Stock Markets Are Wild, but Bond Markets Can Be Dangerous
The sell-off in stocks isn’t the only ominous economic sign emanating from financial markets. The bond markets, much more closely linked to the actual economy, are also flashing a warning.
By Matt Phillips and Peter Eavis
Ask someone how “the Dow” is doing and, even if they don’t know the answer, they’ll know what you’re talking about. Ask them about the bond market and you’ll most likely get a blank stare.
When it comes to the economy, however, bonds are far more important than stocks.
Bond markets dictate the cost of borrowing money, and that can determine actual economic activity. The decision by a C.E.O. to build a plant or take the plunge on a new product is often decided by how much it will cost to borrow the money to pay for it. When that payment climbs too high, corporate activity slows, and so does the economy.
Lately, borrowing costs have been rising quickly. Investors worried about corporate debt loads and the impact of a potential slowdown on profits are demanding companies pay them higher interest rates.
And, in a recent troubling sign for the economy, fewer companies have been turning to the bond market to finance their businesses.
As with the swooning stock market, weakness in the bond market doesn’t mean the economy is destined for an immediate downturn. But signals being sent by bond investors will almost certainly arise in discussions among policymakers at this week’s Federal Reserve meeting on monetary policy, which will culminate on Wednesday with a decision on interest rates.
Here’s what you need to know.
There’s the government, and then there’s everyone else.
Like any borrower, a company raising capital in the bond markets pays interest. What they pay depends on how likely it is that a lender will get repaid. Consumers have credit scores. Companies have debt ratings.
The greater the risk that a borrower won’t be able to pay up — known as credit risk — the higher the interest rates. American Treasury bonds almost always have the lowest interest rates. That’s because lending to the United States government — which has a virtually unblemished record of repaying creditors — is considered pretty much the safest investment on earth.
Everyone else, even the most powerful, cash-rich corporations, must pay more. For example, Home Depot went to the bond market late last month, raising $1 billion by selling 10-year bonds. At the time, the yield on the 10-year Treasury note — the federal government’s cost to borrow for 10 years — was about 3.06 percent. Home Depot, considered a safe or “investment grade” borrower — paid an interest rate of almost 4 percent to borrow for 10 years.
The difference between the low interest rate that the government pays and the higher rate of another borrower is called the credit spread. Riskier borrowers typically have larger spreads.
Bankers who arrange bond issues for companies set the interest rate by looking at where the company’s other bonds are trading and assessing the demand for the new bond.
A higher credit spread can also reflect investors’ concerns about things like the broader economy and the future ability of any company to pay money back. In recessions, for example, they rise for even the healthiest companies.
“As the credit spread goes up, lenders are saying, ‘We’re really worried about making loans, riskier than lending to the government,’” said Philip Bond, a professor of finance at the University of Washington.
Rising credit spreads are sending a warning.
Since early October, credit spreads have increased fast.
Borrowers with investment-grade debt ratings (essentially higher credit scores) are paying more than 1.4 percentage points above Treasurys to borrow, up from less than 1 percentage point at the start of the year.
Spreads on junk bonds, issued by companies that are considered significantly less creditworthy, have risen even more, from around 3.2 percentage points at the start of the year to more than 4.5 percentage points now, according to FactSet.
The sudden increase — “widening” in the bond market’s lingo — is telling us that investors are suddenly more nervous about handing over their cash to corporations. The same change in sentiment is playing out in the stock market and the reasons are largely the same.
A trade war that has no end, signs of a slowing world economy and a widely expected deceleration in growth the United States have all pushed investors to take less risk. At the same time, the Fed is slowly removing the helping hand it has extended to markets and the economy for the last decade, by raising rates and shrinking the stockpile of bonds it owns. Recent drops in oil prices are also making investors less willing to place their money with the smaller energy companies that tend to borrow in junk-bond markets.
While the stock market sell-off may eventually affect sentiment among consumers and corporate executives, bond market moves can have an immediate impact on the economy by discouraging borrowing and investment.
“As those spreads are widening, definitely there is going to be a reluctance to invest, especially in risky ventures,” said Marti Subrahmanyam, a professor of finance at New York University’s Stern School of Business.
There are already signs that the recent jump in borrowing costs is slowing the flow of money to companies. In the junk bond market — where the riskiest borrowers are — there have been no new corporate debt deals this month, according to data from the financial market research firm Dealogic. If none happen, it would be the first such shutout since November 2008, near the peak of the financial crisis.
Can corporate American handle a downturn?
It is true that borrowing costs are still very low by historical standards, because the Fed only just began to step back from its post-crisis programs to keep them that way.
But one concern among investors is that this effort to hold down costs encouraged borrowing to a point that could be problematic in a downturn.
Netflix has gone from having very little debt in 2010 to having more than $10 billion now. Verizon now has $113 billion of debt, more than double the amount it had six years ago. By one measure, the ratio of corporate debt to G.D.P., the total level of borrowing is at all-time highs.
In general, higher debt levels could make it tougher for companies to repay the lenders if there’s a slump in the economy, or a hiccup in sales, or a decline in the value of assets.
Back in 2015 we had just such a situation, when a similar surge in corporate bond spreads pushed borrowing costs up sharply. A sharp dive in crude oil prices was at the heart of the rout, making people less willing to lend money to indebted energy companies. A wave of defaults by energy-related companies, like Linn Energy and SandRidge Energy, ensued.
That turmoil didn’t lead to a full-blown recession. But it did coincide with what some economists, including those at JPMorgan Chase, now call a “mini recession” between 2015 and 2016, in which industrial spending by companies in the manufacturing sector slowed sharply and dragged on growth.
And with the American economy already expected to slow in 2019, the climbing costs of corporate borrowing could determine whether any slowdown turns into something much worse.
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