Junk Bonds Could Signal Recession Risk in 2016
From the Desk of Jim Eccleston at Eccleston Law LLC:
Martin Fridson, money manager at Lehmann, Livian, Fridson Advisors LLC, claims that the junk bond market, as an indicator for recession probability, shows a 44% chance of recession in the U.S. within one year.
Fridson asserts, “I am not an economic forecaster – this is what the market is saying … There are lots and lots of caveats, but if you accept the assumptions, it’s a pretty startling comment.”
Many in the private sector agree with Fridson, supporting that a recession is likely in some magnitude. Jeffrey Gundlach, co-founder of Doubleline Capital, estimates that there is a 33% chance of recession this year. The S&P reported that the near future for corporate borrowers worldwide is the worst it has seen since the global financial crisis. On the Contrary, Federal Reserve officials offer a contrasting opinion, pointing to more interest rate hikes amid falling unemployment.
Fridson’s analysis uses monthly junk-bond spreads since 1986, using Bank of America Merrill Lynch index data. Investors at the beginning of 2016 demanded an extra 7.39 percentage points to hold high-yield debt, landing just below the midway point between the 5.2% average for expansionary months and 10.19% average for recessionary months. According to S&P’s Capital IQ Leveraged Commentary & Data, that signals a 43.9% probability of recession.
Often times high-yield index are ahead of experts in predicting slowdowns. Citigroup analyst look to spread levels on the Markit CDX North America High Yield Index, a credit-default swaps benchmark tied to the debt of 100 speculative-grade companies, and they expect a loss of 21.2% over the next five years. That would be the same as saying approximately 22 of that 100 companies default and investors recover 0% of their investment. Superimposed to a macro level, that statistic is rather startling.
While analysis of the high yield market is common tool of experts and official arbiters, it is not an infallible measure, according to Fridson. He thinks that the market may be overstating the near term risk of recession which would mean that high-yield bonds may still offer good value.
Fridson also posits that the state of the energy sector may add another caveat to the calculation. Oil has experienced the largest drop in over four years having slid more than 15 percent in the previous six sessions. If one were to exclude the commodities portion of the calculation, the probability of recession drops to only 20%.
Fridson stated, “I am inclined to be a little bit more optimistic that the calculation taken at face value, in particular because the spread is inflated by the very distressed state of the energy and metals and mining sectors … You could say that if you take out energy the rest of the market is not indicating a particularly high recession risk, and that’s also a valid comment.” His restrained optimism may put the market in perspective for other forecasters.
Yet, his calculation as it stands in its original form tends to closely align with other market forecasters. He says, “At the very least, the market’s opinion is worth considering.”
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