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The High-Yield Bond Market Is Flashing Danger Signals

Yet another worry for stock and bond investors alike is the prospect of widespread downgrades of corporate debt, and the possibility that one-time investment grade issuers may default on their obligations. These fears are being stirred by the news that California-based electric and gas utility PG&E Corp. (PCG) will file for bankruptcy protection as the result of massive liabilities stemming from wildfires in 2017 and 2018 that started on its property. Its principal operating subsidiary already is in default.

Meanwhile, the junk bond market is facing liquidity problems, and thus may suffer a complete collapse if forced to absorb a flood of fallen angels, or bonds that have dropped from investment grade to junk status, CNBC warns. That report sketches the scary scenario summarized below.

A Junk Bond Nightmare Scenario

  • Value of high yield market at 5-year low of $1.25 trillion
  • Liquidity, or the ability to find willing buyers, is falling in the junk market
  • Large numbers of investment grade companies may be downgraded to junk
  • A glut of new junk debt would create a surge in yields
  • Failures will mount among companies dependent on junk debt financing

Source: CNBC

Significance For Investors

Utilities traditionally have been viewed as among the safest of safe havens for risk-averse investors, thus magnifying the shockwaves from the PG&E crisis. The company faces $30 billion of liabilities from the wildfires, per another CNBC report. PG&E recently estimated that complying with a federal judge's order may cost a mind-boggling $150 billion, according to Bloomberg. However, on Jan. 24, 2019 investigators for the State of California cleared PG&E of wrongdoing, per a later Bloomberg report, sending its battered stock up by nearly 75% on the day.

The three major bond rating agencies downgraded PG&E to the lower levels of investment grade status in November 2018. Recently they cut it again, to junk bond status, after PG&E announced that it would file for bankruptcy on Jan. 29, 2019, per Institutional Investor. Subsequently, PG&E's principal subsidiary, the Pacific Gas & Electric Co., sunk into default by failing to make scheduled interest payments, per Reuters. Prior to the positive news on Jan. 24, 2019, PG&E stock had plummeted by more than 80% since Nov. 8, 2018, causing its market cap to crash from roughly $24 billion to $4 billion, per Yahoo Finance data.

Junk bonds had a rough 2018, with the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) down by 2.0% for the year, based on adjusted close data from Yahoo Finance. That fund has rallied by 3.8% YTD through Jan. 24, 2019, but more rough times may be ahead. While spreads between junk bond yields and those on comparable U.S. Treasury debt widened by 222 basis points from early October 2018 to early January 2019, this only about half the widening that occurred during previous periods of stress in 2011 and 2015, the Financial Times reports.

The woes of the junk bond market and individual corporations such as PG&E are set in the wider context of exploding debt burdens worldwide, among governments, businesses, and households alike. Total global debt is now at $244 trillion, or roughly 3.2 times the size of global GDP, according to the Institute of International Finance, as cited by Barron's. In the year 2000, the global debt to GDP ratio was 1.7 times.

Indeed, General Electric Co. (GE), General Motors Co. (GM), and Ford Motor Co. (F) are among the highest-profile investment grade companies that may be at risk of downgrades to junk status, per an earlier Barron's article. All are highly leveraged, and face sharply higher refinancing costs as interest rates rise.

Looking Ahead

There is now about $2.7 trillion of BBB-rated corporate debt in the U.S., which is the lowest category of investment grade bonds, the FT notes. A wave of downgrades could swamp the already illiquid junk bond market, which is less than half this size. This may be a growing problem if interest rates spike, or the economy sputters. However, over the past 10 years, the S&P U.S. High Yield Corporate Bond Index has held up well, delivering an average annual return of 10.45%, per S&P Dow Jones Indices.