What’s Causing Jitters in the Credit Markets?

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

So last week when I was out, Liz Ann had Kevin join her on the podcast. And this week, while Liz Ann is traveling, I'm joined by my colleague, Collin Martin. So, Collin, thanks for being here.

COLLIN: Thank you for having me. It's always fun to join this podcast.

KATHY: Well, I'm sure Collin is familiar to listeners of the show. He's been on several times in the past. He's managing director and senior fixed income strategist here at Schwab, primarily focusing on corporate credit or taxable bonds. But he also knows a lot about the macroeconomic issues as well. I wanted to start big picture, Collin. What do you think the Fed's going to do at the FOMC meeting next week, Federal Open Market Committee meeting, given that we don't have much in the way of economic data for the Fed to analyze?

COLLIN: I expect them to cut rates by 25 basis points or a quarter of a percentage point next week. That's widely expected. So I'm saying that because that's really what the markets are expecting right now. We look at the Fed funds futures market to get an idea of what investors across the globe are kind of pricing in and there's basically almost 100% likelihood of that happening. And we're on board with that. 

I think you hit the nail on the head, Kathy, with the idea of how are we viewing this meeting in the absence of economic data? And the way I view it, and why I like coming on these podcasts, because we always might think about these things a little bit differently, but I think it's the path of least resistance.

Because the Fed cut rates in September, and based on the idea that the labor market appears to be weakening, they made a change to the statement to kind of highlight that the risk appears to be more about a weakening labor market down the road as opposed to inflation, you know, reaccelerating from here. So I think that's really important. And now we don't really have any data to change that view. So I think it's just easier to cut again, almost as an insurance cut, but more importantly, without anything to change what that outlook was. I think the Fed will cut rates. 

There's doesn't appear to be too much dissent about that right now. I think most people agree. I think, when we look further ahead, that's where there's a lot more questions. And sitting here right now, middle to the end of October, I don't think the Fed needs to necessarily cut as much as the markets are currently pricing in right now. So if we go back to that Fed funds futures market that we use to kind look at the implied probabilities, there's close to 100% chance of a second cut or another cut by December and then cuts to below 3% by next September. I just think that that sounds too aggressive right now with the data that we have because the labor market, yes, it appears to be cooling, but I don't know if it's slowing so much that the Fed needs to embark on this consistent and methodical rate-cut cycle.

KATHY: Yeah, I 100% agree with you. I mean, Powell has basically, Fed Chair Powell has basically indicated he is inclined to cut again at the next meeting. So I think the market takes a lot of confidence from that. Even though there is a dispersion of opinions at the Fed, I think the idea that the Fed Chair is willing, that means that there's probably a consensus at the Fed to make another cut based on this weakness in the labor market.

But I agree with you. We've talked about this in the past, about how low can they go unless inflation actually starts to decline? So the market is pricing in below 3%. That means a negative real Fed funds rate if inflation doesn't come down, because inflation's stuck at 3%. So it seems to me that that's maybe overly enthusiastic on the part of the market.

The second thing that I think isn't getting enough attention is that yes, the labor market's slowing down, but inflation's stuck. And this idea that the Fed is restrictive is questionable, at least in my mind. And when we look at something like financial conditions, financial conditions are really easy. Companies are not having trouble financing and actually at lower rates than they were a while back.

Capital markets are wide open. Stock market's near all-time highs. There's not a lot of evidence that their policy, which is based on interest rates, right? That the high interest rates are really providing a restriction to people financing whatever it is, car purchases, et cetera. Whether or not that's turning out well for them is another question that we can dive into.

But, you know, it seems to me, the Fed cuts more than… financial conditions get even softer. They're at risk of really fueling higher inflation and higher inflation expectations. So that's why I really have my doubts about this sequence of rate cuts coming very rapidly, unless the economy really deteriorates more than we see right now. But, you know, we don't have any data.

So no data, no problems, right? Market will just continue to extrapolate from where we are. But that does… the financial conditions and the financing cost leads me to a topic I really want to dive into with you today. And that's the recent jitters in the credit markets. We saw some high-profile failures, defaults, in some consumer-oriented companies. And recently, it's sent a bit of a jitter through the credit markets. What's your take on what's going on there?

COLLIN: It's certainly interesting right now where we got a couple, I call them headline-grabbing defaults, and then we got some headlines from a few regional banks that they had some issues with their loan books. And the questions that I'm hearing, and when I look at various articles written in headlines, are these idiosyncratic or is this a canary in the coal mine and this is the new trend? And I think it's somewhere in between.

