Corporate Bonds Flash Warning
If the negative pattern develops, I’d be quick to hit the sell button.
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Quick update on diesel, which continues to be an issue for the economy and bonds:
The Russian diesel deal was too small to matter. There’s no evidence that the administration’s “pivot” with Russia is helping on the diesel front. The EU diesel release is disappointing as well. Rather than allowing a “new” 50 million barrels or even 50 million barrels including previously-announced-but-undelivered barrels, it looks like the EU is only contemplating accelerating delivery of 20 million barrels already announced. Even then, it looks like some countries will slow play this. Was that always Europe’s plan? Or did the recent “pivot” with Russia make it more conservative? We might never know, but big relief is not coming from Europe at the moment.
Which really leaves one option for getting prices down: getting resolution in the Middle East that allows the oil to flow — the refineries there and abroad to get what they need and then deliver the distilled products.
At the moment, I expect diesel to remain “stubbornly high” until some resolution is reached in the Middle East. And the latest news flow, with Iran continuing to hit ships and the Houthis fighting the Saudis, is not good in that direction.
Credit Warning Flags
Stocks have handled the march to higher yields in treasuries quite well.
There was a brief wobble while French (and Italian and Spanish) bond yields blew out versus Germany a few weeks ago.
Now it seems that the risk is a “test” to the credit markets. When I think about credit, I primarily focus on public investment grade and high yield debt (including leveraged loans). I also look to private credit. To a lesser extent (at least at the moment), I will keep an eye on delinquency rates in mortgages, credit cards and autos.
This is important, because while the equity market has the ability to absorb higher yields, it has difficulty absorbing it when the reason for higher yields is widening credit spreads.
I apologize if this is “wonky” but I think it is important.
For months (or maybe almost a year), I’ve been dismissive of references to (ORCL) credit spreads, which had been getting a lot of attention. But recently, many names in the AI space ((CRWV) front and center last week) and some recent new issues ((PSKY), (SOFTBK)) have been trading very poorly.
So far, the bulk of the damage has remained isolated to specific credits and sectors. That is good. When the credit risk is “specific,” then markets can function as it is only the names getting the attention that face higher costs to roll their debt, and might see their growth plans reduced.
What I am watching for is any warning that this selling pressure on a few sectors can morph into something bigger. I am more concerned about this occurring from a technical perspective, but there is a fundamental story to go along with it.
The fundamental story would be along the lines of: if the biggest engine of domestic economic growth is the compute buildout and the compute buildout is going to have to slow down, then we have to be more worried about economy, which is not good for credit spreads (nor equities).
In equities we can look to VIX for warning signs (though I don’t think it is much of an early warning indicator any longer since so many “income” strategies involve option selling, which suppresses volatility).
In the treasury market, we can look to the MOVE index. It also has some flaws. In any case it has been elevated and has been hinting for a number of weeks of elevated risk. Some of which has filtered into equities.
For credit markets, I have found one very reliable indicator:
- How credit ETFs trade relative to their NAV. Unlike equities, where it is very easy to observe and trade the stocks in an ETF, hence they almost always trade at NAV, credit markets are not liquid in that way. Individual bonds trade in larger blocks and they have a wide range of liquidity associated with each bond. Hence, you can get this deviation.
- I use the Bloomberg terminal to identify the NAV and price. You can go to the individual websites. Here are the ETFs I track:
Those five give a good cross section.
Why that’s so important:
- When these ETFs trade lower (or see spread widening) and are trading in line with their NAV, that indicates lower but orderly.
- When they trade cheap to NAV on a down move, it indicates lower and disorderly.
My experience, time and again, is lower and disorderly tends to create more lower and disorderly, until a violent move occurs, resetting levels and demand interest.
I fear this is already wonky enough and that trying to explain why I believe this occurs would be excessively wonky.
Suffice it to say, since the GFC (when it was more about CDX indices than bond ETFs), this breakdown has been very reliable warning that spreads have more room to widen rapidly and that equities do not do well when this occurs.
Currently, all of the ETFs mentioned are behaving “normally” – which is good!
But there is enough chatter in corporate bonds that I fear we could see this negative pattern develop.
For now, this is a warning flag, yellow alert, something to put on your “things to watch dashboard” (alongside diesel futures, etc.).
I hope the market stabilizes without going into this sort of ETF spiral triggered by trading at a discount to NAV, but if it occurs, and it is a big if, I will be quick to hit sell buttons, because it has been such a reliable indicator.
