When you think of the interest rate markets, you probably think of plain-vanilla Treasuries. But there’s much more to them than that.
One of the most important sub-markets of all is the one for high-yield, or “junk,” debt.
As the name suggests, junk bonds are debt securities issued by companies with higher-than-normal credit risk. They compensate investors for that risk by offering higher yields than traditional, highly rated corporate bonds.
I follow junk bonds very closely, and it would behoove you to do so as well – especially in this day and age.
One reason? The “spread,” or difference, between yields on junk bonds and corporate and Treasury debt of similar maturities is a great indicator of future economic growth, risk appetite, and inflation or deflation risk.
Is the Junk Bond Market Exploding…or Imploding?
The junk bond market has exploded in recent years, and activity there has been a key driver of stock prices. The volume of junk bonds outstanding roughly doubled to $1.8 trillion this year from $940 billion at the depths of the Great Recession.
That’s because investors dog-piled into junk bonds, mutual funds, and ETFs as a way to generate better yields in a world flooded with cheap money and rock-bottom interest rates. And their voracious buying allowed companies to sell record amounts of debt.
Companies took all the easy money they raised, and went on a buying and spending spree. But many firms didn’t build a bunch of new factories or corporate headquarters buildings … hire millions of new workers … or invest heavily in capital equipment. Instead, they bought other companies and bought their own shares.
Stock buybacks surged to a near-record $492 billion last year from only around $125 billion in the recession. Merger and acquisition volume more than doubled to $2.2 trillion from $900 billion.
That was great if you were a CEO or someone else with millions of shares. The value of your stock went up as the supply of shares shrunk. Merging with competing companies, firing thousands of workers, and boosting corporate profits also meant a nice, fat paycheck.
But those aren’t the kinds of corporate actions that help the broader economy in the long term. Worse, the credit cycle is now turning … and that means everything is starting to move in reverse.
Financial Engineering is Becoming Less Economic…and Less Rewarding
Junk bond yields, and the junk bond spreads I mentioned earlier, are rising sharply. That’s driving up the cost of stock buybacks and M&A transactions — making financial engineering less economic and rewarding. So companies are stepping back.
The elimination of the never-ending buyback bid, and the end of the massive M&A boom, is starting to put downward pressure on stock prices. That, in turn, is making junk bond investors even more worried, leading to even more selling.
There’s no telling precisely how this cycle will play out. But the events I’m seeing in the bond market aren’t very encouraging. So you definitely want to pay attention to what’s going on in junk bonds.
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Until next time,