Understanding the Current Economic Climate

Economic predictions are often challenging, and I tend to adopt a cautious outlook, so please interpret my insights accordingly. One key area I monitor closely is the behavior of junk bond yields.

Junk bonds are issued by companies that do not hold an investment-grade rating. They play a vital role in debt capital markets, as many businesses, especially small to medium-sized enterprises that employ a significant portion of the workforce, fall into this category. These companies are classified as junk due to their inconsistent revenue streams, lower profit margins, limited assets for collateral, and insufficient cash reserves. Consequently, they rely heavily on the ability to issue junk bonds to sustain their operations.

At present, junk bond yields (illustrated by the blue line) are trailing behind inflation rates (depicted by the green line): Source: Federal Reserve Bank of St. Louis.

It's logical for Treasury bonds to yield less than inflation (shown by the red line). Central banks hold these bonds as part of their foreign exchange reserves, which allows them to access U.S. dollars through the repo market. Additionally, institutional investors, like insurance firms, utilize these bonds to hedge against their liabilities. The demand for low-risk investments remains high, particularly in uncertain times, which further drives down Treasury bond yields. Nevertheless, yields on short- and medium-term bonds are rising quickly, and the yield curve between 10-year and 2-year bonds is on the verge of inversion, signaling additional economic uncertainty (more on this in future discussions).

However, it is perplexing that junk bond yields are currently lower than inflation. These bonds are inherently risky and highly susceptible to economic fluctuations—without a positive real rate of return, there is little motivation for investors to hold them. Presently, based on five-year breakeven rates (which reflect market expectations of average inflation over the next five years, see below), the bond market seems to anticipate that the U.S. will manage to rein in inflation. But is this assumption overly optimistic? Source: Federal Reserve Bank of St. Louis.

With inflation consistently exceeding 7%, confidence in this outlook is likely to diminish. This growing concern, coupled with the war and its repercussions on the energy sector, has led to an uptick in junk bond yields, even amid historically low corporate bankruptcy rates in 2021 (source). Typically, bond markets exhibit a more pessimistic outlook compared to equity markets. While stocks can yield substantial returns as earnings and growth expectations soar, corporate bonds offer limited upside potential—except in extraordinary circumstances that push yields to extreme highs, as witnessed in 2008.

In the best-case scenario, interest rates may decrease, and the absence of bankruptcies allows bond investors to earn the anticipated yield along with modest capital appreciation. Given the restricted upside potential, it's crucial for junk bond investors to ensure they are adequately compensated for the risks involved. When inflation significantly surpasses the earned yield, the answer is evidently no.

Thus, a less-discussed risk of prolonged inflation is the potential decline in capital allocation from investors to riskier segments of the debt capital markets. This could lead to liquidity issues for many firms dependent on these markets, which, if unaddressed, may escalate into a widespread bankruptcy crisis. Indeed, these are troubling times.

The first video titled "Junk Bonds: This chart is stunning in its implications" explores the implications of rising junk bond yields against the backdrop of high inflation, shedding light on the current economic landscape.

Chapter 2: The Impact of Inflation on Bond Markets

The second video, "US Inflation & High Bond Yields -- How Both Are Fueled By Congress -- Why The Fed Can't Fix It," discusses the relationship between inflation and bond yields, highlighting the challenges faced by the Federal Reserve in addressing these issues.