Big, blue-chip companies can always borrow money from somewhere…
So-called “investment grade” companies are called that for a reason. They’re worth the investment from banks and other lenders. And they’re at low risk of defaulting on the debt.
When a problem arises, it’s often in a less-followed corner of the economy…
Not every business can get credit as easily as investment-grade companies. They often need to get creative and turn to other lending sources.
That’s especially true in the current market environment…
Everybody is paying more to borrow now than they did a year ago.
But as I’ll explain today, the data shows that lenders aren’t singling out any particular businesses. And that gives the economy a fighting chance to avoid a crash landing…
As investors, we often focus on the largest companies. But small businesses play a major role in the economy…
According to the U.S. Small Business Administration, these firms typically account for 64% of new U.S. jobs. And they contribute about 44% of economic activity.
And yet, the public capital markets don’t serve these businesses.
To get capital, about 73% of entrepreneurs rely on personal and family savings and other assets. Others turn to business loans (more than 16%) and personal credit cards (around 9%).
Anything that helps small businesses raise money is good for employment and the economy. And the reverse is true as well.
Now, financial theory and our own personal experience tells us that the folks who supply capital to higher-risk ventures expect to earn higher returns. It’s called the “risk premium.”
This happens all over the credit markets…
U.S. Treasury bonds are viewed as the safest investment in the world. Their risk premium is low. So in turn, they come with the lowest yields (interest rates).
The U.S. government will pay – even if it has to print more money.
The risk premium on large, investment-grade corporate loans and bonds is slightly higher than U.S. Treasurys. So they offer slightly higher yields. Right now, the yield on “AAA” bonds (the most creditworthy group) is around 4.5%.
Meanwhile, “high yield” borrowers are more likely to default. This type of debt is sometimes referred to as “junk” – though it’s not always that way. The risk premium is simply much higher.
A representative high-yield interest rate today is about 8.4%. (That’s based on the ICE BofA U.S. High Yield Index.)
Rates on small-business loans are harder to pin down. But NerdWallet estimates that small-business-loan rates averaged around 5.1% to roughly 10.5% in the fourth quarter of 2022.
Given the similar yields, we’ll use high-yield rates as a proxy for small-business-loan rates…
By looking at high-yield spreads, we can see whether small-business loans are getting more or less expensive than investment-grade debt.
A higher spread means small businesses are suffering more than other borrowers. That would spell trouble for the economy…
Remember, these companies are huge job creators. So a wider spread would indicate that they’re more strained and less able to employ people.
The following chart shows the ICE BofA CCC & Lower U.S. High Yield Index Option-Adjusted Spread. That’s a mouthful. Here’s all you need to know…
This chart tells us the “spread” (difference) between a computed index of all bonds in this bond-rating category and a spot U.S. Treasury curve at any given time. Take a look…
Notice that this spread became exceptionally low during the post-pandemic, stimulus-driven “easy money” spell a couple years ago. But that’s an unsustainable level…
Lenders need to get compensated properly to take on higher credit risk.
Now, the spread looks to be settling near a level that has long been associated with healthy small-business lending. You can see that a spread of about 10% is normal over the past 25 years.
So in other words…
Today, the yield spread suggests that small businesses can continue to stay in the game. In turn, that suggests a milder recession. And it supports our current outlook on stocks…
“Don’t follow the crowd and run for the exits.”
Good investing,
Marc Gerstein
