Credit Risk in Stocks Using the Fed Definition of Speculative Grade Stocks Shows Elevated Risk Today

  • The chart shows that the weakest quintile of stocks is as vulnerable today as they were in 2000
  • Vulnerability is measured by ICR, or EBIT/Interest Expense, and associated criteria as explained in the Federal Reserve’s 2020 paper
  • As documented in our last quick take, these financially weak firms that may not be able to make their interest payments should a correction take place, were rocked in the Covid crash as Junk Bond yield spreads exploded

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Financially Fragile Stocks at risk of default: Should High Yield spreads widen from record lows today, these firms may suffer tremendous losses over both the short term and long term.

Vulnerability of the Weakest 20 of Companies

In our last Quick Take, Junk Stocks Funded by Junk Bonds, we showed that junk bond yield spreads are at record lows. We went on to demonstrate what the last spike in yield spreads during the Covid crash meant to financially weak firms that ranked poorly in KCRs Rankings Engine. We found that 70% of these firms suffered losses far worse than the S&P500.

Even absent the KCR screen, the 97 Financially Fragile firms that make up the chart above, suffered crushing losses in 23 trading days during the Covid Crash. As we noted in the prior quick take, the Fed’s latest findings note that financial fragility has become more severe in the post-Covid-19 pandemic era. In our view, the Fed methodology is a great cross-check on the credit rating of corporate bonds. During a crisis, firms that lack the resources to cover emergency expenses suffer inordinate losses.

KCR believes the confluence of irrational bond prices, interest rate risk, an influx of stimulus checks pumped into the market and inflation could be especially harmful to these Financially Fragile firms’ balance sheets in a market correction. Please click here for the full list of Financially Fragile firms identified using the Fed’s ICR ratio.

Today so many of America’s biggest companies and most promising “TAM” stories rest on the foundations of ever-increasing globalization. The valuations and expectations are higher than in 2000. The backdrop of current events looks particularly challenging. Maybe we are reading too much into it but is anyone pricing in this video?

As always, our working papers compare historical precedence of market risks and opportunities with today’s landscape. The higher interest rate spreads in Junk Bonds we saw during the Covid Crash could easily rear their ugly heads again and lead to real-time risk for investors. Whether it be another financial crisis, a continuation of inflation or a simple pricing correction, some of our work below may be of particular interest to KCR’s readers.

KCR views today’s speculative environment as one of the most precarious in history. As we have documented, today’s market appears to combine the most dangerous traits of the Nifty Fifty era with the Dot.Com bubble. If you are interested in the Nifty Fifty, please read The Collision of Arithmetic & Over-Optimism – Why Today’s Larger Cap Growth is More Precarious than the Nifty Fifty. For some of our research on the speculative Dot.Com risks we see in markets today, please see High-Quality Midcap Value: The Case for Common Sense and What Does Volume Mean in Stocks?

For those looking for uncommon opportunities, please see our piece on what we believe is a terrific opportunity to invest in growth at a reasonable price.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

  1. Click the following to read more about the Top Credit Card Stocks, Lottery StocksBest Stocks For Inflation Hedge


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