When will the Corporate-Debt Bubble Burst?
Optical illusion in the form of a focus on flows — rather than stocks — is a well-known flaw in the analysis of asset markets. Two examples this year demonstrate the phenomenon: one from the market for gold and the other from the market in stock options. Analysis of the illusion in gold helps provide a clue to how present high speculative temperatures in corporate bond markets — intimately related to the options market — will collapse.
Taking gold first, the World Gold Council (WGC) pronounces in its latest quarterly report (August 2018) that demand for gold has fallen by around 2 per cent to just below 1000 metric tons. By implication, this ties in with the decline in the dollar price of the yellow metal. The message is also consistent with the market narrative which spells out how new demand is concentrated in emerging market economies, especially China and India, and the sharp slowdowns there together with currency depreciation justifies a serious price fall (in US dollars).
This narrative is economic nonsense. With the stock of above-ground gold at near 190,000 metric tons, it is evident that the price depends on the heterogeneous expectations and preferences of worldwide holders of the yellow metal in all its forms (jewellery, bars, and coins) not on the additional trickle of demand identified in each quarter by the WGC or anyone else. Even so, malfunctioning markets for some time — especially under conditions of monetary inflation — can award flow narratives undue weight and this is maybe what has been occurring recently.
We turn second to the market for options on equities. We know from finance 101 that a holding in corporate bonds of company X is equivalent to an investment in riskless government bonds plus a kicker in the form of writing a put option at a low striking price (relative to present price) on the (hypothetically unleveraged) equity of X, collecting meanwhile the premium income. The risk (from the viewpoint of the investor in this combination) is that the equity falls sharply in price, meaning that the buyer of the put has a growing claim against the writer – equivalent to the corporate bond price falling far below par.
The Yield Famine Leads to Irrationality
Rampant monetary inflation in recent years has gone along with the fanning of a hunt for yield by income-famished investors — and this is characterized by severe irrationality involving underestimating risks of loss. And so there has been a huge demand for corporate bonds, especially low-rated investment grade bonds (i.e., BBB) and junk. Equivalently this has meant a plentiful supply of cheap puts on equity. Correspondingly, the conventional formula (Black-Scholes) for relating option prices to underlying volatility shows this latter to be very low given prevailing cheapness (of puts). The most widely quoted index of volatility is VIX, based on the S&P 500 index, for which a broad traded market exists.
In late February this year, VIX suddenly spiked, as a mini-crash in the equity market drove several investment funds which had been taking highly speculative positions (described as “risk-parity” arbitrage). This was based on low volatility continuing (selling puts in particular) suddenly sought to liquidate positions. But in hindsight it is clear that this mood-change occurred in the tail, not the dog. Demand for corporate bonds from a huge span of investors has remained strong. VIX has fallen back to historical lows and correspondingly the yield spreads of risky bonds over Treasuries remain near their low-point for this cycle — except for emerging market debts.
So in retrospect the February/March VIX shock was all about the antics of a few highly speculative funds and nothing to do with the long heralded decline of speculative temperature in corporate bond markets. The pessimists have been confounded by the financial engineers. These deploy their skills so as to bolster apparent equity returns by camouflaged increases in leverage. Their job is easy in that stage of the monetary inflation when equity prices are rising strongly. Then big issuance of debt and buy-backs of equity may not even show up in raised leverage, where debt and equity outstanding is measured at present market value. Today the debts outstanding of US non-financial corporations are at a record high relative to GDP, but leverage based on market value of equity is well below previous peaks.
The engineers have been bolstering debt issuance not just in response to strong demand for corporate debt (equivalently put issuance) from income-famished investors (which could be offset in some cases by running down bank borrowings). The engineers also do so as to resist a creeping de-leverage driven by rising equity values. If that de-leverage were allowed to continue unabated then the equity of any given company would lose momentum – rising less than its peers who resisted as the bull market continued. Its equity would get a “staid” image rather than join the “momentum stocks.” And in the irrational conditions of monetary inflation there are many investors who seem willing to be fooled by earnings per share growth which stems from financial engineering.
When the monetary inflation in the equity market transitions into its late stage of asset deflation, then the leverage ratios calculated at market value suddenly spike. The increasing leverage adds to the momentum of equity price decline. In principle the company could slow the momentum down by de-leveraging, but which corporate officer would sell large equity to retire debt in a bear market unless forced to do so as part of a capital reconstruction? The yield spread on corporate debts above Treasuries would gap wider just as VIX jumped and investors sought (for the main part unsuccessfully) to join a stampede out of these. Their losses on debts would be aggravated by a seizing up of liquidity.
Is it possible that the bubble-bursting in the corporate debt markets could precede — rather than coincide with — a bear market in equities? Yes, if history is any guide, such as was the case through the second half of 2007 and into early 2008. In principle the irrational pursuers of yield may experience shock or a re-awakening (of rationality) ahead of sentiment turning on equities. But the scenario of equity and corporate bond market downturn coinciding and reinforcing each other from the start of the asset price deflation process is also highly plausible.