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July 11, 2018

US corporate bond market structure indicates rising risks

US corporate bond market structure indicates rising risks

The US corporate debt market is rapidly losing its quality.


Deterioration in credit rating – a signal of the uncertainties of the times ahead for US firms?

According to Morgan Stanley estimates, the volume of bonds issued with investment grade “BBB” exceeded 2.56 trillion dollars, which is 10 billion dollars more than the amount of debt securities with the highest credit rating. 

Recall that the bonds “BBB” are a step away from the line, after which the securities get the rating of “junk”.

In total, the corporate debt of the United States is $ 7.5 trillion, where $2.55 trillion accounts for bonds with higher credit rating, $2.56 trillion related to bonds with “BBB” rating and $2.43 trillion for securities related to risky and extremely risky investments.


US corporate bond market structure

US corporate bond market structure. Source: Bloomberg


In the early 2000s, the total of bonds with “BBB” rating were 1.7 x EBITDA / net debt. Today, the coefficient almost doubled, reaching 2.9x. The net debt to EBITDA ratio is a measurement of leverage what is a proxy for risk of holding stocks of the company (“levered equity”).

 The credit rating of BBB is often considered borderline and at the time of worsening economic conditions, most of the bond can go to a lower class.

It turns out that a third of the US corporate bond market structure is already in the high-risk zone. Another third (bonds with BBB rating) can easily go there in case of a serious slowdown in economic growth.

That is, there is a possibility that with the next recession, more than half of all the debt of US firms will turn into “junk” bonds. The risk of default is extremely high because at times of monetary tightening firms revenue may fall due to more cash flow directed to servicing debt.


Oil: treading on “terra incognita”


Hedge funds were not spooked by the new OPEC + deal and retained upbeat outlook on prices despite that producers agreed on gradual increase in output. 


Oil COT data 3 July

Oil COT data as of 3 July. Hedge funds are bullish on oil after OPEC meeting. Source: CFTC, Reuters


According to CFTC COT data, as of July 3, hedge funds accounted for 451,600 long and 17,400 short contracts. Last week, the amount of longs increased by 40.8 thousand contracts, and shorts fell by 2.6 thousand contracts. Thus, the total net long position on oil increased to 434.2 thousand contracts, which is only 61.9 thousand less than the highest point of the current year.

At the same time, there have been significant changes in the positions of the four largest traders on the New York Mercantile Exchange: the spread between “shorts” and “longs” materially decreased. It was 4.4 percentage points in favor of short positions at the end of May, then by Tuesday, the difference fell only to 1.1 percentage points.

Oil prices have several footholds today. First, production in Venezuela is declining. It’s the country which have one of the biggest oil reserves in the world. Secondly, sanctions are possible against Iran with US pushing its allies to withdraw oil purchases from the country. Third, the steady rise in oil consumption as world economy seen expanding. And, fourth, stalling production in the United States.

Against this background, it’s unlikely that increase in production by OPEC members will lead to the market surplus, what brings oil back in sight of speculators pushing prices to the new highs.

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