Friday, October 2, 2015

The Junk Bond Bubble...........DO NOT MISS THIS!

The Junk Bond Bubble

BofA Issues Dramatic Junk Bond Meltdown Warning: This "Train Wreck Is Accelerating"

BofAML is out with a new note describing HY as a "slow moving trainwreck that seems to be accelerating."

The turn of the credit cycle is upon us. This is just the beginning. We suspect that this is the start of a long, slow and painful unwind of the excesses of the last five years. Along with decompression comes a tick up in defaults, and we expect those to increase in 2016 and 2017.

Though we don't and won't pretend to predict the next corporate scandal or regulatory hurdle, what we do know is that as cycles become long in the tooth, companies could act desperately.

Any corporate bond can be risky. If the company misses a payment — or it's simply downgraded by one of the major rating agencies — the market price for its bonds can crater almost as swiftly as the price of a stock.

And I'm talking about investment grade bonds (rated triple-B or higher). When it comes to speculative grade bonds (double-B or lower), the risk is even greater.

That's why, in the common parlance of Wall Street, they're called "junk." And it's also why, in normal times, most average investors have considered them forbidden fruit.

But whatever you call them, the fact is that, in the zero-interest rate Eden of the past seven years, junk bonds have been virtually the only fruit that yielded any juice. So investors flocked to them in droves, creating the greatest junk bond bubble of all time:

Just take one look at this chart, take a walk through history, and you'll see exactly what I mean:

1999: Most of Wall Street is going gaga over tech stocks. So junk bonds, even with their higher yields, are considered dull and boring. By 2000, they've attracted only about $650 billion of investor funds.

2007: This time, the big bingeing has been in real estate and mortgages. Yes, the junk bond market had grown since the beginning of the decade — to $960 billion. But it's still not the primary focus of speculation.

2015: Now, junk bonds are back – in a big way. While the real estate markets have been less leveraged and more subdued, junk bonds have suddenly emerged as the poison of choice for yield-thirsty investors.

Try to remind them that junk really does mean junk, and their likely response is to roll their eyes or shrug their shoulders. "Where else can I get a halfway decent yield?" they ask. "And who gives a damn about risk?"

Sound crazy? Perhaps. But these are actually rational responses to a Garden-of-Eden world where the Fed pegs official rates at zero with one hand ... and guarantees a virtually risk-free environment with the other.

Nevertheless, junk bonds are a giant house of cards, waiting for the day when the Fed decides to throws up both hands and eject investors into the real world.

When will that begin? There are some early signs it already has begun:

Junk bonds issued by energy companies, coal miners and metals producers (about one-third of the junk bond market) have already been falling all year — along with the plunge in commodity prices. But the idea that investors could escape the carnage simply by avoiding commodity-related junk isn't working anymore.
For example, Moody's recently downgraded much of Sprint's junk bonds to Caa1, precipitating a chaotic and fierce market response. Sprint's $2.5 billion of bonds maturing in 2028 plunged as low as 80.8 from 88.4 the day before, while $4.2 billion of its notes maturing in 2023 fell to as low as 90.1 from 98.6. For bonds, which rarely move by more than a point on any given day, that was the equivalent of a big crash.
Junk bond mutual funds and ETFs have also been a big part of the junk bond bubble with over 200 funds in all. But in recent months, more than $8 billion of investor money rushed for the exits, a prelude to the stock market exodus we saw in August.

High-yield bonds have decoupled from equity markets, just as they did in 2007/8, and the credit cycle's turning will inevitably flow through to crush the only thing left supporting stock valuations - the irrational non-economic corporate buyback-er. However, as we detail below, time's running out and it's getting tougher out there for our QE and ZIRP-coddled corporate junk-bond heroes.

This chart below, shows the distress ratio of leveraged loans as measured by S&P Capital IQ LCD (blue line) and of junk bonds as measured by BofA Merrill Lynch (red line) which depicts reality in an even harsher light than Standard and Poor's. Leveraged loans are generally secured and hold up better in a bankruptcy than bonds. But distress levels of both have recently begun to spike:

Rising spreads make raising money more expensive to get, and for the biggest sinners – the very companies that must get new money or fail – impossible to get. Investors will try to stay out of harms way. In this manner, spiking spreads lead to rising distress, and rising distress leads to rising defaults. And that's when these bonds go kaboom.

These rising spreads – regardless of what the Fed will do in terms of flip-flopping on interest rates – is a very bearish signal for stocks. 

Next big questions:

What happens when the party ends — either because the Fed is shutting off the lights or because investors see the handwriting on the wall?

How will a junk bond bust impact other markets — investment grade bonds, small cap stocks, and other recent targets of high-risk capital?

If you're heavily invested in any of these areas, I would not wait for the final word before taking protective action.

If you own junk or "high yield" mutual funds and ETFs, seriously consider taking advantage of any intermediate market strength to get out.

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