. As of June 30, 2016, below are U.S. banks with the largest derivative exposures.

Citigroup has amassed the largest stockpile of interest-rate swaps as they bet on central bank rate changes.

Five U.S. banks hold 93% of all derivatives: Citigroup, JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley. The total value of these derivatives is $247 trillion (notional).

Morgan Stanley has $31 trillion in derivatives with $1.6 trillion (notional) in credit derivatives. What is scary is that Morgan Stanley is back to speculating in the same credit derivatives market that took down AIG in 2008. I don’t think Morgan Stanley necessarily wants to speculate in credit derivatives but with revenue flat the last few years, they may be getting more desperate to prop up their stock price. Morgan Stanley’s stock is down more than -25% over the last year.

Most traders in the U.S. don’t care about Morgan Stanley’s risky credit derivatives portfolio, but they should. Morgan Stanley has more than 15,770 retail brokers managing $404 billion of other people’s money (mom and pop savings, retirees, pensions, retirement accounts, etc.cause). Morgan Stanley’s risky credit derivatives position poses a huge threat to the investing community in my opinion.

Banks and Financial Firms Will Not Disclose Information Until It’s Too Late

If you are waiting for banks and financial firms to disclose risks and even how much they were bailed out from the last time they made risky credit derivative bets, don’t.

Wall Street On Parade writes

To survive the 2007-2009 Wall Street crash, Morgan Stanley received an injection of $9 billion from the Japanese bank, Mitsubishi UFJ Financial Group; a $10 billion injection from the U.S. government and over $2 trillion in secret, cumulative, below-market-rate loans from the Federal Reserve. According to data obtained by Bloomberg News following a multi-year court battle to obtain the information from the Federal Reserve, Morgan Stanley’s one-day secret outstanding loans from the Fed peaked at $107.3 billion on September 29, 2008.

The public would have never known about these secret loans shoring up Wall Street’s reckless conduct and hubris and obscene bonuses except for the court battle of Bloomberg News and legislation secured by Senator Bernie Sanders of Vermont requiring a Fed accounting.

Credit Derivatives Exposure On the Rise In the US

The Office of the Comptroller of the Currency reports some scary facts in their most recent quarterly OCC report.

– Insured U.S. commercial banks and savings associations reported trading revenue of $5.8 billion in the first quarter of 2016… $1.9 billion lower (24.9 percent) than a year earlier. [In my opinion, when trading revenues are down, trading divisions take on more risks in a desperate attempt to meet quotas like buying riskier credit derivatives as the data points below confirm].

– Credit exposure from derivatives increased in the first quarter of 2016. Net current credit exposure (NCCE) increased $65.1 billion, or 16.5 percent, to $460.1 billion.

– Notional derivatives increased $12.0 trillion, or 6.6 percent, to $192.9 trillion.

– Derivative contracts remained concentrated in interest rate products, which represented 76.3 percent of total derivative notional amounts.

Using Derivatives To Bet On Interest Rate Changes

The OCC reports

Measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted. The total of all contracts with positive value (i.e., derivative receivables) to the bank is the gross positive fair value (GPFV) and represents an initial measurement of credit exposure. The total of all contracts with negative value (i.e., derivative payables) to the bank is the gross negative fair value (GNFV) and represents a measurement of the exposure the bank poses to its counterparties.

GPFV increased by $0.8 trillion (26.6 percent) in the first quarter of 2016 to $3.8 trillion, driven by a 29.9 percent increase in receivables from interest rate and FX contracts. Because interest rate contracts make up 76.2 percent of total notional derivative contracts, changes in interest rates drive credit exposure in derivative portfolios. Declines in interest rates tend to increase exposure. This effect has increased in recent years, as the maturity profile of interest rate derivatives has increased, making credit exposure more sensitive to changes in longer-term rates.

Credit risk exposure increased a whopping 26.6% in Q1 2016. Much of that increased credit risk exposure is coming from bets on Federal Reserve rate hikes. If interest rates go up, credit risk exposure in derivative positions goes down. If interest rates go down, credit risk exposure goes up. In other words, most of the bets in the derivatives market are on interest rates rising. Better hope Janet Yellen doesn’t have to lower interest rates!

Credit Default Swaps Dwarf All Other Forms of Derivatives

Credit default swaps dwarf any other form of credit derivative trading.

The OCC reports

The notional amount for the 54 insured U.S. commercial banks and savings associations that sold credit protection (i.e., assumed credit risk) was $3.6 trillion, up $206.4 billion (6.0 percent) from the fourth quarter of 2015. The notional amount for the 50 banks that purchased credit protection (i.e., hedged credit risk) was $3.8 trillion, $224.9 billion higher (6.3 percent) than in
the fourth quarter of 2015.

It is interesting that many people are reporting having received a letter from their credit card company informing them that their interest rate is going up from 19.9% to 25% in August 2016. Some people have even reported receiving credit limit increase letters too. How kind of these bankers to go long credit default swaps while raising your credit limit and interest rate to insane levels at the same time.

Folks derivatives are dark financial products that cause excessive risk taking that ultimately leads to disaster. I have little doubt that the next global financial crisis will, at its core, once again involve speculative derivatives betting.