Currently, certain metrics used to predict future financial behavior are projecting two wildly different outcomes of enormous financial systemic risk and virtually no financial systemic risk in US markets. In a recently published article on this financial blog, I spoke about how overnight repo and reverse repo market trading volumes were indicative of how liquidity in the US banking system was drying up and how this would eventually have significant consequences in other asset markets. Yet, if we look at the indicator below of US corporate junk bond yields, we can see that yields are the lowest in a quarter of a century at less than 4.00%, which is quite astounding. So what gives?
US overnight repo markets inform us risk is growing in the US banking system yet the corporate junk bond market, always a lead indicator of growing risk in US capital markets, informs us that risk is at the lowest in twenty-five years. Obviously both cannot be true, so what is the correct interpretation? As we can see in the above chart, when US stock markets were collapsing during the 2008 global financial crisis, US corporate junk bond yields soared to 21.81%, more than five Xs higher than rates today. But as the US Central Bank cut interest rates indefinitely to 0.00% to 0.25% and embraced ZIRP (zero interest rate policy) for the last thirteen consecutive years, US corporate junk bond yields also collapsed to their lowest rates in a quarter of a century.
Consequently, the interpretation that 25-year low junk bond yields reflects no risk in bond markets and therefore, no risk in stock markets is incorrect. Rather, the perception that risk no longer exists because the US Central Bank can fix every problem in the market has led to quarter low corporate junk bond yields that are not reflective of reality. Rather, the problematic massive volume of the o/n reverse repo markets are correctly warning of risk that lies ahead in the US banking and finance sector, so most likely when the risk matches reality in corporate junk bond yields, we likely will not see a gradual easing in corporate junk bond yields from 3.99% to 5% to 5.5% in a period of a few months but rather an explosion from 3.99% to 10% in a month and then perhaps a doubling from 10% to 20% in just a few more months’ time. Thus, I believe this indicator will not provide the usual latency between warning and manifestation of risk as it normally does due to the system being so incredibly broken at the current time.
Of course because bond yields and price have an inverse relationship, the price of corporate junk bonds in US markets have been skyrocketing. Still it is deeply problematic when the worst of all companies from an ongoing entity can raise money in the debt market so easily at all-time low costs. Does not anyone see a problem when a nations’ financially riskiest companies can raise money so easily at low interest rates to fund expansion and growth. Such conditions can only have a negative outcome that leads to the implosion of many risky companies in the future as the conservative debt metrics that usually bind and limit a risky company’s growth, and for very good reasons, have been largely removed, thereby encouraging companies with more financial risk than the peers in their asset class to assume even greater risk with free flowing access to capital.
Typically corporations that offer junk bonds have to offer high yields because of the higher risk of default on the bond issuance. However in 2020, the $421B of high-yield bond issuance nearly exceeded the total $450B of high yield bond issuance in 2018 and 2019 combined. And with plummeting junk bond yields this year, I imagine 2021 will set new records. Apparently from current yields of less than 4%, the perception is, “What risk?”
Anytime, improper risk assessments occur, as I often pound this point home with crypto enthusiasts (and warned all my patrons of high risk levels that existed at $59k to $60k BTC prices earlier this year in April 2021), this causes much financial misery later for people engaged in the markets in which improper risk assessments occur. Currently, AAA rated US corporate bonds are only offering yields of a measly 1.80%, which is causing investors to chase yield in the junk bond market. However, when even chasing 3.99% corporate junk bond yields that are well below the real US inflation rate of either 9% (per shadowstats, using 1990 US government inflation formulas) or 13% (using 1980 US government inflation formulas) that yield massive real net losses, this marks desperation in the banking sector to chase yield no matter the irrationality of doing so.