One of the greatest dangers in today’s financial markets is an implosion of the debt market.
What is the Debt Market?
The debt market is a financial market where investors trade in debt securities like mortgage-backed securities, CDs, bonds (corporate, government, municipal), and so on.
A debt market implosion can bring down the economy because corporate America has accumulated enormous amounts of debt. SIFA Research estimates that U.S. corporations had $10 trillion in outstanding corporate bonds (debt) in the first quarter of 2022.
An implosion of the debt market could leave many companies with no way to finance their operations. Worse, many of those companies will have no way to pay off all that debt.
The Financial Times estimates that one-third of publicly-traded companies in the U.S. don’t make enough money to cover the interest payments on their debts.
Those companies survive by borrowing more money at higher interest rates (often in the form of junk bonds) to pay the interest. If those companies can’t borrow, they face bankruptcy because they can’t pay the interest.
Is the Debt Market Imploding?
There are some signs the debt market is imploding. For instance, rising inflation is scaring investors away from the debt markets.
The prices of exchange-traded funds (ETFs) that specialize in corporate debt took a big hit on June 13. In 2022, shares of the largest Junk Bond ETF; the iShares iBoxx USD High Yield Corporate Bond ETF HYG, fell from $86.97 on Jan. 3, 2022, to $73.82 on June 16, 2022.
Corporate bonds are fell over fear the Federal Reserve would raise interest rates to counter inflation.
The Fed raised interest rates by 75 basis points on June 15 — the largest increase recorded since 1994. Officials hiked rates by 50 basis points the month prior.
The Fed said it expects to increase rates by another 1.75% over the next four policy meetings, ending the year above 3%, CNBC reports.
Will the Junk Bond Market Implode?
The greatest danger from rising interest rates is the junk debt market. The danger is acute because unhealthy companies rely on junk, or high-interest, bonds to finance their operations. Small price increases can make it too expensive for companies to pay off junk bonds.
It’s estimated that the amount of expensive junk debt in the U.S. has doubled to $1.5 trillion over the past decade. The Financial Times estimates that expensive junk debt comprises 15% of total U.S. corporate debt.
The Financial Times claims only massive injections of liquidity from the Federal Reserve allowed the junk bond market to survive the COVID-19 pandemic. There is evidence the junk bond market is falling again.
Reuters reports that BlackRock’s iShares iBoxx $ High Yield Corporate Bond ETF (HYG.P) fell by 2.1% on June 13. That was the lowest price since April 2020.
Expensive junk debt is destructive because it finances the weakest companies. For example, declining retailers such as the department store operator Kohl’s (KSS). Notably, Kohl’s management announced it was selling the company to Franchise Group Inc. (FRG) in June 2022 as interest rates rose.
Shadow Banks and the Debt Market
The greatest danger in the debt markets is the private lenders The Financial Times’ Ruchir Sharma calls “shadow banks.” Shadow banks include pension funds, private equity firms, and hedge funds.
Shadow banks make unregulated loans and sell junk bonds to risky borrowers, including small businesses. Sharma estimates shadow banks had $63 trillion in assets worldwide in May 2022. Shadow bank lending rose from $30 trillion in 2012.
BNY Mellon estimates what it calls “Alternative Assets Under Management” will rise from around 12% of assets under management in 2021 to around 22% of assets under management in 2026. BNY Mellon’s definition of alternative assets includes private debt, private equity, and hedge funds that invest in debt.
Shadow banking is growing at a rate of 8% to 10% a year, Sharma claims. It’s hard to track shadow bank lending because many private investors make many such loans. Many shadow banks operate in underregulated secondary markets such as Luxembourg and Ireland.
One reason for shadow banking’s growth is the central banks’ crackdown on traditional debt markets such as mortgages after the 2008 meltdown. The crackdown drove enormous amounts of money into the shadow markets, which offer higher returns.
One popular segment of shadow banking is “business development companies” that make loans to financially fragile companies. Investors like business development companies because they offer returns of 7% to 8%. The danger is that financially fragile companies are the first to collapse in an economic crisis.
The growth of junk debt and shadow banking shows the question investors need to ask is not if debt markets will implode, but when debt markets will implode. Many investors will want to protect themselves from a debt market implosion by hedging their money. Hedging means keeping part of your money outside the markets in cash or precious metals.
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