Traders believe the corporate debt markets will get worse.

So far, most of the rout in the debt markets has been linked to the US subprime mortgage debacle. Increasingly, however, many hedge funds are betting there is far worse to come for the corporate debt market as well.

Hedge fund managers and the trading desks of some of the savviest firms on Wall Street are expecting a severe downturn in the corporate debt market. A big part of their bet is that bonds will perform far worse than in previous meltdowns, because financial engineering has created so many layers of debt on top of unsecured bonds, which are the last debt to get paid in the event of a default.

Their pessimistic views are not yet borne out by traditional benchmarks of corporate health. Historically, the markets tend to focus on corporate debt default rates but this measure is under scrutiny. In December, the average default rate reached a record low of 0.26 per cent. S&P;’s Leveraged Commentary & Data analysts think the data is so misleading that it has created a shadow default rate measure by including companies that are not able to pay interest and have taken advantage of clauses in their documents that allow them to issue more debt when they have no cash to pay out interest.

This time, the amount of debt and the number of companies whose debt trades below par – or at less than 100 cents on the dollar – may be a better indicator of things to come.

Virtually every loan in the market now trades below par, a far cry from six months ago when virtually every leveraged loan traded above par.

As long as corporate cash flows hold up, distress isn’t likely to be widespread. But thanks to the inventiveness of bankers, Wall Street and the private equity owners of companies in trouble can buy time because lenders sometimes allow them to issue more debt if they cannot pay their interest in cash – the so-called payment-in-kind debt.

Such terms are great for owners and the borrowers, because companies can stay afloat without creditors pulling the plug. However, in some cases, companies that are no longer truly viable stay afloat longer than they should, destroying more value and eating up more capital than they should, and lowering recoveries for creditors when they finally do hit the financial wall.

In the past, there were lots of early warning signs of looming stress when cash-strapped companies could not meet the terms of their loans. But after years of easy credit, there are fortunate borrowers who are tied to virtually no terms.

David Rubenstein, co-founder of Carlyle Group, has observed that even if many of the companies he owns wanted to default, they could not because they have no obligations at all.

Today, the gap between where loans trade and where bonds trade is the highest since May 2005 when the rating agencies considered lowering their ratings on the American car companies, which caused a short-term swoon in the credit markets.

This gap highlights the poor outlook for corporate bonds. This is the result of “a lethal cocktail of falling equity and bond prices and poor economic news”, says S&P;, the rating agency, adding that defaults are already higher than official numbers.

It Toggles The Mind

I spoke about “toggle bonds” and “covenant light” strategies that allow companies to pay back debt with more debt in Toggle Bonds – Yet Another High Wire Act. The credit markets have now stopped such insanity but so far anyway, not much has blown up yet.

I have been watching watching AFBIX as a proxy for junk bond stress for quite some time.

The investment seeks to provide investment results that correspond generally to the inverse (opposite) of the total return of the high yield market consistent with maintaining reasonable liquidity. The fund normally invests at least 80% of net assets in CDSs and other financial instruments that in combination should provide inverse exposure to the high yield debt (junk bond) market. It seeks to maintain inverse exposure to the high yield bond markets regardless of market conditions and without taking defensive positions in cash or other instruments. The fund is nondiversified.

AFBIX Weekly Chart

click on chart for sharper image

AFBIX is an inverse fund so a rising chart shows junk bond stress. Stress in corporate bonds during the mid-summer credit crunch has abated for now. How long that lasts, I do not know. What I do know is that a junk bond implosion is another “shoe” waiting in the wings that has not yet dropped. Eventually it will.

Mike “Mish” Shedlock
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