And that might be a little vague. I don't want it to come off as a cop out. But I don't think they're idiosyncratic because defaults have been happening. And that's something that, when I've been talking about this over the past few weeks, I've been leading with that. Where we look at default data from the rating agencies, like Standard & Poor's and Moody's Investor Services, and out of there, they rate corporations, so they have a whole universe of companies that they're following, and in their universe that they follow, they track how many of those issuers are defaulting. And they look at it at from a speculative-grade standpoint, so sub-investment grade issuers, also called high-yield issuers or junk bonds. And if we look at data from both S&P, Standard & Poor's, and Moody's, the default rates aren't at super concerning levels, but they're elevated from where we were in late 2020 and into 2021. And they're closer to long-term averages. 

So we're seeing these headlines about defaults, but they've been happening kind of behind the scenes. And I don't think we've been hearing about them because a lot of them are distressed exchanges. Now, when a company defaults, that can mean a lot of things. It can mean that they actually file for chapter 7 or chapter 11, and they go to the courts.

They might miss an interest payment or miss a principal payment. That would be a default. But what we're seeing a lot of issuers do over the past handful of years is a distressed exchange, where they might see that they're facing some financial difficulties. The debt burden that they have, they might realize it's becoming too much. So they work with their lenders, they work with investors to renegotiate those bonds. And maybe there's some sort of principal haircut where if I'm a bondholder, I get less than what is promised to me, but maybe this puts the issuing company on more solid footing. 

Maybe they extend the maturity of the bond to kind buy themselves more time. But these are considered defaults, because when you buy a bond, invest in a bond, there's a prospectus and it lays out the details of what you're effectively promised by the issuer. So if you're getting less than what's promised or they're extending the terms, that's by definition a default. And there's usually some sort of credit loss in there to investors. So this has been happening. But now is it a canary in the coal mine? I don't think so just yet, because as you mentioned, Kathy, financial conditions are pretty easy right now. There's a lot of demand for these sort of investments. That can kind of cut both ways. That can be good and bad. But there's… strong demand means that issuers should be able to refinance their debts as they come due.

And if we look at corporate fundamentals, there's two key metrics that I look at if I'm looking at corporations, whether it's investment-grade or high-yield, and that's the interest-coverage ratio. What are they making? What are they earning relative to those interest payments? Those are decent. They're off their highs from the 2021, 2022 period, but they're at somewhat elevated levels compared to the previous decade.

So companies are making enough money to remain current on their debts. And then if we look at leveraged debt, debt relative to their earnings, they're not really flashing any warning signals either. They're relatively low right now, too. So I think it's somewhere in between.

KATHY: Yeah, so Collin though, you're talking in aggregate now, right? Now just want to be clear on this because this is kind of the universe of corporate debt, whereas we're sort of focusing in on the lower-end of the spectrum. So is that necessarily true at the lower-end of the spectrum? Or has leverage risen? Have coverage ratios deteriorated?

Can you kind of sort it out that finely? And, as an investor, isn't that what I should care about, right? Shouldn't I care about whether I'm in the ones that are having trouble or the ones that are not having trouble?

COLLIN: So those numbers, those trends I'm talking about actually are in the high-yield market. So we get data from Bloomberg and they have a great team of analysts and they slice and dice both the investment-grade and the high-yield market. And if we look specifically at high-yield issuers, those fundamentals look OK. They're not the best they've ever seen, but they're not necessarily flashing warning signs. But I think you made a really good point. We look at this in aggregate, but we kind of kicked this discussion off with the idea that there are defaults.

So even if things look good from a tops down level in aggregate, there can be risks below the surface. And, to kind of not necessarily throw cold water on the positive spin I just threw on, but I think when we look at how investors should consider this. So, one, defaults happen. That's part of the high yield market and those are riskier companies and that's why the yields tend to be higher, to kind of compensate for the risk of default. And we as investors hope that we're earning enough income over time that if there are problems and the company defaults that maybe I've made enough to kind of offset that or maybe it mitigates the downside. But we want to make sure that we as investors, or our clients at Schwab, are earning enough risk premium for that default risk. And we don't think you really are right now. 

So even though, hey, maybe defaults might not surge from here, maybe they might stay elevated, is the risk-reward proposition attractive? I don't think it's super attractive right now, because the main thing we look at is credit spreads. So that's the extra yield that a high-yield bond offers above a comparable Treasury. So it's meant to compensate for the risk that maybe they do default down the road. In aggregate, so we look at the Bloomberg US Corporate High-Yield Bond index, that credit spread, the extra yield you earn is less than 3 percentage points.

