DJIA: -0.03% to 29,186.27
S&P 500: +0.03% to 3,321.75
Nasdaq: +0.14% to 9,383.77

The Hot Stock: Capital One Financial +4.5%
The Biggest Loser: Mosaic -5.3%

Best Sector: Technology +0.4%
Worst Sector: Energy -1%

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What's Up in the Corporate Bond Market?

Interest rates around the world are at or near record lows. The Federal Reserve, the European Central Bank, and the Bank of Japan are expanding their balance sheets to the tune of roughly $100 billion a month combined. Investors are hungry for yield, and that is forcing them to take on risk they normally wouldn’t for acceptable returns.

All of that is showing up in the corporate bond market.

The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) rose more than 17% in 2019, while the iShares iBoxx High Yield Corporate Bond ETF (HYG) added 14%. As investors pile into bonds and drive their prices up, their yields decline and the spread over risk-free Treasuries tightens. U.S. investment-grade bonds now yield an average of just 2.8%, while high yield goes for 5.1%.

The high liquidity and investor demand means that some companies have been able to secure financing that otherwise might get a more-skeptical look.

“One of the consequences of the [central banks] easing again...is that they’re feeding the zombies, the walking-dead businesses that would be out of business by now if it wasn’t so cheap and easy to get credit,” economist Edward Yardeni, president of Yardeni Research, told Barron’s for our 2020 Outlook. “With interest rates so low around the world, investors are reaching for yield, and that means they’ve been buying junk.”

The investment-grade portion of the corporate bond market (bonds rated at BBB- and better) has exploded  to $3.3 trillion today from $800 billion in 2007, according to Scott Minerd, global chief investment officer at Guggenheim Investments. He is concerned that rapid growth in issuance has coincided with deteriorating quality.

“Today 50 percent of the investment-grade market is rated BBB, and in 2007 it was 35 percent,” Minerd noted in a letter to clients this week. “More specifically, about 8 percent of the investment-grade market was BBB- in 2007 and today it is 15 percent.”

Minerd is worried that investors’ appetite for corporate bonds has been unfazed by that trend. Guggenheim expects up to 20% of BBB-rated bonds to be downgraded this year. That could see $660 billion worth of debt swamping the high-yield market.

“Ultimately, we will reach a tipping point when investors will awaken to the rising tide of defaults and downgrades,” Minerd wrote. “The timing is hard to predict but this reminds me a lot of the lead-up to the 2001 and 2002 recession. The prolonged period of tight credit spreads experienced in the late 1990s lulled investors into unwittingly increasing risk at a time they should have been upgrading their portfolios.”

As long as the credit-expansion machine continues pumping out liquidity, the stability it creates will keep investors comfortable taking on risk in corporate bonds despite their declining quality. “Ultimately, this leads to what [economist Hyman Minsky] called a ‘Ponzi Market’ where the only reason investors keep adding to risk is the fear that prices will be higher tomorrow (or in the case of bonds, yields will be lower tomorrow),” Minerd wrote.

He doesn’t see a recession on the immediate horizon, but noted that increased defaults and wider credit spreads predated the 2001-2002 recession by three years.

“This would sound like good news for yield-starved investors and I would agree,” Minerd wrote. “But patience will lead to bigger opportunities for disciplined investors who don’t wander off into exotic asset classes or chase current returns.”

The Calendar

American Airlines Group, Comcast, Discover Financial Services, Intel, Kimberly-Clark, Procter & Gamble, Southwest Airlines, and Union Pacific report earnings.

The European Central Bank announces its monetary-policy decision. ECB President Christine Lagarde, who replaced Mario Draghi last November, is widely expected to announce that interest rates will remain steady at negative 0.5%. Lagarde may also shed some light on the strategic policy review that the ECB is undertaking, the central bank’s first since 2003. The continued viability of negative interest rates and how the ECB should best address persistently low inflation, are topics of discussion.

The Federal Reserve Bank of Kansas City releases its manufacturing survey for January. Economists forecast a negative six reading, rebounding from December’s negative-eight figure. The survey had negative readings every month in the second half of 2019.

What We're Reading Today

• 3 Start-ups That Could Save the Planet, From the Man Behind Overture and Picasa Barron's
• 5G and 2 More Reasons to Buy AT&T Stock Now Barron's
• Hess and 5 More Energy Stocks That Could Cut Their Dividends Barron's
• If You Still Own Actively Managed Stock Funds, Get Ready for Some Bad News Barron's

Thanks for reading and have a great night.

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