Unbelievable! Debt markets show excitement with NO harm in sight!

Good morning. Friday I he wrote that “if the jobs report comes in much stronger than the consensus estimate of 195,000 new jobs, there could be a bit of a market frenzy.” The number jumped to 339,000 and the market freaked out. On the upside. The S&P rose 1.5%, its biggest daily gain since April. Maybe yesterday’s debt ceiling deal mattered more to investors than the threat of further rate hikes? Did the market take comfort in the decline in hourly wages, which came on top of large downward revisions to the wage component of Q1 GDP? Maybe it was bearish placement? Or maybe Armstrong just got it wrong. In any case, email me: robert.armstrong@ft.com.

Subprime auto debt and junky junk bonds

There is, as has Unhedged underlined recently, something is wrong with the low-end US consumer. And if the problem spreads, it seems likely it could spill over into auto credit, the kind of debt that many Americans in the low-income deciles have no choice but to carry. The closest thing to timely data on subprime auto debt that we’ve found is the Fitch 60-day delinquency ratio in the subprime auto-backed securities they rate. The numbers go up to April:

Insolvencies are now reaching pre-pandemic highs and the trend is sharply increasing. Jenn Thomas, a portfolio manager at Loomis Sayles and Unhedged’s favorite consumer debt expert, tells us that the stress in subprime auto is concentrated in the most recent years: loans taken out in 2020 and 2021.

While the trend has improved somewhat recently, this is because borrowers in these years that have been in the worst trouble have defaulted on their loans and been removed from the underlying loan pools of asset-backed securities. Rather than delinquencies reaching recessionary levels, Thomas says, what we’re seeing are borrowers “playing it again”: falling into early delinquency but paying just enough just in time to avoid recovery, and so on. But demand for subprime auto ABS remains very strong, he says: “It’s hard not to like a yield above 5% on a two-year bond.”

We will monitor the crime numbers closely. Meanwhile, is something similar happening with lower quality corporate bonds? Well, maybe… just. Bank of America’s Oleg Melentyev reports that 10 US high-yield issuers defaulted on $7.2 billion in bonds in May, an annualized default rate of 7.3%, and a notable acceleration from the US default rate. 2.3% in the last year (according to Moody’s, there have been 20 defaults in the entire first quarter). Here is a graph of the default rate up to the end of March from Melentyev’s team. Note that the ex-energy default rate (the brown line) is still below 2016-2018 levels:

Melentyev also notes that yield dispersion (defined in high yield as the percentage of bonds trading 4 percentage points or more from the benchmark index’s return) is increasing. Over 50% of CCC bonds (the riskiest junk) now trade so far behind the index, up from a low of less than 20% in 2021. The market is discriminating more between ‘good bad junk’ and ‘bad junk’ . Finally, recoveries (the amount bondholders receive in the event of default), at around 30 cents on the dollar, are “close to historic lows.”

Is the market responding to these signs of stress by demanding higher discounts to own riskier debt? Bloomberg reports that, seen on a global basisAnd:

Riskier corporate bonds are falling as signs of economic weakness spread, raising the specter of further defaults and hardships.

Debt of CCC-rated companies – the lowest level of junk – fell to an eight-month high in May, led by a 23% drop in Chinese bonds. It is expected to remain under pressure as interest costs rise, earnings decline and access to capital decreases as the economies of Europe, China and the United States sputter.

“Buying CCC is now playing with fire,” said Hunter Hayes, portfolio manager at the Intrepid Income Fund.

This is emphatically Not it’s happening in the US, however. US CCC spreads versus Treasuries have narrowed in recent months. Also, since the end of last year, the spread difference between US CCC debt and single B debt (slightly less risky junk) and BBB (the bottom rung of investment grade) has narrowed. In other words, the premium for owning riskier US debt is shrinking:

The US corporate debt market does not appear to be heavily pricing in recession risk. This may be because the market is understocked with bonds, as my colleague Harriet Clarfelt did written. Melentyev thinks the market is stuck where it is in part because, in a highly dispersed junk bond market, “the good stuff is already tight [expensive]; and difficult things don’t get offers. However, the pattern of fundamentals weakening at the margin while prices remain stable is similar to what we see in equities. There is risk appetite out there.

Shadow banks in Europe

Unhedged usually keeps its focus squarely on the United States. But also for US investors, the European Central Bank’s financial stability relationshipand especially the section on shadow banking risks, is worth reading.

The key points made in the report are familiar enough. Non-bank financial institutions – investment funds, pension funds, money market funds, insurance companies – are growing much faster than banks. With higher interest rates, there’s a chance they could face withdrawals and liquidity shortages, especially as shadow banks increased their exposure to illiquid assets like real estate during the low-rate era.

Importantly, the report notes, there are significant links between the non-bank financial system and banks: in particular, the former owns many of the latter’s non-deposit liabilities, including nearly all of the convertible bonds of European banks. “Significant outflows from such investment funds can trigger sales of securities issued by banks and other financial institutions. This could amplify the negative impact of price pressures on bank funding markets.”

The risks are not theoretical: we have already seen microcrises where a combination of leverage and illiquidity at non-bank institutions has triggered tremors in broader markets. The ECB provides this handy table, which serves as a sort of glossary of how things can go wrong:

Ian Harnett of Absolute Strategy Research – who was kind enough to point us to the ECB report over the weekend – notes that essentially all of the growth in financial assets since the crisis has taken place outside the banking system. Non-banks now hold well over half of euro area financial assets. This makes the ECB report, in his words, “difficult to read”. Europe’s next financial mess is unlikely to start in a bank.

A good read

Germans eat much less sausage.