Junk Bonds Are Setting Up To Destroy Investor Wealth
by Dave Kranzler, Investment Research Dynamics
“Pigs are greedy and hogs get slaughtered.”
When I was a junk bond trader in the 1990s’ we referred to anyone who bought a bond yielding over 12% as “a yield hog.” Back then, anything over 12% had a high probability of default. Back then 12% was 600 basis points (6%) over the 10-yr Treasury bond.
Currently, some junk bonds with triple-C ratings are yielding under 6%. This is less than 400 basis points (4%) over the the 10-yr bond. Think about it: because the Fed has taken short rates to zero, investors are chasing bonds with 5% yields that have at least a 50/50 chance of defaulting. This is despite the fact that energy junk bonds recently have delivered $100’s of millions of losses to junk bond investors.
The retail investor is always the last one in when chasing an investment bubble and always gets hurt the most when the bubble collapses. Currently there’s a massive bubble being blown in the junk bond market.
An article published by Bloomberg – LINK – this morning started off with a rather improbable assertion: “The new fixed-income haven is, of all things, the market for junk bonds.” As a former junk bond trader this got my attention.
The Merriam-Webster dictionary defines the word “haven” as “a place where you are protected from danger, trouble, etc.” Referencing junk bonds as a place where investors “are protected from danger” is the epitome of theatrical absurdity. I doubt Henrik Ibsen could have written anything as grotesquely obtuse.
High-yield bonds represent “some of the best strategies to generate total return in today’s low-return environment,” said Payson Swaffield, the London-based chief investment officer for fixed income at Eaton Vance Investment Managers, which oversees $300 billion. – from the Bloomberg article linked above.
Anyone invested in Eaton Vance high yield funds should head for the exits immediately. Generating “total return” is not necessarily the best investment strategy, especially when you add in the risk of not having your money returned at all. Mr. Swaffield has described the “yield hog” chasing strategy that we used to laugh at when I was a junk bond market professional. We laughed because we made a lot of money selling those bonds to people like Mr. Swaffield and we knew they were going to get hammered eventually.
The Central Banks are at the root of this impending tragic investment bubble. ZIRP and NIRP policies are forcing investors out of cash and near-zero or negative yielding “havens” and into slightly higher yielding investments in which the potential rate of return does not even remotely reflect the degree of risk being taken. In other words, current monetary policy has completely removed the concept of “risk evaluation” from the market.
The risk in higher yielding junk bonds first and foremost is derived from fact that any company paying north of 5% to issue debt has a high probability of never paying back the investors who by the debt. Again, I reference the recent collapse of energy junk bonds.
The second source of risk is liquidity risk. NO ONE is considering this risk. Liquidity risk derived from an investors ability to sell an investment when the market is dropping. The junk bond market is notorious for going “illiquid” at times when investors need bid-side liquidity the most. I’ve seen a big seller who needed to sell a big position in a junk bond issue force the market down 40 points in order find a level where buyers would step up.
Now that’s liquidity risk. The current yield on all fixed income securities – and specifically the general yield of the junk market – does not in any way price in liquidity risk (aka a “liquidity premium”).
“It’s very tricky” for insurers, said Bruce Porteous, an investment director for insurance solutions at Standard Life Investments, which oversees about $370 billion. They’re making a shift because “they can’t earn enough money on the assets they hold to provide the benefits that they offer.” – Bloomberg
That statement by Mr. Porteous is just a politically and socially correct way for saying that insurance companies are being forced into junk bonds because they are currently underfunded in relation to their expected future insurance claim payouts – i.e. insurance companies have a negative net worth. So the solution is to become a junk bond yield hog.
If insurance companies and pension funds are underfunded currently, just wait until the junk bond market goes through another cyclical collapse…
The graph above (source: The Aleph Blog, edits in red are mine) shows what happened to junk bonds during the tech crash in 2000 and the Great Financial Collapse in 2008. The graph only goes through Dec 2012. If it extended to today, the purple line – which represents the Merrill Lynch High Yield Master 2 Trust – would be a bit below 5%. I would suggest that when the current stock bubble pops, the two areas in red circles above will look like small blips in comparison to the carnage that is in store for the junk bond market.
The Fed and the other western Central Banks have imposed this extreme moral hazard on the market in what is being termed as “attempt to prevent deflation.” However, I would also suggest that it is just another massive wealth transfer mechanism being used by the elitists to fleece the public.
Wall Street makes $100’s of millions underwriting junk bonds and selling them to the public. Junk bonds are typically subordinated, unsecured debt obligations of the issuer. It means that if you own the junk bonds of a company that goes bankrupt, you get to stand in line behind all of the senior secured and senior unsecured claimants before you see a dime. This includes specifically holders of derivatives, who get to stand at the front of the line courtesy of the Obama administration. If you have a retirement fund or an insurance policy, you are exposed to the junk bond market.
When I was a junk bond trader in the 1990’s, high yield money would be pulled from the market abruptly and quickly, usually about a week before the stock market would undergo a big sell-off. With the current capital markets having been flooded with Fed, Bank of Japan and ECB money printing, I’m not sure the junk bond market will act as a warning beacon this time around.
In fact, I would bet good money that junk bond investors will wake up one day and find that the value of their holdings will be down 40-50% overnight. And that’s just for starters. Wait until the herd of insurance companies and pension managers try to unload their holdings.
This is yet another Fed engineered bubble that accomplishes the massive transfer of wealth from the public to Wall Street and that will end very badly for investors, especially retail investors.