Looking for yield? Be careful what you ask for...
Every slick Wall Street operator is hawking junk bonds and leveraged loans as the ultimate drug for yield-starved investors - those seeking "juicy returns" in an otherwise risk-saturated bond market.
What they'll find is suicide by credit overdose.
I'm not surprised we've come to this point.
Now, those who know me know I'm not a big fan of the U.S. Federal Reserve. Acting as Wall Street's un-official "drug pusher" for decades, it went hog wild post-2008, dispensing low-rate, cheap, and always freshly printed money at grotesque levels.
As a result, today's "stimulus-addicted/Fed-supported" securities markets - thoroughly embroiled in bubbles - have crossed the Rubicon of debt and are now limping toward their own suicide, as you'll see.
But it doesn't have to get you.
Your broker and even your friends might think you look crazy for doing what I'm about to suggest, especially because the "good times" still appear to be rolling, but when the reckoning comes - and it will come soon - you'll look not only smart, but downright rich compared to the folks who didn't listen...
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Why the Bond Apocalypse Looks a Lot Like the Zombie Apocalypse
You see, since 2008, when the Fed prints money like this...
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And suppresses interest rates to the basement of history like this...
It causes households, companies, and the government itself to borrow like this...
The net result is a complete - and I mean complete - distortion of natural market pricing, risk awareness, and moderation.
Nowhere is this more obvious than in the U.S. bond market, which has become the ground zero of our next market implosion.
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For over a decade, the Fed has been dispensing ("engineering") suppressed low-interest rates. The cost of borrowing, in short, has never been so artificially cheap. As a result, companies are dispensing bonds ("IOUs") faster than a drunk Justin Bieber in a South Beach Lamborghini.
Such distorted bond flows have created the single largest and most toxic corporate debt bubble in U.S. history.
Needless to say, these low rates have been inducing otherwise crappy companies, from WeWork Co. to Carillion Plc., to borrow and borrow and borrow, despite balance sheets with zero cash flow, profits, or future viability.
Since 2008, the growth in junk bonds looks like this:
On Wall Street, individual companies who lack the cash flow to even make interest payments are called "zombies"- you know, walking dead men who pose a dire threat to the living.
And guess what? These zombies are everywhere. Today, fully 20% of the Russell 2000 index and 14% of the S&P 500 are zombies.
As Stan Druckenmuller recently mused: "Who knows how many corporate zombies are out there because free money is keeping them alive?"
Well, when that free money vanishes, so does this bond market.
Of course, market salesmen and fee-seeking cheerleaders from the big banks and sell-side boutiques will tell you that "bonds are a safe part of a balanced portfolio," as historically-speaking, bonds traditionally carried less market risk.
Unfortunately, thanks to the low-rate keg party Fed Chair Greenspan and his minion successors unleashed, this ain't our grandpa's bond market anymore...
In fact, companies with highest default risk on their bonds make up more than 60% of the wider $7.6 trillion U.S. bond market, with $2.6 trillion rated-BBB "junk bonds," another $1.3 trillion euphemistically described as "high-yield bonds," and upwards of $1.2 trillion called "leveraged loans." These last represent the proverbial bottom of the barrel, the crappiest and riskiest of all bonds.
So why would anyone want to buy this high-risk pile of crappy bonds?
Simple: Investors are desperate for yield in a bond market that the Fed has stripped of yield since 2008.
That is, when the Fed stepped in with quantitative easing and replaced natural market demand with Fed demand (created by money printed out of thin air), it pushed bond prices up and thus bond yields to the floor. Indeed, from 2008 to late 2014, the Fed essentially became the bond market.
So much for free markets, flag-waving capitalism, and prices set by the "invisible hand" of supply and demand à la Adam Smith...
Folks, it really is this sad, and it really is this simple: We now trade in a Fed-engineered market - with an extremely visible hand - rather than a natural, free market. Period. Full Stop.
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As Willie Nelson would say, the net result has been a search for yield in all the wrong places - namely "high yield" junk bonds and leveraged loans, which, ironically, don't even produce any "high yield" at all.
Today, the iBoxx High Yield Corp. Bond ETF (NYSEArca: HYG) yields 4.04%, which maybe sounds okay if you're nine years old. In 1985, by contrast, high-yield bonds offered 26% of yield for their risk.
