The Fact That Junk Bonds Are Back Is A Warning Sign To The Prudent Man

In an interesting development in financial news, high-yield and high-risk bonds, known as “junk bonds”, are back for investors according to a report:

While stocks hog the limelight with their best January in three decades, another corner of the risk assets marketplace sprang back to life last month after having taken a pounding at the end of last year, though some investors question whether the recovery has legs.

Junk bonds in January delivered their strongest monthly performance in more than seven years with a total return of nearly 4.6 percent, according to ICE BofAML index data, retracing almost all of the fourth quarter’s losses. Issuance of new debt rebounded after a near-complete shutdown in December.

Along with the surge in stocks, it would appear to be an endorsement of a U.S. economy that continues to outperform its global peers, as well as the shift by the Federal Reserve to a wait-and-see posture regarding future interest rate increases.

Companies with risky credit profiles brought $11.7 billion in new high-yield debt to the market in the first month of the year, after a nearly six-week dry spell at the end of 2018. The bounce-back from December has led fund investors to put the most cash into high-yield bonds since 2016, according to Lipper.

That backdrop would typically be seen as constructive for more gains. Some big bond managers, however, remain skeptical of the rebound, attributing it more to a clutch of technical factors that will soon peter out than to a lasting improvement in fundamentals.

“We don’t think this is a particularly strong buying opportunity,” said John McClain, portfolio manager at Diamond Hill Capital, anticipating a market correction that will pull prices lower. Strong high-yield gains in January 2018 were more than erased by a volatile February.

December saw just $594 million in high-yield deals, the lowest monthly issuance since August 2008. Companies stepped back from raising debt because global macroeconomic trends – such as slowing global growth, the U.S.-China trade war and Brexit – had whipped up volatility in financial markets. But when Fed Chairman Jerome Powell last month signaled a pause in the U.S. central bank’s interest-rate hiking policy, confirmed in last week’s policy statement, markets rebounded.

Still, the high-yield market’s recovery from the December trough adds up to less than half of January 2018’s issuance. The relatively small size of the market may be artificially buoying prices. The compensation paid to high-yield bond investors for holding riskier securities, which had widened to 5.357 percent over Treasuries on Jan. 3, has narrowed by 108 basis points since, according to ICE BofAML indexes.

“The (junk bond) market is currently weak. Buyers are being stingy and disciplined, and sellers are offloading as soon as they can,” said Kathleen Gaffney, director of diversified fixed income at Eaton Vance.

Two one-time events may also be shrinking the market and inflating prices: the recent upgrade of HCA Healthcare’s debt to investment grade and the merger of speculative-grade First Data with the investment-grade Fiserv.

Nonetheless, strong investor demand has led issuers to increase the size of their deals. Military aerospace parts maker TransDigm Group priced its $3.8 billion deal Wednesday, up $1.1 billion from initial price talk. The Targa Resources bond which reopened the market in January added a tranche, doubling the offering to $1.5 billion.

The terms secured by investors are particularly impressive given that the economic and geopolitical worries that roiled markets in December have not disappeared.

Moreover, U.S. corporate profit growth, a key driver of junk bond performance, is seen stalling through the first three quarters of this year as the tailwinds fade from last year’s tax cuts, according to Refinitiv data. In the first quarter alone, profits are estimated to barely rise at all – growing by 1.1 percent year over year.

“Nothing has really changed that much,” said Michael DePalma, chief executive of hedge fund PhaseCapital LP. “People were just projecting forward: we’re going to have trade wars, the economy is slowing, the Fed’s going to raise rates and that’s going to ruin everything.”

This January, he said, nobody cares.

Given the persistence of those macroeconomic themes, the volatility that spooked high-yield issuers in December could easily return in 2019. And although the Fed may be open to pause interest rate hikes this year, the continued strength of the U.S. labor market may make it difficult for the Fed to justify holding rates unchanged for too long.

“The market reaction to the Fed’s dovishness is overblown. Economic fundamentals have not changed and the Fed could raise again after a pause,” said Gaffney.

For managers skeptical of the rebound in junk, then, January provided an opportunity to remove risk ahead of anticipated volatility. “We’ve used the first month to really clean up any of the mistakes we had made in our portfolio. This really is the time to get out without taking a meaningful haircut,” said McClain. (source, source)

In the film Indiana Jones and the Last Crusade, one of the tests that Indiana Jones had to face with was the “Breath of God” challenge, where it is said that “only the penitent man will pass.” In this challenge, Indy had to kneel or rather, duck as large blades jutted out of the floor:

The fact that a risky investment such as junk bonds are back is a highly ominous financial sign. Instead of “only the penitent man will pass,” it is a sign that another financial crisis is coming, and that “only the prudent man will pass.”

I warned on February 3rd, 2018 that the year feels like 2003 all over again, but so few notice. I speak not merely of politics, but especially of finance, and this story, which came out February 4th, is a dangerous sign that this is so.

Junk bonds are one of many types of risk-straddled “investments” that are almost always best to avoid because the risk of default is very high. Investors, while they can make a handsome profit, also stand to lose everything they have and in the case of borrowed collateral, to be forced into a margin call scenario and be unable to pay what one owes, and thus have one’s accounts and other assets seized to service debts. In the case of large companies, as one saw in the 2007 and early 2008 TARP bailouts, what the average man lost his life saving over was what the corporate world received a government-funded bailout for. The money that they could not pay was paid for by money printing.

