Moody's Lonski: HY 'very worrisome,' 'treacherous' amid market volatility; Ben to the rescue?

By Paul Deckelman

New York, Aug. 8 - Moody's main market-watcher, John Lonski, had a two-word assessment Monday of the current state of the high-yield world: "very worrisome," given the extreme rise in overall financial market volatility.

The volatility has only been exacerbated by the intense investor reaction to the late-Friday announcement from Standard &Poor's of a first-time cut in the U.S. government's formerly-sterling AAA rating.

He said that the outlook for junk bonds at this point is "treacherous," with "a lot of downside risk" for considerable widening in Junkbondland spreads - although he also said that investment grade, particularly the non-financial companies, is holding its own, at least for now, although that too could change.

Lonski further projected that with the chance of a big fiscal stimulus package "off the table" as a result of the recent budget deficit compromise and the Obama administration unlikely to take any major steps on the regulatory front to restore business confidence, any relief from Washington would probably come from the Federal Reserve, whose policy committee meets on Tuesday - but only if it receives what he calls "an SOS" from the financial markets requesting quick action.

HY senses double-dip ahead

Even before the unprecedented downgrade of U.S. Treasury debt hit, Lonski - the chief economist for the capital markets research group at Moody's Analytics, a separate division within Moody's from its better-known bond-rating service - had written at the beginning of last week that junk market spreads, even at that point, had already widened to an average 545 basis points over Treasuries.

The spreads were well beyond where they normally would be, given the "atypically low" U.S. speculative-grade default rate seen in June - 2.6% and continuing to fall. That indicated to him that the junk market "earlier concluded that the risk of a double-dip recession was between 25% and 50%, as opposed to the conventional expectation of a 0% to 25% risk of a double dip."

And Lonski further said in that Aug. 2 screed that the "barely expansionary" 50.9 reading which the Institute for Supply Management reported last Monday for its widely followed index of U.S. industrial activity - well down from June's 55.3 - "warns of a greater than 100 bp broadening of the high-yield bond spread."

Bad as that environment was, it was before the sharp downturn that the junk market suffered last week, following the lead of equities - which had their worst week since September 2008. Lonski's assessment then also preceded the shocking, but not-totally unexpected S&P Treasuries downgrade announced after the close of trading on Friday.

Lonski told Prospect News on Monday that the Chicago Board Options Exchange VIX index measuring equity market volatility had climbed, over several sessions to an intraday high of 38.5 on Friday - and "ordinarily, a VIX index of that particular height, historically, has been associated with a high-yield bond spread of 1,044 bps - that's ugly."

He said that as of Friday, the high-yield bond yield was averaging 620 bps, "so there's a lot of downside risk in the high-yield bond market right now, according to heightened equity market volatility and heightened risk- aversion on the equity side, that is captured by this very steep index for the VIX."

In Monday's trading, the VIX - sometimes referred to in market circles as "the fear index" because of its ability to reflect bearish investor sentiment when things are going badly - moved even higher; it jumped 50% on the day, from Friday's close of 32.00, to 48.00 at the market close.

With the VIX continuing to head northward, Lonski sees "a worrisome situation. The risks are definitely on the rise, and it's difficult to feel confident about a turning point in the high-yield bond market any time soon."

Numbers present a puzzle

Lonski noted that the current VIX-driven spike in junk yields is all the more notable because of the extremely low default rate. For July, Moody's on Monday pegged it at 1.9% globally and 2.3% for U.S. speculative-grade bonds, with projections of a rate as low as 1.5% by year's end.

The last time default rates went that low in a post-recession period, Lonski said, was in June-July of 2005, coming off the 2001 recession; at that time, junk bond spread hit "a thin" 298 bps over, while in May of 1994, in the aftermath of the 1990-91 recession, junk spreads had narrowed to 375 bps.

With the continued decline in default rates seeming to indicate that a double-dip recession is unlikely - but the rising VIX, and along with it, junk spreads seeming to say exactly the opposite - Lonski said that the question that a bond investor must ask him or herself is, "is the VIX index right about where the economy is headed?"

"Are we going through a rough patch, a period of extreme turbulence, that will be followed by a period of conclusive growth, no matter how mild? If that's the case, spreads will narrow," he said. However, he cautioned that even if that were to be the case, "spreads are unlikely to return to their sub-400 bps band of the two previous recoveries any time soon."

He explained that generally speaking, macroeconomic risks "are going to be greater than they were during previous recoveries. That's owing to the reduced scope for government intervention on behalf of a possibly ailing economy. 'Too big to fail' doesn't mean what it meant in the past."

He also projected that "you're not going to have investment-grade financial company spreads return to the very narrow bands they held during the previous economic recovery, as well as [during] the recovery of 1991-2000.

"So I think ultimately, what it comes down to, is that if you're buying in the high-yield bond market, if you're going long with high-yield debt, you are assuming that a double-dip [recession] will be avoided."

Liquidity dry-up looms

But things could just as easily go the other way. Lonski warned that "[from] the last time we had a high-yield bond spread move above, say, 750 bps, there's a pretty good chance there will be a contraction of financial liquidity. That might be enough to push the economy into a double-dip."

He explained that a contraction of liquidity "means even less [lending] to consumers and small businesses. Moreover, a contraction of liquidity would imply that the default rate will be higher than currently expected. As liquidity is diminished, more of those high-yield issuers that are of more marginal quality would find themselves unable to secure the liquidity they need to make good on their debt repayment obligations and thus fall into default."

