Aggressive Fed Rate Hikes Could Put Junk Bond ETFs In Danger

From John Ross Crooks III: We’re not in Kansas anymore. But we are in Kansas City, where Esther George is president and chief executive officer of the Kansas City Fed. And the only thing transient is economic weakness.


More rate hikes.More rate hikes.

More rate hikes.

That’s what Esther George thinks this economy needs.

Yeah, sure — we need for 20% of U.S. corporations to default.

Wait. Hold up. She didn’t say that.

I did.

I mean, I took some of what Ms. George thinks and mixed it with part of what the IMF’s Global Financial Stability (GFS) report thinks will result if Mrs. George gets her way.

George thinks the economy is stable enough to warrant more rate hikes. Despite some weak economic data that she considers transient, she’s all for interest-rate normalization.

Let’s not forget, though, that normalization is not really all that normal.

Many still believe strongly that “normalization” is simply the necessary preparations to be made before the Fed must start cutting rates again.

Technically, one could say that is relatively normal. If one is looking at the ebb and flow between monetary loosening and tightening cycles.

But today’s normalization is not about addressing an economy that can support higher rates. Rather, it’s about preparing for one that’s soon to need lower rates. That means hike rates enough so that they can be cut enough.

There is a difference. Trust me.

Back to Ms. George …

She too thinks that this is the year central banks should start clearing debt off their balance sheets.

No comment.

Clearly the GFS report sees some significant risks to Ms. George’s enthusiasm for monetary tightening.

The following charts are taken from the GFS report. Let’s start with the Interest Coverage Ratios (ICRs) for corporations — which are dropping toward historically infamous levels!

And then there is this next comparison of Earnings Before Interest and Tax (EBIT) to those ICRs.

Again, perhaps the most important thing to point out is the current level relative to the two most recent (bubble-induced) recessions … as well as what higher financing costs (higher interest rates) would mean:

Basically, earnings are less able to cover companies’ interest expenses.

Heading to a conclusion of what higher interest rates would mean to this measure, consider the leverage of S&P 500 companies:

Again, it’s relative.

So, if leverage and vulnerability of companies with weak interest coverage ratios (<1) are already at worrisome levels, what happens when interest expenses rise?

Here is another look at current pressures — servicing debt has been absorbing a growing share of income despite negligible interest-rate normalization.

The debt service ratio obviously isn’t challenging the ’01 and ’08 peaks … yet.

But how quickly might this measure jump if normalization really sets in?

Lots of comparisons.

Lots of questions.

Lots of ifs and maybes.

I know.

The question you want me to answer is: so what?

So, I think it’s safe to assume the slow adoption of normalization has kept things calm. With fear absent, valuations become detached from reality.

Last week, I discussed the headwinds that debt is likely to create in a monetary tightening cycle.

But before that I brushed across some stock market valuation metrics in “A Big, Fat ‘Hmmmmm.” I aimed to show that things aren’t necessarily doomed if everyone stays calm.

The problem, therefore, is that the only thing we have to fear is fear itself.

Errr. Yeah, I guess so.

Because if we start to fear what interest-rate normalization will mean for overvalued markets … and for companies whose earnings are supporting less and less of their debt-driven-activity …

Then we’re liable to create the precise situation we fear.

A situation where dislocation becomes relocated, where the mispricing of risk is repriced.

One dislocation that relates closely with today’s discussion is in high-yield, or junk, bonds.The idea is that these high-yield corporate bonds represent the biggest risks of the corporate bond market.

The IMF’s Global Financial Stability report gave attention to all the previously mentioned metrics because of what they might mean for defaults, which they see as among a few of the big risks to global financial stability.

Between 10% and 20% of companies are vulnerable to default pressure right now. (Based on ICR measures and such.) And they would be all the more vulnerable in a cycle of rising interest rates.

If you think issuers of high-yield junk bonds are due to be repriced, you might consider selling short shares of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) or the SPDR Barclays Capital High Yield Bond ETF (JNK).

Depending on your own analysis and personal trading style, you might also consider buying put options to 1) protect existing exposure to this market or 2) add a leveraged trade that can deliver some significant profits in short order.

The SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK) was trading at $37.04 per share on Monday morning, up $0.17 (+0.46%). Year-to-date, JNK has gained 1.62%, versus a 6.00% rise in the benchmark S&P 500 index during the same period.

JNK currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 36 ETFs in the High Yield Bond ETFs category.

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