Just How Junky Is The Junk Pile?

1.) JUNK – Today’s focus is just one (very large) thing. The junk bond market.

Yesterday I wrote about credit spreads and pointed to the CCC rated market and it's divergence from the rest of the junk. I probably should have expanded on that a tad.

Companies are graded based on how likely they are to pay back their debts. Once we get into the junk-bond market, BB is the better stuff, B is worse, and CCC is the really crappy stuff. I posted this first chart below yesterday, but I’ll do it again here for explanation purposes.

That dark blue line in the top of the chart is CCC-rated debt. Those are the weakest borrowers. The interest-rate premium investors are demanding to lend to CCC companies has climbed to about 12 percentage points above Treasuries.

THAT is what it looks like when credit spreads are widening, or “blowing out” as the Street likes to say.

But that is just on the junkiest of junk debt. Meanwhile, B-rated bonds are around 3% over Treasurys and BB bonds are below 2%. That’s a huge difference. The bond market is basically saying that…“We’re perfectly happy lending money to decent companies. But if your balance sheet looks like a dumpster fire, it’s going to cost you.”

The entire U.S. junk bond market is roughly $2.2 trillion. About $1.25 trillion of that is BB-rated debt. Another roughly $750 billion is rated B. And the really crappy CCC stuff? Just about $193 billion. That is super small in the grand scope of the junk bond market.

The part of the junk bond market everybody’s freaking out about represents less than 10% of the whole thing. Meanwhile, the other 90% — nearly $2 trillion worth of junk bonds — is behaving just fine.

If this was really a broad credit event, you’d expect the stress to spread. You’d expect investors to start demanding significantly more yield across the entire high-yield complex. And that is NOT what is happening. Simply stated, the stress is on the worst borrowers in America.

You can also see that the stress is in the CCC environment by looking inside HYG, one of the largest high-yield bond ETFs in the world. Most of HYG isn’t CCC debt. It’s BBs and Bs.

The chart below is what the spread between HYG and IEI, which are 3-7 year Treasury securities looks like.

Bottom line…is that there is nothing there. So when someone throws a chart of CCC spreads on your screen and tells you the credit market is sounding the alarm and the world is ending, remember what you’re actually looking at. You’re looking at the riskiest, super small corner of a roughly $2.2 trillion market.

But, here is what I’m really interested in.

I want to compare CCC spreads directly with B spreads. The higher this ratio goes, the more the bond market is separating the really, really crappy borrowers from the just kinda crappy borrowers. And those are moving higher.

Now, could this be the first domino of much bigger trouble? Maybe.

But we have to remember that the weakest companies should have problems first! That’s why they’re rated CCC in the first place. So it shouldn’t surprise anyone that the CCC group spreads are rising. But we need to keep an eye on the B’s.

If CCC spreads keep climbing while B stays around 3% over Treasurys and BB stays around 2%, I’m not losing much sleep. The bond market is basically telling us that bad companies are having a bad time.

Okey dokey there Captain Obvious.

But if the B spreads start breaking higher…well that would get my attention.

If the BB’s follow, I’m really paying attention.

That would indicate that the problems are spreading from the weakest, small borrowers into the much larger part of the junk-bond market. “CCC → B → BB” is the progression to pay attention to.

So far…nothing.

If it stays nothing…that is also a signal!

The signal would be that maybe investors have become much better at separating the winners from the losers. After all, isn’t that what markets are supposed to do in the first place?