While investors have spent much of the recent few quarters looking toward commodities as a source of risk, a new saga has been opening. One that all investors should at least be aware of. The second chapter of this saga was concluded this week.

In an addendum to February’s 2015 results Credit Suisse (NYSE: CS) explained to investors that, among other things, it would be accelerating the pace of its restructuring and further downsizing its Global Markets business. This was after a series of bad bets on junk bonds and complex derivatives pushed the bank into the red.

Soured trading positions cost Credit Suisse $633m in the fourth quarter after spreads widened and client activity fell off the edge of a cliff. They also cost it a further $346m in the first quarter, prompting management to exit some parts of the market and reduce scale in others.

It remains an open question as to how soon the bank will be able to walk away from some of these lines of business given that the current illiquid condition of the underlying assets has been a major driver of the above trading losses.

The elephant in the room

The source of Credit Suisse’s trading woes are largely the result of conditions at the lower rated end of the bond market.

Many will remember how the financial world shuddered in late 2015 as a deteriorating junk bond market, which was mostly the result of Fed tightening, forced a small number of US mutual funds to suspend client withdrawals in a series of events that almost echoed those of 2008.    

The problem today is that these conditions have not eased so far into the new year. Spreads are still prohibitively wide and uncertainty pervades.

Moreover, Bloomberg recently reported that 40% of US junk bonds didn’t trade, or change hands at all, in the first two months of the year. This is while most high yield corporate bond indices have fallen to 2009 lows, surpassing levels last experienced during the taper tantrum of 2013 and the European debt crisis.

Casualties and other implications

This article isn’t meant to be a prediction of pending doom or anything close to it. After all, the Fed now appears to be taking a slower path toward a tighter policy environment, while the shift to negative rates in Japan and the increasing scale of the ECB’s intervention may also mean that a certain level of ‘reaching for yield’ continues regardless of what happens in the US.

However, it does not take a rocket scientist to see the potential for casualties on both sides of the market in the coming quarters. Some investors are clearly concerned about the implications of tighter policy in the US and economic conditions elsewhere in the developed world, while there remains a large universe of highly leveraged companies out there, many of whom depend upon access to capital markets for survival.

If the current environment persists then there are going to be further implications for investor confidence in the ability of these companies to service and eventually repay their debts. Such concerns may even spread to encompass some of the more highly rated, but similarly geared issuers.

Other banks with large fixed income operations, like Barclays, could suffer from trading losses if the market does not improve, while some of the lower rated issuers could face insolvency if the market deteriorates further and they are deprived of access to funding.

One thing that seems almost certain is that, as private investors, it is probably time to rethink expectations for returns from the banking sector and to steer clear of highly geared companies. Particularly those at the lower end of the ratings spectrum.


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James Skinner has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.