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Junk Bond Market: The Biggest Red Flag since the Great Recession

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The junk bond market continues to show signs of cracking… For months now, we’ve pointed to the decline of junk bond values as one of the biggest red flags in the entire market. The bond market is where companies, countries, and individuals go to borrow money. It’s far larger and more important than the stock market. The U.S. bond market, for instance, is about twice as large as the U.S. stock market. If an economy, industry, or company is in trouble, warning signs usually appear in the bond market long before they show up in the stock market. We’ve focused specifically on the bond market’s riskiest offerings, junk bonds, which are bonds issued by companies with shaky balance sheets. They’re riskier than bonds issued by strong companies, so they pay higher yields. When the economy slows down, companies in poor financial shape feel the pain first. That’s why junk bonds often point out problems before other assets do. •  On Monday, one of the biggest junk bond ETFs hit its lowest level in over six years… SPDR Barclays High Yield Bond ETF (JNK) is the second-largest junk bond ETF in the U.S. It holds $10 billion worth of junk bonds. On Monday, it dropped to its lowest level since July 2009. The chart below shows JNK’s performance since then. As you can see, it’s been in a downtrend since June 2014. JNK has fallen 9% this year. It’s lost 4% in the past three months alone.   Junks bonds are a huge portion of the overall corporate bond market. Yesterday, Financial Times reported that half of all corporate bonds have a junk rating. Since 2007, the proportion of corporate bonds S&P has rated speculative-grade, or junk, has climbed to about 50 per cent from 40 per cent. •  Many companies are struggling to pay their debts… Yesterday, Financial Times reported that companies are defaulting on bond payments at the highest rate since the financial crisis. Currently, 99 global companies have defaulted since the year began, the second-greatest tally in more than a decade and only exceeded by the financial crisis which saw 222 defaults in 2009, according to Standard & Poor’s. U.S. companies account for 62 of this year’s defaults. Many more companies are likely to default. Last month, The Wall Street Journal reported that corporate downgrades are at their highest level since the Great Recession. Standard & Poor’s Ratings Services downgraded U.S. companies 297 times in the first nine months of the year, the most downgrades since 2009…with just 172 upgrades. A downgrade is when a credit agency lowers a company’s credit rating. This happens when a credit agency thinks a company’s financial health is getting worse. The huge spike in downgrades this year suggests the health of the entire economy is deteriorating. •  The Federal Reserve has encouraged companies to borrow obscene amounts of money, which is a big reason for this mess… In 2008, the Fed dropped its key interest rate to effectively zero. At the time, it was trying to fend off the worst economic downturn since the Great Depression. The Fed has held rates at effectively zero ever since. Low rates make it cheap to borrow money. The past seven years of incredibly low rates have fueled a corporate borrowing binge… U.S. companies have issued $9.3 trillion in new bonds since the financial crisis. That includes $1.4 trillion in new bonds in the last year alone, according to the Securities Industry and Financial Markets Association. That’s a new all-time record. But U.S. companies will probably top it this year. They’ve already issued $1.3 trillion in bonds through October. That’s 8.4% more than the same period last year. All this borrowing has left corporate America with a massive debt load. In September, financial news site MarketWatch reported that U.S. corporations outside the financial sector owe $7.7 trillion in debt. That’s nearly 50% more than a decade ago. •  Many U.S. companies could struggle to pay back all this money… Because profits for major U.S. companies are shrinking. As of Friday, 95% of companies in the S&P 500 had reported third-quarter results. The S&P 500 is on track to post a 1.6% decline in earnings for the third quarter, after 0.7% drop in earnings in the second quarter. It would be the first back-to-back quarters of declining earnings for the S&P 500 since 2009. Declining profits means less money for companies to pay off loans. Many of the most indebted companies will have no choice but to default. •  Meanwhile, the stock market isn’t as healthy as it looks… The S&P 500 fell 11% in six days in late August. It was the first time since 2011 the U.S. stock market had dropped 10% or more. However, a strong rebound has pushed U.S. stocks up 12% from their August low. Today, most U.S. stock indexes are back near all-time highs. Yet only a few companies are driving the rally… The chart below compares the Dow Jones Industrial Average and the Russell 2000 since the market bottomed in late August. The Dow tracks the performance of 30 giant U.S. companies. The Russell 2000 tracks 2,000 smaller companies. The Dow has gained 13.6% since late August. The Russell 2000 has gained just 5.7%. •  In a healthy market, large stocks and small stocks usually rise together… But right now, a small number of huge companies is driving the rally… Earlier this month, E.B. Tucker, editor of The Casey Report, explained why this is a […]

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