The term ‘canary in the coal mine’ refers to the days when coal miners faced the problem of detecting the build-up of the extremely toxic, but effectively unobservable gasses such as carbon monoxide. Taking a canary in a cage down into the mine provided them with an effective early warning system – when the bird passed out, it was time to head for the exits.
Investors are continually searching for a reliable equivalent – especially right now. Current investment conditions are very unusual – take South African equity markets for example. The JSE ALSI reached yet another high this week – but over the last month there have been ongoing strikes, downgrades of economic growth and thus tax revenues. The rating of government debt has been recently downgraded and it seems this may be revisited. Globally there is a similar pattern across the board. We’re seeing rapid increases in geopolitical risk, the economic malaise in Europe and Japan continues while China struggles to redirect its economic development away from the infrastructure build path it’s used to date. It’s only the US economy that seems to be actually recovering from the crisis in any meaningful way. Yet equity markets remain at, or close to, all-time highs, while bond yields continue to fall.
Are those toxic gasses building up? Obviously we are seeing the effects of zero interest rate policy, but this in turn might direct us towards a good (i.e. sensitive) canary. We follow the yields on high yield corporate bonds (issued by companies who do not meet investment grade) in the US and compare them to equivalent government bonds. The difference gives us a sense of what the market is prepared to pay for these relatively risky assets.
Current zero interest rate policies are making issuing debt very attractive – levels of issuance in this space has grown dramatically since 2009 (see graph). What is interesting is that we have seen the yield of this debt fall from a high of 7.11% in October 2011 to a low of 2.32% in July 2014 – clearly there is a demand for it.
However, over the past few weeks, the tide seems to be turning – the yield spread has increased by 1/5th since the beginning of July. This canary is beginning to look a bit green….
Why might high yield bonds be a good canary? Well, first of all the companies issuing these bonds are usually smaller and thus more directly exposed to local economic conditions. Secondly, they wouldn’t qualify for government support if they run into trouble (i.e. they are small enough to fail). This means that the pricing of their debt is a more accurate measure of their health, as it excludes the implicit government guarantee on the companies that are too big to fail. Finally, the work of Hyman Mynsky suggests that the worst credit risks are those that arrive last on the big credit splurge that precedes a crisis. Mynsky’s work, which was rediscovered following the 2007/2008 financial crisis, emphasises the role of complacency in terms of declining lending standards as lenders become complacent given a stable investing history.
This is exactly consistent with what we’ve seen – the growth in high yield bond issuance combined with the decline of the high yield bond premium over government debt. Investors searching for yield are happy to take on higher risks. According to Mynsky’s theory, the default of these companies on this debt becomes the trigger for the next crisis. Tracking this would then be a good idea.
In terms of recent movements we have seen an increase in the high yield premium over the last two weeks. This on its own is not really enough to say that the canary is in trouble – but it does seem worth continuing to watch it closely.