The all-time low is around 2.4%. So we're not far off the all-time low. But I've talked about all these defaults that have been happening. Default risk is not at an all-time low. So I feel like there's a mismatch there. And in terms of, is there an attractive opportunity? It's not super attractive right now. Investors can consider it, ride out the ups and downs, but if people are looking for what we think, using the analysis that we're providing and the guidance we're providing, we think there's probably better opportunities elsewhere.

KATHY: I want to pick up on one other thing that I think is relevant here, because you talked about demand being still very robust. Some of that demand, or a good portion of that demand, is coming from private credit funds and private credit investors, right? So what we see on the public side maybe is actually better quality than what you might be seeing elsewhere. Am I interpreting that right?

So, in other words, if you're able to be in the public market and high-yield market, that's because you probably… your metrics are pretty good and you don't have to go to the private market where the cost might be higher. Tell me if I'm thinking about that, right?

COLLIN: You know, it's interesting, Kathy, I don't know if that's right or wrong, to be honest, but I think that's a really interesting way to think about it. There's pros and cons to each side of that equation. So let me dig into that a little bit because it's been making a lot of headlines and there's a lot of demand there in the private markets. When you invest in the private markets, specifically private debt markets, you don't see what the bond terms are, you don't see the fundamentals of that issuer.

You don't see how the bond is trading, because it's private. A private credit fund is basically lending to that issuer, and kind of just holding it themselves, or a couple or a few private credit funds. Where if you look at the public markets, you get that transparency, you can see the company's earnings, you can see what the price and yield of those bonds are. In terms of the issuers choosing a market, the case can be made that there's pros and cons of each.

I think the point you're getting at, and I'll agree with this, is when you go to the private markets, they tend to have higher borrowing costs. And that's what we hear as potential investors. "Hey, we're earning higher yields with these private credit investments than are offered in the public high-yield bond markets." So my question would be, "Well, if I'm an issuer, why would I want to pay a higher rate?"

Now there's a few nuances there because since it's private there's no underwriting fees, things like that. But is that higher yield enough to offset those potential underwriting fees, capital market fees? Is the higher yield enough to get the issuers interested that they only have to deal with a few lenders as opposed to the whole public markets? But I think that's a really good point.

Because I always say if you're seeing a really high yield compared to things that don't necessarily have that same high yield, what is the implied risk there?

KATHY: Yeah, that's always the point I like to make. If you start with a risk-free rate, which presumably is Treasuries, and then you get a higher yield, you're taking some sort of risk because the market's compensating you for that extra risk, whatever that is, however you define it, however you can see it. So I think that's a good point to make. Going back to this question, now to circle back on this and then we can move on, but canary in the coal mine or a one-off, right? 

This is what a lot of people are worried about right now, understandably, right? Is there more to come? It would seem that the big banks have a lot of money on their balance sheets. They're well-capitalized. That's what they continue to tell us right now because of these concerns. Do you think this has downstream impact on smaller regional banks that might have overloaded on some of this lending or do we not have enough information to really know?

COLLIN: We probably don't have enough information, but I think the risk with some of the smaller regional banks is they probably have less diversification in their loan books. And I think that's kind what we saw with a couple of headlines last week about the idea that if you have one loss and you're not geographically diversified, that can be a big hit. 

I think with some of the relaxation of bank rules, there could be some consolidation down the road in terms of the banks, but I would agree that there's probably a little bit more risk in terms of the lending done with smaller regional banks than some of the larger ones. 

I do want to touch on a point you made about demand and what sort of impact that can have, and I think that kind of ties in with how we kicked off the conversation about these defaults. There's a lot of demand right now, both in the public and the private markets. And I do get concerned, and I try not to be too curmudgeonly about this, but I think it's important to highlight risks. We know that the...

KATHY: Come on, you're a fixed-income guy. You can be as curmudgeonly as you want to. It's what we specialize in.

COLLIN: I know we're trying to provide the listeners with a big-picture look of what's going on here. And if we can help them make better informed decisions, that's what our goal is here. When there's a lot of demand out there, and I think we're in that environment right now, do you lose price discovery? And do you lose the tight, tough standards that you otherwise might have? Because if you're a… whether you're a public, call it a high-yield bond manager, or a private manager, you have assets, investors are giving you money that you need to now find a home for, in order for you to earn that fee. And if there's all this money looking for a home, do we start to see weaker standards, lending standards? Or have we already begun to see weaker lending standards?

The case can be made that, yes we're starting to see that, given those recent defaults we've seen. One was fraud, but should that have been picked up earlier if there was more due diligence? I don't know the answer to that, what could have solved it, but I think that is a concern. So there's a lot of demand, which can be a risk in and of itself, but most importantly, what's the price of risk? If we're considering these investments, are we being compensated enough for the risk that defaults stay where they are? Or worse, they reaccelerate? And right now, it just doesn't look super attractive.

