Yield Spread Spikes Signal Storm Over Horizon
Anyone in search of a reliable Lipton teabag to generate the right timing signals for the stock market knows that such tools are rarely consistently reliable. One indicator, however, has proven in the past to be quite a reliable one.
Often overlooked by stock investors, the yield spread — or the spread between junk bonds and Treasuries — has time and again proven to be a reliable leading indicator for the stock markets.
The reasons for the predictive qualities of the yield spread are multi-fold. For starters and at the risk of stereotyping, bond investors are by and large more sophisticated than stock investors. Granted, this distinction is relative as bond investors’ behaviour in the past six years of zero interest rate policy (ZIRP) has suggested.
Qualitatively, the spread between the risky junk bonds and the relative safety of government treasuries, is a direct measure of investors’ appetite for risk. The past six years of ZIRP has effectively driven the yield starved investors towards bonds issued by riskier companies in search for extra yields, resulting in the spread between junk and Treasuries being compressed to historic lows. As these companies fail and default on their debts, investors get re-acquainted with risk and demand a high return for the added risks. As such, a rising yield spread is indicative of the underlying stress below the economic surface.
Quantitatively, the spread is also a reflection of the nominal yield and direct measure of the cost of debt a borrowing company needs to bear. When interest rates are insanely low, one would be insane not to borrow. On the flip side, when yields (and, hence, spread) spike, the ability for companies to roll over maturing debts or issue new ones to cover cash-flow shortfalls or conduct financial engineering, as we shall see below, gets severely truncated. The inability to borrow often sets into motion a debt spiral for these debt laden going concerns.
This latest Wolf Street article does a good job providing a snapshot of where the yield spread currently sits and puts into context how it has — and will — influence the stock markets.
Specifically, it shows how low yields provided two sources of rocket fuel to the stock markets: (1) stock buybacks and (2) M&As. The surging yield spreads, just as night follows day, take away the two rocket fuels which have been the fundamental drivers of the stock market in at least the past three years.
To understand why that is the case, it is instructive to understand which groups were the key buyers of stocks in the past few years. Retail investors as well as institutional investors such as mutual and pension funds have been marginal net buyers to net sellers in the past few years. As it turns out, the biggest group of buyers happened to be public companies buying back their own shares.
Companies re-purchase their shares at different economic cycles for different reasons. When a company’s shares are in the dumps, management would purchase its shares when they feel the value of the company has been mispriced by the market . However, such is not the case in the past five years when the stock market has been on a one-way street storming ever higher and the stock overvaluation across the board has entered uncharted territory. When companies purchase their own stocks at record high levels, they do so for two main reasons.
First, the float of the company’s stocks needs to be reduced in order to make room for the large number of stock options being exercised by management as they cash out. Second, and more importantly, companies faced with flat to declining revenue have resorted to reducing their outstanding shares in order to make their earnings per share look respectable (remember that earnings is on a per share basis, so if you can’t increase earnings, decreasing the number of shares would maintain the ratio).
How do they re-purchase shares when revenue is flat to declining? By borrowing money, of course. A company can goose its per share earnings by destroying its balance sheet as long as (1) the cost of debt is low, and (2) one has not toxified its balance sheet bad enough to trigger a ratings downgrade.
Indeed, the low cost of debt – a direct result of ZIRP of the central banks — has been the enabler of this self-liquidating corporate behaviour as corporations have been issuing both investment grade and junk bonds like there is no tomorrow in order to buy back their shares and allow management to cash out.
As the economy turns sour and trouble spreads from the ground zero sectors of energy and industrial commodities, junk bond yields start to explode higher and the yield spread between high yields and Treasuries start to blow out. The current spread, 18% at last check and rising, is already higher than that at the height of the European sovereign bond crisis in 2012. The smell of the 2008 global financial crisis is definitely in the air.
With the cost of debt rising inexorably, the ability for many corporations to continue borrowing more money to buy back their shares is rapidly drawing to a close.
Another rocket fuel feeding the stock market has been the M&A activities. Again, companies traditionally rely on (1) their rising share price in an ever rising market as currency, and (2) raising a large amount of debt to fund the purchases. While the recent market correction puts quite a damper to (1), the rising spread, again, would make future M&A deals look so much uglier and harder to pull off.
All in all, the corporate binge on ZIRP fuelled debt in the past six years have loaded the balance sheets of numerous companies with a toxic level of debt. With investors’ appetite for risk rapidly souring, junk bond yields spiking and revenue declining, their ability to borrow more to fund stock re-purchases is coming to a close. Without the tailwinds of this powerful driver, the only men left standing with the means to keep the stock markets at these elevated levels are the central banks and sovereignty wealth funds. It remains to be seen what else might be left in the central banks’ bag of tricks and how far they would venture into the financial twilight zone. But if the Bank of Japan’s monetary policy is any indication, the answer could very well be ‘quite far’.