Since the beginning of 2009, the U.S. 10-year yield has averaged around 2.6%.
Consequently, most investors feel that interest rates have nowhere to go but up. However, from 1930 to 1955, the U.S. 10-year yield also averaged 2.6%. That’s 25 years! There was even a double-digit annual inflation rate after World War II, yet rates stayed low.
Most people fail to realize that interest rate cycles can last a very long time.
Furthermore, the forces conspiring to keep a lid on growth and inflation – and hence interest rates – are secular (long-term) dynamics. We’re in the latter stages of a historic global debt supercycle. Many developed economies are faced with aging populations and a contraction in their labor forces. Plus, technological advancement is producing a good type of deflation as well as contributing to a growing glut of low-skilled labor, thereby pressuring wages.
These factors aren’t going away any time soon, which is why I don’t believe our biggest risk is a meaningful jump in interest rates. However, a bond market upheaval does appear to be upon us, even if the risks are ignored in the financial media because the facts don’t fit the “Treasuries are in a bubble so buy stocks” narrative.
The bond market revolt is in credit. High-yield energy bonds are going “bidless” with increasing frequency. Linn Energy’s (LINE) 8.625% coupon bonds due 2020 have plunged from $90 in June to $60.50 as of this writing. Astoundingly, these bonds traded at par ($100) at the beginning of November 2014, when I warned about energy sector leverage.
SandRidge Energy’s (SD) 8.75% coupon bonds due 2020, which were just issued on May 28, 2015 at par, have already declined to $74. This is an ugly consequence of the “reach for yield” phenomenon.
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The bonds of basic materials producers are getting clubbed in similar fashion. AK Steel’s (AKS) 7.625% coupon bonds due 2020 have declined from more than $90 to $60 in a little over a month.
Lest you think that the bond market dislocation is confined to the commodity complex, let me point out that investment-grade (IG) credit spreads are widening. Credit spreads are the additional yield above Treasuries an investor can earn from corporate bonds due to their higher risk.
In December 2014, I noted that benchmark single-A credit spreads had started to widen, which has continued as you can see below:
Spreads have bounced off of the key 1% level and are now back to late-2013 levels. Keep in mind, these aren’t small, overleveraged oil exploration and production companies. Many large, blue-chip multinationals carry single-A credit ratings.
So, the risk aversion in the credit markets ranges from junk to high-quality issuers. This represents a big-time divergence with the equity market, which has continued to rally, although with deteriorating breadth.
Seemingly everyone believes the biggest risk out there is rising interest rates. Because of this facile view, they’re missing the real message the bond market has been sending.
Given the aforementioned secular forces and the fact that the credit (default) cycle is of a much shorter duration than the interest rate cycle, credit spreads are likely to blow out well before interest rates rocket higher. In fact, it’s already starting to happen.
Safe (and high-yield) investing,
Alan Gula, CFA