The next domino.
While the stock market is in panic mode, the losses in corporate bonds are comparatively small. This could change.
We still remember an analysis by Pictet in October 2018, when the Swiss took a close look at the corporate bond market and wrote: "Beware oft the fallen angels.
The chain of argumentation went like this: Many large investors are only allowed to buy so-called investment grade bonds - i.e. securities with good or very good credit ratings. Their rating must be at least BBB (from the Standard & Poors agency) or Baa (from Moodys).
In the past, the proportion of bonds that just fall into this category has risen dramatically. BBB-rated paper, Pictet wrote, now accounts for about half of the corporate bond market in the US and Europe.
Obviously, many companies have taken advantage of the opportunities of the low-interest era and borrowed massively on the capital market to refinance bank loans, pay for acquisitions or finance share buybacks and dividend payments.
The problem is that in the next recession, Pictet says, a significant proportion of these borrowers will probably be downgraded by the rating agencies and lose their BBB. Investment-grade bonds will become so-called high-yield bonds - in market jargon, these papers are falling angels, fallen angels. If you are only allowed to invest in investment-grade bonds, you must sell them. The interesting question then is: Can the high-yield market, whose total volume comprises only a third of the BBB securities, absorb this material? And at what price? Pictet concluded at the time: BBB-rated paper is the least attractive part of the entire bond market.
Today, as the likelihood of a recession increases, this story becomes red-hot
On balance, debt in the US corporate sector is currently higher than ever relative to GDP. If the corona epidemic were to lead to serious problems in the global economy, a number of highly indebted companies would probably face massive difficulties and the number of insolvencies would rise
What happens then? Let us do a thought experiment: Yields in this market segment would rise significantly to compensate for the greater risk of bankruptcy. Prices would begin to fall. Investors in high yield funds would now face losses and reduce their positions. The managers of the funds would have to sell in order to create liquidity. And not just them. Even normal bond funds, mixed funds and multi-asset funds, in their desperate search for returns, have expanded the proportion of high-yield bonds in their portfolios very far in recent years. This means that they have done very well, especially in 2019. The managers of these funds would probably also try to reduce their positions quickly if the worst came to the worst.
Who would buy? The exit door would now very quickly become very narrow. And the next domino in the capital market would fall.
Of course, it does not have to be that way. But you should at least consider this possibility in the current review of your portfolio.