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Good morning. On Friday, I wrote that “if the jobs report comes in much stronger than the consensus estimate of 195,000 new jobs, a market freak may ensue.” The number reached 339,000 and the market panicked. Upwards. The S&P rose 1.5 percent, its biggest daily gain since April. Perhaps the previous day’s debt ceiling deal was more important to investors than the threat of more rate hikes? Perhaps the market took solace in the fall in hourly wages, which came on top of major downward revisions to the wage component of GDP in the first quarter? Maybe it was bearish positioning? Or maybe Armstrong was just wrong. In any case, email me: firstname.lastname@example.org.
Subprime car debt and junky junk bonds
There is, as Unhedged recently pointed out, something amiss with the low-end US consumer. And if the problem spreads, it seems likely it will spread to car credit — the kind of debt that many Americans in the lower income deciles have little choice but to bear. The closest thing to actual data on subprime auto debt that we’ve found is the Fitch index of 60-day delinquencies in the subprime auto-backed securities they review. The figures go through April:
Delinquencies are now running at pre-pandemic highs and the trend is strongly bullish. Jenn Thomas, portfolio manager at Loomis Sayles and Unhedged’s favorite consumer debt expert, tells us that the stress in subprime autos is concentrated in the more recent vintages — loans that closed in 2020 and 2021.
While the trend has improved somewhat in recent times, this is because the borrowers in these vintages that ran into the biggest problems defaulted on their loans and were removed from the underlying loan pools of the asset-backed securities. Instead of defaults reaching recession levels, Thomas says, we’re seeing borrowers “playing games again”: falling into early delinquencies, but paying just enough and just in time to avoid repossession, and so on. But demand for subprime automotive ABS remains very strong, she says: “It’s hard not to be happy with yields above 5 percent on two-year paper.”
We keep a close eye on the overdue figures. In the meantime, is something similar happening with the lowest quality corporate bonds? Well, maybe – just. Bank of America’s Oleg Melentyev reports that 10 U.S. high-yield issuers defaulted on $7.2 billion in bonds in May, a 7.3 percent annualized default rate and a notable acceleration from the 2.3 percent default rate. percent in the past year (there were 20 defaults in the entire first quarter, according to Moody’s). Here, from Melentyev’s team, is a graph of the default rate through the end of March. Note that the ex-energy default rate (the brown line) is still below 2016-2018 levels:
Melentyev also notes that return dispersion (defined in high yield as the percentage of bonds that are 4 percentage points or more away from the benchmark index return) has increased. More than 50 percent of CCC bonds (the riskiest junk) are now trading this far from the index, up from a low of less than 20 percent in 2021. The market is more differentiated between “good bad junk” and bad junk. Finally, recoveries (the amount bondholders receive in the event of default), at about 30 cents on the dollar, are “near historic lows.”
Is the market responding to these stress signals by demanding bigger discounts to own the riskiest debt? Bloomberg reports that, viewed on a worldwide baseit is:
The riskiest corporate bonds fall as signs of economic weakness spread, raising the specter of more defaults and misery.
Debt of companies rated CCC – the lowest level of junk – fell the most in eight months in May, led by a 23% plunge in Chinese bonds. The country is expected to remain under pressure from rising interest costs, falling profits and declining access to capital as the economies of Europe, China and the US sputter.
“Buying CCCs now is playing with fire,” said Hunter Hayes, portfolio manager of the Intrepid Income Fund.
This is emphatic not happens in the US though. US CCC spreads against government bonds have narrowed in recent months. In addition, the spread between US CCC debt and both single B debt (slightly less risky junk) and BBB debt (the lowest tier of investment grade) has narrowed since late last year. In other words, the premium for owning the riskiest US debt is shrinking:
The US corporate bond market does not appear to be pricing in much recession risk. This may be because the market is undersupplied in bonds, as my colleague Harriet Clarfelt has written. Melentyev thinks the market is stuck in part because, in a highly diversified junk bond market, the “good stuff is already tight (expensive); and difficult things don’t get a bid. Still, the pattern of fundamental weakening at the margin while prices remain firm is similar to what we see in equities. There is risk appetite.
Shadow banks in Europe
Usually, Unhedged keeps its focus completely on the US. But even for US investors, the financial stability of the European Central Bank reportand in particular the chapter on shadow banking risks, is worth reading.
The base points in the report are familiar enough. Non-banking financial institutions – mutual funds, pension funds, money market funds, insurers – are growing much faster than banks. With higher interest rates, there is a possibility that they could experience withdrawals and liquidity shortages, especially as shadow banks increased their exposure to illiquid assets such as real estate during the low interest rate era.
Importantly, the report notes, there are significant links between the non-bank financial system and banks — in particular, the former owns a large share of the latter’s non-deposit liabilities, including nearly all of the convertible bonds of European countries. banks. “Significant outflows from such investment funds may lead to the sale of securities issued by banks and other financial institutions. This could amplify the negative impact of price pressures on banks’ funding markets.”
The risks are not theoretical: we have already seen microcrises where a combination of leverage and illiquidity in non-bank institutions has led to tremors in broader markets. The ECB provides this handy table, which serves as a sort of glossary of how things can go wrong:
Absolute Strategy Research’s Ian Harnett – who was kind enough to point us to the ECB report this weekend – notes that essentially all of the growth in financial asset holdings since the crisis has occurred outside the banking system. Non-banks now control more than half of the financial assets in the euro area. This makes the ECB report, in his words, “uneasy to read”. The next European financial mess is unlikely to start with a bank.
A good read
Germans eat much less sausage.