Saturday, August 10, 2019

If you have not noticed, there is a lot of risky debt outstanding

Sometimes investors have to be hit over the head with a 2x4 to notice risks. This week saw one of those 2x4 moments. High yield spreads as measured by the BAML OAS spread index for both high yield and BBB-rated bonds exploded wider with increases of 50 bps and 15 bps respectively. This was a 10+ percent increase in spreads based on last week's spread levels in both markets. Investors talked about the difficulty of finding liquidity in these markets. While the market seemed to calm by the end of the week, there was only a limited reversal in spreads. 

The debt market structure suggests there is a lot of risk in credit investing. First, the amount of the lower-rated bonds on the cusp between investment grade and high yield has never been higher. Second, the ability to pay as measured by debt to EBITDA could not be worse.  

These conditions are unlikely to change even if there is further Fed rate cuts. Debt supply has not slowed even when rates were rising. Any decline in earnings will hurt the denominator in the debt/EBITDA ratio. There are buying opportunities and liquidity warnings. While the reach for yield may intensify if absolute rates decline, this week was a warning. Fundamentals are not good, so spreads have little reason to tighten. 

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