With uncertainty reigning in the financial markets - the warning signs are balanced somewhat by a few nuggets of recently positive news, such as the somewhat better-than-expected July jobs report and a recent stabilizing trend in the weekly unemployment claims figures, he said - "it's still a treacherous outlook for the HY bond market and the overall economy."

High grade hangs in - for now

While junk bond spreads have widened alarmingly of late, Lonski said that - relatively speaking - investment-grade seems to be holding its own, at least for the moment.

"A big difference between today and what happened with Lehman's collapse is that your investment-grade spreads are much better-behaved. We haven't seen much of a widening by the bond yield spreads of investment-grade non-financial companies. They've been relatively steady."

Some have done even better than that. Lonski said some investment-grade yields even "have dropped to record lows, or close to record lows," as measured by the Barclays high-grade index. "We have a long-term Baa industrial company bond yield that goes way back in time - and that recently fell to its lowest level since May of 1966. It's a far different story from 2008."

However, he added that "where you have seen some that have widened, and this is where you continue to have weakness - weakness that's going to weigh on the high-yield market and financial markets in general - that's with the investment-grade financials."

While declaring that in the investment-grade space, "we are not looking at a replay, yet, of what happened in September 2008, thank goodness," he wondered aloud how long the high-grade bonds could hold up under the current conditions.

"If you have a VIX index that hangs in there at 35-40, chances are that medium-grade spreads will begin to widen significantly, as will, of course, high-yield bond spreads. And that makes it all the more likely that the real economy is going to suffer," he said.

Will the Fed step in?

With a double-dip recession now seen by many observers as, at the least, a very real possibility - the message the VIX index seems to be sending, Lonski says, is that comparisons to the 2007-2009 financial crisis and the resulting recession would seem to be almost inevitable.

But while the federal government moved aggressively the last time around, with injections of TARP money to the financial sector, the auto industry bailouts and the stimulus package enacted in the opening weeks of the Obama administration, things are likely to be quite different this time around.

Lonski asserted that "with the budget deficit reduction package, fiscal stimulus is off the table. It's been removed as a possible support for the U.S. economy."

He also said that while moves in the regulatory area might provide at least a psychological boost to a battered business community and frightened markets, "I don't think that the administration is going to be willing to make major changes on the regulatory front that might improve prospects for economic growth."

He said that "if you're going to get any help from Washington, perhaps it comes from the Federal Reserve."

Will the QE3 launch?

With the central bank having already taken interest rates it can directly control, like the discount borrowing rate and the Federal Funds interbank rate, down to historic lows, the only real available option might be another round of quantitative easing.

The central bank's policy-setting Federal Open Market Committee is scheduled to meet on Tuesday, and Lonski speculated "who knows? You could see the Fed acting by the end of the week. It's not inconceivable."

He noted that the second round of quantitative easing - nicknamed QE2 - "was very good at stabilizing, if not boosting the equity market, which, in turn benefitted the high-yield bond market considerably." He said that while "some would argue that it did so at the cost of boosting commodity prices - the good news [now] is that of late, commodity prices have been sinking. So perhaps there's more room for a QE3."

But with Fed chairman Ben Bernanke and the Fed's governors and regional bank presidents well aware that "the financial markets were less than entirely enthusiastic about QE2," the Moody's research chief cautioned that "it appears as though financial markets will have to practically beg the Fed to implement QE3 before the Fed decides to do so."

He said that "effective begging by the financial markets means even lower share prices [and] heightened financial market volatility, along with, a wider high-yield bond spread."

He added that the Fed likely "doesn't want to implement another round of quantitative easing, until it is convinced that by doing so, it will have a quick and positive effect on the financial markets. It doesn't want to risk another round of quantitative easing adding to the downward pressure on financial asset prices."

Lonski said that the Fed leaders "are waiting for some signal from the financial markets that QE3 is a necessity, that it's needed as soon as possible." As of Monday afternoon, he said "the financial markets have yet to send the Fed the SOS that they need help now, before they need help further."

But he agreed that continued sharp deterioration in the financial markets might be "more than enough" to send such a distress signal to Washington.

Indexes show weakness

In Monday's dealings, the bellwether Dow Jones Industrial Average - which already suffered horrendous losses last week - plunged by another 634.76 points, or 5.55%, to put it below the psychologically important 11,000 mark, at 10,809.85. Since peaking at 12,810.54 on April 29, the Dow has surrendered slightly more than 2,000 points, or more than 15%. Other, broader equity indices, like the Standard & Poor's 500 and the Nasdaq Composite, reflected even bigger percentage declines on the day than the blue chips.

Back in the junk bond market, Monday's blood-letting was equally severe, dwarfing even last Thursday's steep selloff. The widely followed Markit CDX North American High Yield Series 16 Index nosedived by nearly 4 full points - traders called it the worst loss in their memory - to end at a 92.87 midpoint. That's more than 7 points down from its week-ago level at 99.96, and a full 10 points below the 102.91 level at which it had begun the year.

The Markit index's spread ballooned out by 104.8 bps on the session to end at 686.36 bps - 185.37 bps wider than its week-ago level of 500.93 bps and 256.24 bps wider than the 430.12 bps spread recorded as the year opened.

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