Insolvency Is a Concern For Some Firms
Investors sent stocks and high-risk bonds spiraling in opposite directions since the November 8 presidential election, much to the detriment of the junk bond market.
Yields had compressed in recent years as central banks continued to offer historically low interest rates, but the sudden shock of Donald Trump’s victory caused investors to re-evaluate the risk between asset classes.
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These differences are most apparent in the relationship between the small-cap focused Russell 2000 Index and the iShares iBoxx $ High Yield Corporate Bond ETF. (Source: “Junk Bonds Sound Stock-Market Alarm,” The Wall Street Journal, November 14, 2016.)
The former rose 8.7% since the election was decided, showing that investors are being extremely generous with pricing the effects of a Trump presidency (the Dow Jones Industrial Average (DJIA) also hit an all-time high last Thursday).
However, the 2.8% fall in the iShares ETF suggests that goodwill does not extend to high-yield (junk) bonds.
Bond yields move in opposition to prices, so the the fall in junk bond prices means their interest payments must rise. This shift would eat into their cash flow, causing some, if not many, of the underlying companies to teeter on the edge of insolvency.
It is a sharp break from previous years during which the stock market and junk bond market moved in lockstep. To be clear, the spread between junk bonds and “risk-free” Treasury bills has not fattened since the election, so markets are not worried about credit quality.
But they are worried about the Federal Reserve raising interest rates next month and that Donald Trump’s economic plans could spur inflation. They see his infrastructure schemes and tax cuts as an economic adrenaline shot which will induce a healthy pace of inflation.
This phenomenon, rather than issues of insolvency, drove the recent weakness in junk bonds. It was an entirely innocuous shift but it could, in a bitter twist of fate, push the underlying companies into financial straits by forcing them to accept intolerably high borrowing costs.
In other words, junk bonds could become the first collateral damage of a Trump presidency.