KATHY: Yeah, so I come back to what our guidance typically is for investors looking at high-yield. And that is to keep it a relatively small portion of a portfolio, not only because of the risk that you've just highlighted, particularly at this valuation, but also because it's highly correlated with equities. And I think it's something people don't think about necessarily when they're allocating some portion of their bond portfolio to high-yield, that that is more highly correlated with equities than actually with Treasuries or other core bonds that we call them. 

So another thing to keep in mind, if you're allocating to fixed income because maybe you've made a lot of money in the stock market and you're reallocating based on your asset allocation, if you stretch into the lower-credit quality, you're actually increasing your equity-type risk in the portfolio.

COLLIN: Yeah, I think that's a really good point. I don't want to keep harping on this issue, but I want to really follow up with that, because that's important. There's a place in portfolios for high-yield bonds. If you're a long-term investor, if you're a little bit more aggressive and you can ride out the ups and downs, the yields they offer are higher than a lot of other alternatives out there. 

The relative yields aren't super attractive, but absolute yields, income earned are high, but understand they come with those risks. So how do they fit into your portfolio? Because the term "high-yield bonds," it's kind of funny. When you put it that way, who wouldn't want that? If we're talking with clients and you said "Show of hands, who wants a high-yield bond?" I think most people would say, "I want that." But those high-yield bonds, they're driven by their credit rating and the riskiness of the issuer. So it's all a balancing act. It's considering things in moderation. And how are these investments going to fit into your portfolio to help you reach your goals?

KATHY: So this is the time that we normally look ahead to next week. So Collin, what's on your radar for the next week or so?

COLLIN: I thought about not answering and just having silence because there's not much we're going to be focusing on here with the government shutdown. But there is a CPI report, Consumer Price Index, we're getting this week. I think that's going to be really interesting because we've been in this data void where we haven't gotten anything. And I think there's a risk that if there was a surprise, either upside or downside, that it could move the Treasury market a little bit just because we haven't had anything to move us in one direction or the other. So I think there's a risk for that.

But more importantly, next week we do have the Federal Open Market Committee meeting. I think what will be equally as important, or even more important than the statement and Fed Chair Powell's press conference, is all of the participants' and officials' their speeches and comments after the fact. Because I think it's important to remember that it is a committee and there needs to be a vote.

And you need to get a majority to vote on these issues. And we know there's a wide dispersion of views. So I'm going to be looking to see what the various officials are saying and how they see the economic outlook evolving. I think that's going to be really important.

KATHY: Yeah, it's going to be difficult because as much as they have good information, better than a lot of people, access to information, they're still working in the dark at this stage of the game. The Fed members, they have their regional Fed indices. They have the surveys that they do in their own districts. So they have a feel on the ground for what businesses and consumers are focused on and how things are going.

But the gold standard is still the numbers put out by the Bureau of Labor Statistics. And even though they're going to give us a Consumer Price Index, I don't know how thoroughly that has been executed without the standard number of people trying to do that. Now, not trying to cast doubt on the number, but I think when we get the number, a lot of us are going to be saying, "Well, is this one that's going to be subject to a lot of revision?" 

Because, you know, they only collected a third of the data that they would normally collect? Or they only had 20 people working on the seasonal adjustment this time around as opposed to, you know, 40? We don't know, right? And that's what happens when we have this void in terms of information. There's a lot of question marks that are going to come around it, but yeah, we know at least it'll be something. We'll have something to go on, so that'll be a positive. Other than that, I don't think we have a whole lot of data or lot of events to focus on at this stage of the game.

COLLIN: No, we're just waiting for hopefully an end to the shutdown so we can get that data. One thing I'll add, you talk about the noisiness of the data and how complete of a picture will it paint. I think the October jobs data, whenever we get that, will be really difficult to analyze. Because the September one… you know, a lot of the work was done, but then the BLS essentially, you know, shut the doors and haven't been able to finalize it.

That one will probably be a pretty clean look on September. October, no one's really doing anything right now. So whenever that comes out, I think it's going to be very noisy.

KATHY: So that's it for us this week. Thanks for listening. You can always keep up with us in real time on social media. I'm @KathyJones on X and LinkedIn. That's Kathy with a K.

COLLIN: And you can find me on LinkedIn, Collin Martin, Collin with two L's, and you can find all of our published reports on Schwab.com under the Learn tab.

KATHY: And if you've enjoyed the show, we'd be really grateful if you'd leave us a review on Apple Podcasts, or reading on Spotify, or feedback wherever you listen, or tell a friend about the show. We'll be back with Liz Ann and with a new episode next week.

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.