Monday’s Commentary shared a graph showing Fed Funds have risen by 5.25% over the last year and a half, yet the difference, or spread, between junk bond and Treasury yields has remained the same. Corporate bond spreads are a measure of implied default risk. Essentially, the junk bond market says that despite much higher borrowing costs for financially impaired companies, the risk of default is unchanged. While that may seem strange, the corporate bond market is often lulled to sleep while the Fed is hiking rates. It’s the cutting of rates accompanied by recessions and financial crises that quickly awaken junk bond investors.
One might counter that massive Treasury debt issuance is offsetting the increasing risk of holding junk bonds. The following graph says that is not the case. It compares junk bond yields to those of highly rated AA corporate bonds. Once again, we find the change in implied risk between highly-rated AA bonds and junk-rated BB bonds is more or less unchanged despite higher rates. Therefore, once we remove the Treasury issuance risk, we continue to see no concerns for junk bond defaults. Regardless of what the market implies today, yield spreads between junk and investment-grade bonds and U.S. Treasuries will widen when the Fed starts cutting rates.
What To Watch Today
Earnings
Economy
Market Trading Update
Yesterday, the market traded a bit wildly as the new quarter got underway. The return of hedge funds shorting oil and bonds and buying the top-7 mega-cap stocks looked like positioning by managers to chase performance. As noted this past weekend, the market remains oversold, and the overall sentiment and positioning are negative. Despite yesterday’s sloppy trading, the market seems set up for a rally in the short term. The 200-DMA remains key support for the market at 4200. A break below that, and 4000 becomes the next logical support level.
As noted, we still think the bias is to the upside for now, but nothing says it can’t get worse before it gets better. Continue to run risk management as needed.
High Dividends With Minimal Price Risk
Every Friday, we publish Five for Friday in SimpleVisor. The weekly article scans for stocks that best meet certain criteria. Each week, the theme changes so we can present a wide variety of stocks meeting many different potential outcomes. This past week, we looked for stocks with high dividend yields and low share price volatility. The goal was to present five stocks that may act as a surrogate for bond holdings.
We took a unique approach to find stocks meeting these criteria. Per the article:
Our starting point for this scan is the top fifty holdings of the Vanguard High Dividend Yield ETF (VYM). We then calculate a modified Sharpe Ratio for each stock based on daily prices over the last year. The Sharpe Ratio measures a stock’s total return as a function of risk, aka volatility. The higher the Sharpe Ratio, the more the investor gets paid per unit of risk.
Our modified Sharpe Ratio uses the dividend yield, not the total return (price and dividend), in the numerator. Like the Sharpe Ratio, the denominator is annualized volatility.
The graph below shows our modified Sharpe Ratios for the top fifty holdings of VYM. The Sharpe Ratios for bonds (IEF) and stocks (SPY) are plotted as well to provide context.
Kaiser Permanente Workers Are Set To Strike
Following the recent UPS threatened strike, resulting contract agreement, and the current UAW strike, Kaiser Permanente is threatening to strike on Wednesday. If the 75k Kaiser Permanente workers strike, it would be the largest health care strike in history.
While an agreement is still possible, the broader message is clear. Workers have newfound leverage. The historically low unemployment rate and flat to negative real wages empower unions to seek higher wages and better benefits. The Bloomberg graph shows that starting in 2022, union strike activity rose rapidly. This year, the number of strikes is already over 310k and could rise significantly if Kaiser strikes. Further, the UAW strikes may continue to increase. If both occur, union strike activity could rise to 20-year highs.
Fear Of The Fed
The following comes from the most recent Richmond Fed CFO Survey.
For the first time in over a decade, respondents to The CFO Survey cited monetary policy as their most pressing concern, slightly ahead of labor availability, inflation, and demand for their products/services.
Perhaps not surprisingly then, around 40 percent of respondents reported that the current level of interest rates has caused them to pull back on capital and non-capital spending, a sizeable increase from the roughly 30 percent of firms that responded similarly in the Q4 2022 survey.
Companies are becoming increasingly sensitive to higher interest rates. The lag effect is finally taking hold. Firms are now pulling back on spending and increasingly fretting that rates will stay higher for longer.
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2023/10/03