The famous ending scene from the movie “Trading Places.” A full explanation of what is happening is here, but basically the point is that Eddie Murphy and Dan Akyroyd use a fake crop report in combination with insider information to convince their ex-employer, the Duke Brothers, to overbuy in the frozen orange juice commodity market. The Dukes overbuy, and then Murphy and Akyroyd offer to sell at the high price and buy at a significantly lower price, while the Dukes are forced into the opposite scenario, bankrupting the Dukes and greatly enriching Murphy and Akyroyd. At the end of the scene, the Dukes are forced to pay the difference owed to the brokerage house lost by their trades- “margin call” -and as the amount is in the hundreds of millions they cannot and so are forced into bankruptcy.

I do not believe that a financial crisis is “imminent.” This would be gravely incorrect to say so. However, the makings of it are taking place right now. Another piece of evidence which supports this is that housing sales and auto sales, while some say they are slowing, are still continuing to climb. Subprime auto loans, which greatly contributed to the 2007 crisis, are back and continuing without so much as a notice. Credit card and personal debt continues to rise, and many people believe that the economy under Trump, just like under Bush II, is doing great and will continue to get better. All of this is happening on the eve of the impending election for 2020, about a year away, and with a Democrat party in a state of feigned disarray and chaos.

In other words, it is 2003 all over again.

I have been reading news since before High School, and I remember reading about the economy leading up to the crash and seeing various warning signs, although not as clearly as now for reasons that should be obvious. While “hindsight is 20/20,” one’s youth as well as learned experience make a tremendous difference, especially if one is for the most part self-educated, and that goes for any subject.

An economic crisis would not be good. I do not want anybody to experience this because the consequences are serious. However, I cannot help but see patterns of economic and political behavior too similar to what happened sixteen years ago. Given the cyclical nature of history, while I do not pretend to impart any sort of “financial advice” at all, I can say that one should look at the current set of events as counsel and a comfort to the prudent, and an opportunity for the savvy.

It is said that in a crisis, one man’s disaster is another man’s opportunity. Again, I am not saying that in five years there will be a crisis, but I am saying that the patterns which lead up to the previous crisis seem to be repeating. Having noted this, one may remember that while many people lost their savings, those who had holdings in tangible financial assets such as precious metals fared well. In addition, those with large cash holdings were able to purchase large amounts of assets be it property, homes, cars, or other items at rock-bottom prices as people were selling everything they could to service their debts without considerable regard for price. Those who had little to no personal debt also did very well, as not only were they able to obtain credit in a market that increasingly did not want to extend further credit as one could not guarantee payment of one’s debts, but in the event that creditors wanted to call any debt, it could likely be serviced without major losses.

The lesson to be taken from this is that based on patterns of observation, one may want to conduct an experiment on one’s own life in the theme of Aesop’s tale in The Ant and The Grasshopper.

In the tale, there is an ant and a grasshopper. The ant works very hard all around the year storing up food and provisions, while the grasshopper chooses to do nothing and pass his time in personal indulgence and idleness. The seasons past from Spring to Summer, and Fall, and then Winter comes. In Winter, the grasshopper has nothing prepared and he starves to death. The ant however fares well and enjoys himself because due to his industriousness he is able to weather the winter and survive until Spring again.

Following in the example here, consider yourself in 2003. If you knew what would happen in four to five years from then, would you work a little harder at work, and maybe get a second job? Would you learn another skill? Would you save some more money, and maybe not take that vacation? Would you simplify your personal habits, eating a little less of the “good food” and spending it on cheaper and less tasty but healthier food? Would you do anything different if you knew that you could come out of the crisis richer, happier, and holier, and be able to help somebody else along the way?

That is what I am proposing here. Consider that if patterns of history exist, that there is little that one can do to change them, and that one can reasonably estimate what may happen, what is to stop one from taking action to benefit oneself in a positive way, and in so doing that one could help some others along the way?

As such, one may want to consider working more if possible, or maybe even taking up a second job simply to save up extra monies. One may want to work on paying down debts, especially large ones. One may want to pass on vacation time, or in the case of time offered by an employer, to do what many allow, and that is to take the “cash value” of the time allotted instead of time off. One may want to learn a skill, and to simplify one’s expenses overall be they for food or other amenities. From the extra monies that one earns, one may want to save them in the bank, or perhaps invest them into a tangible asset.

In three to five years time, if nothing happens, then one will come out wealthier and better off in one’s personal life. However, if there are serious economic troubles that happen, one can have greater peace of mind knowing that one has worked hard to prepare for a crisis, and that one will likely be able to better get through it and be able to help others too.

In both cases, there is nothing to lose, but all that a man has to gain.

I put this out here as “food for thought” because it was something that was presented to me well after the crisis of 2008 happened. Why does one need to “re-invent the wheel” when the ideas already exist and have been discussed, but just need to be placed into another historical context that has a similar series of events that caused the previous crisis? One does not need to do this, but only to learn from what happened to help form a solid basis by which to measure the potential for certain events in the future.

The answer to the problems of today is often times the past, for present problems too often are just repeats of past issues in a different cultural or social context. Time and places change but man does not, and with that the same philosophies of the ancient world are just as important today.

Think about it, and for the ambitious, brave, curious, or those who simply want to try something different and prudent instead of the hackneyed excuses for ideas too frequently offered, consider the suggestions above. After all what does one have to lose?