Credit Markets Point To Rising Default Rates

Yield vs. Safety Of Principal

If an investor was given the opportunity to invest in two nearly identical bonds with one bond paying 2% per year and the other paying 6% per year, logic says most would choose to invest in the higher-yielding bond. In the real world, the bond paying 6% also comes with a higher risk of default. Therefore, when investors start to become more concerned about the economy and rising bond default rates, they tend to gravitate toward lower-yielding and safer bond ETFs, such as IEF, relative to higher yielding alternatives, such as JNK. The chart below shows the performance of JNK relative to IEF. The chart reflects a bias toward return of principal over yield.

Some cracks have started to appear in the credit markets in 2016. From CNBC:

The default rate for high-yield bonds has risen to the highest level in six years, and a top bond analyst sees more bad news ahead for investors in so-called junk bonds….Defaults are only likely to increase over the rest of the year, predicts Diane Vazza, S&P’s head of global fixed income research.

The concepts illustrated on the chart below are described in this video clip.

Potential Problems In The Oil Patch

Longer-term, if the economy flipped into a recession, the bulk of the defaults could come from the energy sector. From Bloomberg:

Wall Street’s biggest banks need to set aside more cash to cover losses as low oil prices take their toll, according to Moody’s Investors Service. Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. would need an additional $9 billion to cover souring oil and gas loans in the worst-case scenario, the ratings firm said Thursday in a report.

Increased Stress In China’s Bond Market

When U.S. stocks sold off early in 2016, one of the market’s principal concerns was the health of China’s economy. Those concerns could resurface in the coming months. From Bloomberg: