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The Wrath of the Butterfly

April 20, 2020

You may have heard of the “butterfly effect.” It’s when a small, seemingly insignificant change in a system can lead to large and unpredictable variation in that system over time.

A common example of the concept is a butterfly flapping its wings in Brazil and causing a hurricane on the other side of the world.

Seems a bit crazy, right?

Well, who could’ve predicted that selling a bat in a wild meat market would trigger the COVID-19 pandemic and severe economic pain? A one-off event created a public health and economic crisis.

And the fallout continues.

The collapse of the Russia/OPEC alliance has created price havoc in the energy markets. Notice how cheap gas is right now?

It’s spreading to credit markets too. Energy bonds are plunging. And bonds from the airline, lodging, and retail sectors are sure to follow.

This domino effect will further hurt corporate earnings and cash flows once a global recession hits, which seems inevitable at this point. The overleveraged corporate sector is about to face the prospect of not being able to issue new bonds while potentially also finding other credit hard to obtain. And the unfortunate truth is some firms need debt to survive.

Which domino will fall next? Nobody knows. But it seems clear they’ll continue to fall.

Don’t forget, many investment-grade bonds have leveraged ratios equivalent to high yield bonds (“junk” bonds). As we learned in the case of Kraft/Heinz earlier this year, ratings agency forbearance may disappear as earnings and cash flows decline.

Heinz was a $30 billion company that saw its corporate bond rating downgraded from BBB- to BB+ by S&P and Fitch in one day. That instantly made 19 Heinz bonds totaling $22 billion ineligible for purchase by many mutual funds. Scary stuff.

Now, many skeptics say the panic is close to the end. To them, I reply with a Winston Churchill quote:

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

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