Junk Bonds and Green Skies

Story Notes:

• Investors today seem stuck in their too-dour sentiment.
• Moody's, a rating agency, has projected junk bond default rates to quintuple.
• Junk bond default rates today are historically low. Even if they did quintuple, they'd remain at unalarming levels.

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Who among us hasn't been tormented into a skewed world vision by a menacing older sibling? Our older brother was fond of holding us in a head lock, or perhaps sitting on our chest, demanding to know the color of the sky. "Blue," we'd squeak. "No," the tormentor insisted, "It's green. Say it's green!" "It's blue. It's blue," we'd gasp, taught never to lie. With our air supply just about depleted, we'd relent, "Fine it's green!" Then our tormentor would release us, cackling, "HA HA! Stupid! You think the sky's green!" and promptly inform the entire neighborhood of his younger sibling's imbecility.

We can't help but be reminded of those fond memories when speaking with investors today—many folks seem convinced the world is very bleak indeed. Despite GDP continuously beating too-dour expectations over the past few quarters, headlines insist a recession is a foregone conclusion if not already underway. Despite unemployment remaining low, folks fret too few jobs were added in December. (See "US Economy: Employment Drizzle," 01/04/2008.) Despite homeownership remaining at historically elevated levels and mortgage rates remaining low, the going story is no one is safe from foreclosure and bankruptcy. (See "Terza Rima," 01/08/2008.)

And we have ongoing fears of a "credit crisis." Because many lenders took on too much risk in issuing subprime mortgages, risk aversion for riskier debt of all kinds spiked. All those companies who dumped their junky debt on us must be defaulting—companies going under left and right must deal the long-heralded economic death blow, right?

Junk Bond Defaults to Rise Fivefold, Moody's Says
By Bryan Keogh, Bloomberg
https://www.bloomberg.com/apps/news?pid=20601103&sid=aaQhnq9NpMf8&refer=us

Looks like the sky really is green! Except, actual default rates for speculative grade debt dropped all 2007 and are lower now than when credit fears first hit this summer. The bigger the fear got, the lower the rate went! The data doesn't jibe with the fear.

Suppose Moody's scenario comes true (having been too optimistic on rating subprime debt, it's likely Moody's is now overcompensating the other direction) and junk bond default rates quintuple? By our calculation, that puts default rates below where they were throughout 2006 when we didn't fear a credit crisis at all! And, we'd still be below the moving average for the last five years. Why is that scary? "Fivefold" sounds terrifying, but a big increase from a historically tiny level still isn't such a big deal.

Throughout this "credit crisis," we haven't had any major banks go belly up—a common feature in past, true major financial crises. Far from lining up in bankruptcy court, banks have carried on, finding ample sources of liquidity at home and abroad. Certainly, Financials have taken an earnings hit and their stock prices have suffered—but trouble seems isolated to Financials and Homebuilders. Other sectors have grown healthily and firms remain awash in cash. (See "Earnings Breather Not a Bear Harbinger," 10/24/2007.)

"High risk" companies are rated high risk for a reason. They're risky. If they go bankrupt and default, that's not really news, is it? Fact is, it's cheaper today for large, public, above-average companies to borrow than a year ago. And the 10-year US Treasury rate is below four percent! No one's mentioning that—stock valuations look exceedingly cheap relatively.

Need more evidence our sense of reality may be off?

Katrina Victim Sues US for $3 Quadrillion
By the Associated Press, MSNBC
https://www.msnbc.msn.com/id/22571349/

One plucky New Orleans resident has asked for $3 quadrillion in damages. Is Dr. Evil aware someone has stolen his bit? In a world where suing for $3 quadrillion is acceptable, maybe today's too-dour economic pronouncements seem rational too. But to us, the sky still seems blue.