Junk prophecy

Credit doomsayers offer confusion not foresight

Investors were selling corporate bonds before the latest global stock market slide. That could be an echo of the 2008 financial crisis, when equities seemed initially to ignore warnings in credit markets. The message, though, is mixed and muffled, and doesn't necessarily suggest debt experts are ahead of their stock-focused counterparts.

The gap or spread between yields on corporate and government debt - an indication of the perceived riskiness of companies - widened in recent months while equity markets remained buoyant. The average spread on US high-yield debt reached 5.19 per centage points in mid-August, according to Barclays, up over a percentage point from levels in early March.

Investors in low-risk investment-grade bonds had that nagging feeling too, and responded with a mild sell-off. Meanwhile, equity market volatility, as measured by the VIX index, stayed relatively low. Now that stock markets are sliding, at least partly thanks to fears over a slowdown in Chinese economic growth, credit markets are looking like Cassandras again: prescient but initially ignored.

Yet the prophecy on offer wasn't at all clear. The sell-off in junk bonds was concentrated in the energy and metals and mining sectors, where slumping commodity prices are causing financial stress. The rest of the market wasn't pricing in widespread distress. The implied default rate for other sectors was still low before the sell-off at around 2.5 per cent on August 20, according to Lehmann Livian Fridson Advisors. Moody's Investors Service forecasts a three per cent rate of insolvency, still historically low.

In the investment-grade sector, the explanation may be different. The Federal Reserve is on the cusp of raising interest rates, which may cause bond prices to fall. Add a wave of issuance related to mergers, and it's not surprising credit investors lost some eagerness. Barclays counts $189 billion of bonds related to mergers and acquisitions this year, versus $24 billion in the same period of 2014.

In fact, credit markets were slower than stock equivalents to react to commodity price-related fears over companies like Glencore and Anglo American, according to Credit Suisse. That's not to say debt investors aren't sometimes ahead of the game - a traditionally longer-term perspective than equity traders, for example, can help spot trouble. But what looks like foresight may be little more than confusion.