Go For Comfort

Go for comfort. Stocks rallied yesterday after the President announced that the trade deal with China is still a go.  With little change in the global macro situation, tech stood out as an upside opportunity, helping to propel markets higher.

N O T E W O R T H Y

City of fallen angels.  More and more bond-talk has been creeping into my notes recently. Not the usual yield curve or real yield stuff but increasingly: debt issuance, zombie companies, and credit quality.  Interest rates are low and companies need money to make up for revenue lost as a result of the pandemic.  So companies that are struggling are essentially borrowing money from the public to keep the lights on. Lending those struggling companies money would seem risky if not for the Federal Reserve entering the public markets as a buyer of last resort… and a big one at that.  The Fed’s QE has assured that there will always be a buyer, prompting many companies to step up and tap into the bond markets.  Even companies that are not struggling are taking advantage of the low borrowing cost and high liquidity because… why not.  But let’s focus on the struggling companies… you know… the risky ones.  Credit agencies like Moody’s and Standard & Poor's assess a company's ability to pay coupons and return principal on their debt. In other words, they assess the credit risk of a company and its individual offerings.  Standard & Poor’s ratings run from the best: AAA through BBB for investment grade, and BB through C for speculative grade. “Speculative” is also referred to as “junk”. Bonds with those ratings are considered speculative (or junky, if you like) because coupon payments and principal return become increasingly vulnerable as the ratings approach C.  The risk doesn’t come for free, though. Investors in these riskier bonds get higher yields compared to lower risk, investment grade corporates or risk-free treasuries. The additional yield for taking the added risk is referred to as risk premium.  That risk premium, or spread is determined by the market.  When there is lots of demand and little supply, those spreads narrow, meaning investors are willing to risk more, or get paid less for risk (depending on how you look at it). As I mentioned above, lots of companies have been utilizing the bond markets to raise cash, so there is lots of supply.  How much supply?  How about $1 trillion in new bond issuance for the first half of 2020?  That is rapidly approaching the already large $1.4 trillion issued for the entire year of 2019… and that was a record year.  With so much supply and a high risk macro environment one would expect risk premiums (spreads) to be wide.  Nope… sorry.  The other half of the equation: demand is picking up the slack.  With very little in the way of yield, investors are grabbing for the only game in town.  Then there is the Fed. They are buying bonds as well, not only bidding them up, but also giving investors more confidence, which only adds to the pressure on spreads.  June has so far proven to be historically the busiest month for junk bond offerings with $46.7 billion in new issues.  By the way, bonds can enter the world as investment grade but get downgraded to junk.  Those bonds are referred to as fallen angels.  Generally speaking, you don’t want to own one of those angels as they fall because their prices fall along with the rating.  To be fair, a downgrade in rating doesn’t necessarily mean that the company will default, so the holder may be safe in the long run (as long as bonds are held to maturity), but no one likes to see the value of their bond portfolio go down.  For investors looking for bargains, they may favor a fallen angel in hopes of scooping up a quality company’s bonds for cheap, with hopes that things will get better.  Sounds like a familiar investing theme doesn’t it?  There are plenty of those for the picking these days.  About $100 billion worth of bonds have been added to the High Yield Index that were considered investment grade at the beginning of the year. Household names too.  The list includes bonds by companies like Kraft Heinz,  Macy’s, Delta Airlines, Ford Motor Company, and (you probably guessed it) Royal Caribbean Cruises.  By looking at that small sampling, you could probably already spot the ones that pose the bigger long-term risk.  As you probably have gleaned by now, there is plenty of risk with investing in “higher” yielding bonds.  The Fed’s aggressive QE gives the illusion that all is good and investors may find themselves chasing prices, which may be good for now.  Though it is not likely to happen anytime soon, the Fed will eventually have to stop buying and may even start unwinding.  That would be equivalent to the music stopping in a game of musical chairs. Remember that game?  You don’t want to be the one left with nowhere to sit.

THE MARKETS

Stocks rallied yesterday after the President tweeted a reminder that the deal with China is still very much alive, despite the weekend admission of his trade representative that the deal was “over”.  Yesterday’s rally was driven by tech as investors were reticent to take in shares of recovery-stocks in the wake of increasing virus numbers.  The S&P500 rose by +0.43%, the Dow Jones Industrial Average climbed by +0.50%, the Russell 2000 Index traded up by +0.40%, and the tech-heavy Nasdaq Composite Index jumped by +0.74% to its 21st record high close of the year (go figure). Bonds slipped and 10-year treasury yields climbed by +1 basis point to 0.71%.

NXT UP

- FHFA House Price Index (April) is expected to have climbed by 0.3% month over month compared to the prior month’s growth of _0.1%.

- DOE US Crude Oil Inventories (June 19) are expected to have fallen to 1.14 million barrels from the prior week’s 1.215 million barrels.

- Chicago Fed President Charles Evans and St. Louis Fed President James Bullard will both speak today.

- WHILE YOU SLEPT equity futures fell in response to reports that the US Trade Representative wants to raise taxes on goods from France, UK, Spain, and Germany.

daily chartbook 2020-06-24