Major Bond Warning

moneyMy Comments: A recent letter to the editor of the Gainesville Sun suggested there was a conspiracy afoot, run by the US Government, to whit “How was it possible for anyone to survive when banks were only paying 1% on Certificates of Deposit.” While the question itself is legitimate, the context implies a vast ignorance of how money works.

I’ve talked in this blog about how interest rates are due to start rising. I’ve talked about how the economy is doing well these days. I’ve talked about the need to position your money so it will have a chance to grow instead of shrink the next time we have a crash.

The following came from a newsletter to which I subscribe. It might or might not help if you have little knowledge about how money works. Here’s what the author said:

In May 2013, I (Porter) gave my first warning.

I told subscribers this was “the single greatest threat to your wealth you will ever face.” Longtime readers might recall I was warning about the bond markets. In particular, I was pointing to the part of the market that provides financing to smaller, faster-growing firms – bonds known as “high yield,” or “junk.”

I know most of my subscribers don’t buy bonds. Most don’t really understand how bonds work – at least, not in any real detail. And when most readers think about interest rates, they probably focus on mortgage interest rates or municipal-bond interest rates.

Here’s the thing, though: If you want to see the next bear market in stocks coming ahead of time, you ought to focus on the corporate-bond market. The corporate-bond market shows how much most companies pay for the capital needed to grow. For some industries, access to such financing is vital. Without a healthy corporate-bond market, some companies would drop to zero almost overnight. And that makes the cost of capital a crucial variable…

Another thing that most investors don’t understand about the bond markets: Interest rates (set by the bond markets) influence how stocks are priced relative to their earnings, their “valuations.” Starting in 2009, the Federal Reserve intervened in the bond markets, driving interest rates lower. That has pushed stock valuations higher, and it has been a powerful driver of this bull market. Higher interest rates, on the other hand, will drive valuations lower. I believe that’s likely to cause our next bear market.

Here’s what I wrote back in May 2013…

The U.S. bond market – particularly the junk-bond market – is going to crash. When this crash occurs, it will be the largest destruction of wealth in history. There has never been a bigger bubble in U.S. bonds. How do I know? It’s simple. Junk bonds (aka high-yield bonds issued by less creditworthy companies) have never yielded less than 5% annually. But they do today. Likewise, the difference between the yields on junk bonds and the yields on investment-grade bonds has almost never been smaller. That means credit is more available today than almost ever before for small, less-than-investment-grade firms. The last time credit was this widely available – and at such low costs – was in 2007. And you know how that turned out…

The coming collapse in the bond market will be far worse than it was last time, too. This time, the Federal Reserve’s actions have driven forward the huge bull market in bonds. The Fed is printing up almost $100 billion per month and buying bonds. That has forced the other buyers of bonds to buy riskier debt that, historically, offered much higher yields.

Today, those yields have been incredibly “compressed.” You can imagine the high-yield segment of the bond market to be like a spring whose coils have been driven together by the force of the Federal Reserve’s market manipulation. As soon as the Fed’s buying stops (and it must stop one day, or else it will trigger hyperinflation), the yields on those riskier bonds will soar again. As bond yields rise, the prices of bonds will fall sharply.

One of the best ways to follow the corporate high-yield bond market is to watch the leading exchange-traded funds that buy huge amounts of corporate bonds, like the iShares iBoxx High Yield Corporate Bond Fund (HYG).

Here’s how HYG has performed since my warning in early May 2013…
15-08 HiYldBonds

As you can see, shortly after my warning, these bonds fell sharply. The funds’ shares dropped from $95 to $89 in a matter of days. They rallied back, though, and roughly a year later (June 2014), they nearly hit a new high. We repeated our warnings in several Digests in 2014 (on May 29, June 4, and June 12).

Here’s what we wrote in the May 29, 2014 Digest…

There’s probably no larger sign of the top than what’s currently happening in the high-yield (aka “junk”) bond market… Investors are lending money to the riskiest corporate credits for near-record-low interest rates – currently a little more than 5%. And these companies literally cannot meet the demand for their paper. According to the Wall Street Journal, of the 10 largest U.S. bond funds at the end of 2013, the four with the fastest growth in assets since 2008 held an average 20% of their portfolios in junk bonds.

That outlook led us to close our high-yield bond newsletter, True Income. There was nothing we wanted to recommend in the entire market.

Still, as interest rates raced for record lows and bond prices shot to record highs, investors decided they had to own junk bonds. While we were shuttering our high-yield bond research, the individual investor began buying junk bonds like never before… many for the first time ever. As former Digest editor Sean Goldsmith wisely noted, “Nobody ever heralded the individual investor for his timing.”

Today, high-yield bonds are trading near their lows of the last three years. HYG is trading around $88 a share. I still believe all the things I’ve written over the last two years: A collapse in the high-yield market will kill the current bull market and wipe out billions of dollars of investors’ savings.

It’s interesting to note that the rising defaults and distress in the bond market are causing the decline in bond prices today, not inflation. In particular, the two fastest-growing parts of the high-yield market for the last decade have been bonds tied to oil and gas companies (some of which have already filed for bankruptcy, many of which are now distressed) and bonds tied to subprime auto lending (which now makes up roughly 25% of all car loans).

I don’t need to tell you that oil and gas prices are way down. As a result, a lot of the investments made into the oil patch over the last decade aren’t going to produce anything like what was expected. As oil and gas companies’ “hedges” expire this year, revenues at most of America’s oil and gas companies are going to go way, way down. A lot of bonds will end up in default.

Likewise, the default rates on newly issued subprime auto loans have been setting new highs, rates much like those in 2008. Specifically, 8.4% of the subprime borrowers who bought a car in first-quarter 2014 missed at least one payment before the end of the year. The early default rate on subprime car loans last peaked in 2008 at 9%. Given that the job market remains strong, this suggest a huge problem in subprime auto underwriting and larger-than-expected losses in securitized auto loan bonds.

Now… consider this. Outside of student loans, auto lending is the only form of consumer lending to grow in the U.S. since 2009. And something like 30% of all the jobs that have been created in the U.S. since 2010 are tied directly to the oil and gas industry. Take the credit weakness in these industries as a significant warning sign. Perhaps all the cars they sold in 2014 (a record for U.S. car sales) can’t actually be paid for… And perhaps all of those oil wells they drilled can’t, either. If that’s the case… no matter how many bonds the Fed buys, defaults are likely going to rise… and bonds are going to fall.

What should you do about this? First and foremost, check your accounts and make sure you don’t own any high-yield bonds. As for other strategies… be aware that a bear market this fall is, in my opinion, likely. Watch your trailing stops. Consider shorting a stock or two as a hedge. And most of all, avoid companies that use large amounts of debt. Their costs are going up