In short, investors are going further and further out on the risk branch, crowding into vehicles like the HYG ETF for less and less reward, like a junkie who has to inject more and more dope to chase a feeling that will never come again.
Of course, the spin doctors of the sell-side "financial advisory industrial complex" (FAIC - rhymes with "fake") will tell you these bonds are "largely safe" and that they're "guaranteed" under the law as debt contracts... etc., etc.
But as anyone who has made a loan to a broke borrower knows, just because you have a "guaranteed payment" doesn't mean you'll ever get paid...
Folks, bad companies default. You deserve a lot more than 4% and change for taking on such risk.
By the way, remember all those sub-prime mortgage bonds - the garbage mortgage-backed securitized debt that was packaged and sold the world over as "safe"? The toxic MBSs that delivered us unto the Great Recession? Well, Lehman Brothers, Bear Stearns, Citigroup, Morgan Stanley, Goldman Sachs, and AIG all promised that debt was "guaranteed."
Still trust the FAIC experts and the bonds they peddle? After all, it was you and I who bailed them out...
In fact, the credit cancer that was sub-prime mortgages in 2008 is very similar to the junk bonds and levered loans of today.
Here's When the End Finally Comes
If history is repeating, we ought to therefore use history as our guide. Every market crisis, in the final analysis, is always a liquidity crisis - i.e. that "uh-oh" moment when there are no buyers for the toxic bonds you are otherwise desperate to sell.
Think of a crowded theater and someone yells "Fire!" and the exit door is the size of a mouse hole. That's today's "high yield" bond market: lots of size, very little trading volume.
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Such liquidity crises (or "fires") occur when otherwise crappy companies can no longer continue to borrow tomorrow to pay yesterday's debt obligations, which is the modus operandi of the current low-rate-driven bond bubble.
Given that the vast majority of our bond market is loaded with companies that rely precisely on such desperate debt rollovers to survive, do you really want to put your money, trust, and risk in a rollover dynamic that's about to roll over dead on its back?
Again, this entire process (and bubble) ends the moment zombies and other crappy bonds can no longer afford to borrow tomorrow at today's low rates.
More specifically: The moment interest rates rise by even a percent or more, these "high yield," levered loans and junk-bond fiascos, these pigs in lipstick, will start to collapse en masse, like a string of dominoes.
The market, therefore, is terrified - and I repeat, terrified - of rising rates. Why do you think the White House, Wall Street, and the mainstream financial media have put so much pressure on Powell to keep rates low? My goodness, even a 25-basis-point hike in the federal funds rate sends the bloated market into a panicked hissy fit, as we saw from October to December.
But here's the rub folks, the proverbial skunk in the woodpile... the dirty little secret no one else is telling you...
The bond market, and not the Fed, will get the final say in pushing interest rates up, thence to its own imminent implosion.
You see, the United States, with a combined public, household, and government debt level of $70 trillion, is...well... broke.
With annualized gross domestic product stagnating at 1.7% and industrial production at 3% (vs. an inflated Nasdaq that has risen by 200% in the same 11-year period), the United States will not be "growing its way" out of our debt bubble.
Rather, the Treasury will need to issue another $1.2 trillion in bonds this year, directly into the face of the already staggering bond bubble, just to keep the lights on in D.C.
As bond supply increases into 2019, and as the Fed's "forward guided" demand for those bonds under quantitative tightening (QT) decreases, we will see a classic moment of supply-driven price declines in the bond market.
This fall in the price of the U.S. 10-Year Treasury will inevitably send its yields up - which means interest rates will rise accordingly, regardless of what the feckless "geniuses" at the Fed will otherwise tell you.
In short, if you want to know where the bond market is headed, just watch the yield on the 10-year U.S. Treasury, not the verbal pirouetting of the Fed, whose record for plain-speak and recession forecasting is a staggering zero in nine.
And folks, if you think junk bonds and levered loans are the best place to be when the next liquidity crisis hits this all-time inflated bond bubble, I'm begging you to reconsider.
Holding such bonds today in a chronic moment of normalcy bias is the equivalent of carrying an un-pinned grenade in your pocket during a rugby match.
Be careful out there.
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About the Author
25-year run as a hedge fund portfolio manager, family office chief investment officer, managing director and general counsel. Internationally recognized expert in credit and equity markets as well as macro risk management.