We've heard rumblings several times in the last decade that interest rates were on the cusp of rising from their near-zero recessionary levels, but it's actually starting to happen now, and the potential ripple effects from rising rates will reach across the financial markets.
In my last column, I talked about two red flags for fixed income investors. Here are three more signs that a seismic shift in the bond markets is coming:
1. Weak covenant quality.
A direct byproduct of low rates has been the flood of yield-chasing money into the junk bond market, making it easier than ever before for speculative companies to borrow. Not only has new debt been cheap to issue, but bondholders haven't demanded the same level of protection they did historically, making the credit market more vulnerable in an economic downturn.
Creditor protections, as measured by the Moody's Covenant Quality Score, have deteriorated in five of the last six years and stand near the worst levels on record. In 2017, bonds with the weakest level of protections represented 65% of the issues Moody's tracks, up from 23% in 2011. In January, a Moody's vice president commented, "Borrowers are making the most of a wide-open loan market. As demand continues to outpace supply and pressure on covenant quality remains intense, it is hard to see what investors get in return for giving up covenants in these frothy market conditions."
2. Unusually low default rates.
In the last 3-4 years, high yield default rates have uncoupled from their historical relationship with overall debt levels. As 13D Research put it, "For roughly three decades, U.S. nonfinancial corporate debt as a percentage of U.S. nominal GDP and the high-yield default rate moved in tandem. It was a logical relationship — more debt meant more defaults. However, the lowest interest rates in human history broke that correlation, and today, the divergence remains near its post-crisis extreme."
As the Fed begins to raise rates and unwind its bloated balance sheet, one would think investors would be cautious. But the combination of placid credit conditions and better yields than the paltry 2-3% paid by many investment-grade bonds has created a false sense of security for enthusiastic buyers, which leads to our final red flag.
3. Tight credit spreads.