Key Gauge Flashing Red Amid Investors' 'Incredible Appetite for Risk'

A key gauge of market risk is soaring as both stock and bond investors seek safety, chase yield and search for profit in the $3.8 trillion municipal bond market, according to a Bloomberg report. To date in 2019,108 borrowers who raised cash in the market for the riskiest state and local government bonds have faced enough headwinds that they have had to miss their debt payments or violate other financial terms of their contracts, such as drawing down cash reserves. This represents a 30% increase over the same period last year, and the most since 2015, according to data compiled by Municipal Market Analytics. 

'Incredible Appetite for Risk'

The junk bond market, seen by many investors as an indicator for stocks' outlook, is also running into trouble. The demand for junk bond yield is now approximately 2.4% above the rate top borrowers pay, the smallest penalty since before the financial crisis, per Bloomberg. 

When it comes to municipal bonds, a big problem is the “incredible appetite for risk,” says MMA analyst Matt Fabian. 

In the municipal bond market, real estate developers, nursing home operators, some factory owners, and other organizations are able to raise funds by issuing debt through local government bodies About 41% of the borrowers that ran into distress sold the debt within the last three years, well above the historical average of about 20% to 25% that came across hardship so early on. 

Another red flag facing the muni bond market is a 19% increase in impairments this year, such as drawing on credit lines to cover interest. “That impairments are rising faster than defaults means that defaults will continue to rise into next year as troubled credit begins to transition to defaults,” wrote MMA analysts in a recent research note. They suggest that a sharp rise in impairments can serve as a signal of increasing defaults. 

What’s Next? 

This comes as the least creditworthy high-yield bonds are lagging the broader market by an “unprecedented” margin, as outlined by Barron’s. While high-yield bonds have returned 11.5% through September, per ICE BofAML Indices, the lowest-rated bonds have returned 6.1%. According to a veteran high-yield bond analyst, Marty Fridson, who is now the chief investment officer of Lehmann Livian Fridson Advisors LLC, this is the widest performance gap on record. 

"Investors are wary of potential defaults in the bottom-quality-tier, where they almost invariably occur,” wrote Fridson. “Danger lurks for those who misread 2019’s high-yield performance as simply a matter of increased risk tolerance.”