The size of the corporate bond market has grown extraordinarily subsequent to the 2008 / 2009 financial crisis, adding ~$4.5 trillion worth of Investment Grade (BBB rated and above) and High Yield debt (BB rated and below) representing an increase of ~150%. Of particular note is the split between BBB (lowest rated Investment Grade debt) and High Yield (junk rated debt). From the chart below it is clear to see there has been an explosion in BBB paper (Investment Grade) largely driven by unprecedented stimulus from central banks, falling credit standards by rating agencies and the market’s relentless search for yield.
Corporate Debt Split by Credit Rating ($ trillion)
Historically speaking the spread on High Yield debt coupled with leverage levels in the economy (debt as a per cent of GDP), have been excellent recession and market dislocation indicators. However, in the current cycle High Yield spreads remain stubbornly low despite record high leverage levels in the economy, a paradoxical situation.
Recessions, Leverage and High Yield Spreads Historically Correlated
Circling back to the dynamic discussed in the first paragraph around sharply increasing exuberance in the corporate debt market. If we look at the total return on Investment Grade debt relative to High Yield, we see a staggering trend emerging. Investment Grade returns are sharply underperforming returns in the High Yield market, which means spreads are widening much faster on Investment Grade debt than High Yield. We believe this is likely an indicator that many companies that would have historically been classified as High Yield are now classified as Investment Grade and have been able to raise capital more cheaply than what would have otherwise been possible. As we move deeper into the later stages of the cycle, the market is now repricing these companies and we are seeing signals flash in the bond market. Which perhaps indicates the chart above would be flashing red for a looming correction if we included the lowest rated (weakest) Investment Grade companies that perhaps should have been High Yield all along.
Investment Grade vs High Yield Total Return (i.e. Coupon + Change in Bond Price)
As balance sheets, valuations and the economy continue to stretch we may be seeing the beginning of an unwind. Here at Montgomery Global, we are laser focused on avoiding companies that have synthetically benefited from credit markets that have allowed weak businesses to borrow debt at inorganically cheap rates, lowering their cost of capital and thus elevating stock prices beyond what underlying fundamentals can support.