Debt Market Storm Rising

Wall Street is abuzz with talk of three economic squalls--the oil price shock, global monetary tightening, and a tech slowdown--that might be converging to produce the Perfect Storm, which could drown the economy. We fear there is yet another squall on the horizon--a growing corporate-bond meltdown. Spreads are wider than they've been since the Asian crisis of 1997, while nonfinancial corporate debt is at a record 46% of gross domestic product. With the economy and profits slowing and the stock market sinking, this may turn out to be the most dangerous storm of all.

Let's go to the numbers. The worst deterioration so far has been in the junk sector, which is at the low end of the quality spectrum. Junk bonds are currently yielding 8 percentage points more than Treasuries. At the beginning of the year, the spread was only 5 points. A second measure of the sharp erosion in lower quality bonds is the spread between the Merrill Lynch & Co. high-yield (junk) index and 10-year Treasury bonds. It has been widening sharply all year and, at 7.13 points, is larger than in 1998, at the height of the global financial meltdown.

If these were isolated junk-bond market problems, the threat to the economy would be limited. But they are not. Top-quality debt is quickly getting hit as well. Triple-A, top-rated industrial corporate bonds that mature in 10 years are yielding about 6.96%, or 1.23 points more than similar top-rated government bonds. At the beginning of the year, the spread was only half that, meaning that investors believe the quality of the country's best corporate bonds is deteriorating as well.

What's behind this sudden drop in credit quality? After all, the real economy looks to be in great shape. The unemployment rate is at an astonishingly low 3.9%, consumer spending is high, and investment is healthy. All true, but the Federal Reserve's tightening of monetary policy is succeeding in slowing the economy, and the prospects for future corporate earnings growth is significantly lower today than it was at the beginning of the year. A whole series of recent earnings disappointments have not only tanked the stock market but triggered a reassessment of risk in the credit markets. This is particularly true for most telecom companies, which carry heavy debt loads. The Internet sector is in even worse shape, with the profit-making potential of many business models now in doubt.

To date, Standard & Poor's has lowered credit ratings on 325 bond issues, and there are currently four downgrades for every upgrade. Credit quality is dropping fast and shows no signs of improving. The weakening in the debt markets augurs ill for growth. It augments the forces that are threatening to come together in a Perfect Storm. Monetary policy may have to be eased sooner rather than later.

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