Nice piece in ZH on Jeff Gundlach dishing with Yahoo Finance on the vulnerability of the corporate bond market in the next recession. In our data analysis piece, which we reposted below, we highlight the fact largest holders of U.S. corporate bonds are “weak handed” foreigners. Given the diminishing market making capacity of the Street, good luck finding a bid when they decide to hit the exits.
Money quotes from the Bond King,
Major risks facing the market
JULIA LA ROCHE: Right. Well, a lot certainly has changed, as you mentioned. And you’re someone who’s known as someone who always looks at risk. You look at various risks. So I’m curious, what is on your radar right now? What are you focused on?
JEFFREY GUNDLACH: Well, I think the biggest risk– and it may not materialize for a little while longer– is that when the next recession comes, there’s going to be a lot of turmoil because the corporate bond market is extraordinarily leveraged. The ratings of the corporate bond market are very low. There’s a study by Morgan Stanley research that said that if you use leverage ratios alone– and there are other variables that the rating agencies used, but the most important, of course, is leverage ratios of a corporation. And if you use leverage ratios alone, that 45% of the investment grade bond market would be rated junk right now. Right now.
So if there’s a recession, obviously, these ratings will have to be lowered. For now, the rating agencies are listening with sympathetic ears to reassuring statements by some large corporations that they’re aware that their leverage ratios are kind of high, but they plan on addressing that sometime in the next few years. If there’s a recession, it’s obvious that the leverage ratios will not be addressed, and the ratings will have to go. So that’s a really big risk.
Also, during the next recession, we’re going to have an extraordinary national debt problem, because the national debt is growing at a very rapid rate already. And we’re supposedly, if I listen to Larry Kudlow and the president, they keep telling me that it’s the best economy ever. I know that they know that they’re being hyperbolic. But it is a growing economy. Real GDP is 3% year over year of the most recent reading. And yet, the national debt in fiscal 2018, which ended September 20, was increased by $1.27 trillion. – Yahoo Finance
Our latest data work on the corporate bond market is very interesting and kinda flew under the radar. We repost it, right here, right now!
Ownership And Profile Of The Corporate Bond Market
- Nonfinancial corporates have almost doubled their stock of outstanding bonds since the GFC moving from 19.5 percent of GDP in 2007 to 26.5 percent in Q3 2018
- Conversely, the domestic financial sector has been deleveraging, reducing bond debt by almost 25 percent since 2007, which reduces systemic risk
- Foreigners are by far the largest holders of U.S. corporate bonds and, we suspect, the weakest hands
We spent most of the day crunching numbers on the U.S. corporate bond market as stocks went on another roller coaster ride. Given all the hand-wringing and concern over the buildup of corporate debt since the Great Financial Crisis (GFC), we have a real need to see and understand the data.
We look at the changes in level, profile, and ownership of the corporate bond market over two different periods with the Fed’s Flow of Funds data. Our point of reference is Q4 2007, which was not only the end of the early century bull run in stocks and beginning of the GFC but also the quarter where nonfinancial corporate debt as a proportion of the corporate bond market was at its lowest (26.6 percent).
Fast forward 43 quarters to Q3 2018, the latest available data, and lag back 43 quarters from Q4 2007 to Q1 1997, and there you have our three points of measurement.
1997 Q1 to 2007 Q4
- The data illustrate the massive build in leverage in the domestic financial sector from 1997 to 2007, which was the primary cause of the GFC. Domestic financial sector bond debt grew by 378 percent over the period, increasing at a compounded average growth rate of 15.7 percent, to almost 60 percent of the market.
- The stock of nonfinancial corporate bonds grew at a more modest CAGR at 5.5 percent during the same period, right in line with nominal GDP growth.
- Foreign issues in the U.S. experienced significant growth though from a small base.
- Overall corporate bond debt to GDP grew from 41.08 percent of GDP in 1997 to 73.15 percent by Q3 2018.
- Foreign issues should be excluded from the bond debt-to-GDP ratio to gain a better measure of the true debt burden on the U.S. private sector.
2007 Q4 to 2018 Q3
- The U.S. domestic financial sector has been deleveraging since the GFC, reflected in the negative 23.7 percent growth rate in the sector’s bonds outstanding.
- Conversely, nonfinancial corporates have grown their bond debt by over 90 percent to 42 percent of the corporate bond market and 26.50 percent of GDP, up from 19.47 percent in 2007.
- Nonfinancial corporate bonds now make up the most significant percentage of corporate bonds outstanding in the U.S. and, by extension, now the biggest
- The diminishing liquidity, or lack of traditional market makers, magnifies the risk of an outsized dislocation in the sector. Though not on such a massive scale, the buildup in nonfinancial corporate bond debt since 2007 mirrors that of the financial industry from 1997 to 2007.
Who Owns The Corporate Bond Market
- Foreign holders of U.S. corporate bonds make up the largest ownership group subjecting the market to capital flight risk, which, in other countries, is often sparked by domestic political instability. Watch this space.
- Life insurance companies are the most significant domestic holders of corporate bonds, taking down almost 20 percent of outstandings.
- Mutual funds are a close third followed by households, which include hedge funds.
- Other makeup over 20 percent of corporate bondholders but each group is less than 5 percent of the market. They include state and local employee pension funds, banks, state and local governments, broker-dealers, ETFs, closed-end funds, among others.
- The largest hands – foreign holders – are most likely the weakest hands. Another risk not even close to the radar of most traders and investors.
You now have the data and charts, folks. Short and sweet, easy to read.
Now you have the knowledge and can’t claim you were unaware of the risks if the GE refrigerator falls through the kitchen floor.
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