The Covenant Lite nature of BBB corporate bonds may create the surprise that triggers the next recession. They won’t all fail, but if a significant number do and new borrowing applicants are turned away that can act to tip the low GDP growth economy into recession. The next stage is that the damage to that sector would then trigger a lightening fast shut down of the excessively permissive granting of credit to nonconforming (B paper) borrowers. This type of lending allows weak borrowers to get loans and to get even bigger debts from a new lender to pay off their old lender. It acts on the margin to provide the opportunity for GDP growth. But when this credit is cutoff then a small percentage of people will have to reduce consumption. Currently the national savings rate is at a 9 year cyclical low implying people are undersaving and overspending. This is unsustainable and it implies this overspending is augmented by abusive use of easy credit to shaky borrowers who can only get credit during good times.
So even if the destruction of Cov Lite bond lending to BBB corporate borrowers causes less damage than in the 1990 recession (caused by too much lending to high risk corporations using junk bonds), the fact is that a small crisis in that field will ricochet over to trigger a shutting of credit spigots to explicitly B paper small business and consumer borrowers. Together the loss of these two types of borrowers’ ability to buy and consume will be enough to trigger a modest gentle recession. The problem is since stocks are overpriced, at double fair value, this will awaken the public to get out of stocks and then the price of stocks will go down 50%.
Stocks dropped 50% in the 2001 recession even though it was a very mild recession. The tiny recession acted to wake people up and realize that PE ratios were at world’s record bubble tops. So even though 2001 had an almost non-existent, shallow recession stocks crashed hard and were revived only because of a new round of rates which dropped 5 percentage points below the 2000 highs of 8% yields when the ten year Note hit 3% in June, 2003. If the Fed seeks to cut the yield on the ten year Note from its current 2.95% by 5% it will have to administer a negative 2% rate which is politically unlikely since it would destroy banks and insurance companies.
Cov Lite works by waiving bond covenants which allow borrowers more freedom to pretend they are investment grade. (Somewhat like “self-certified” Easy Qualifier mortgages). When the truth comes out it will be discovered that there are not enough resources for the weak borrowers to self-rescue and then the borrowers will receive a downgrade to junk status, creating a crisis for institutional bond investors (insurance companies and banks) who have a regulatory mandate to own very little or no junk bonds.
Investors need Independent financial advice about the catalyst of the next recession.