The View From Atop the Junk Bond Bubble

If you’re like most investors, you may not know where to turn right now. Worrying about the collapse of Europe and what that might do to your portfolio before the opening bell might have you opting for sleep, instead of speculation.

Added up, that’s why money has been rushing out of the stock market and into junk bond funds at a record pace.

If that sounds like you, I urge you to reconsider the “junky stuff.” More on that in a moment. First, let’s look at the numbers…

After net outflows in May, last week, more than half a billion dollars flowed into high-yield debt, and close to $18 billion of investor money has flowed into the junky stuff thus far in 2012. If the money keeps coming into high-yield mutual and exchange-traded funds, the record amount set in 2009, when the S&P sank to 666, will be beat.

Corporate America is taking advantage. Companies with junk credit ratings have bellied up to the debt trough like at no other time in history. The first quarter of 2012 will go down as the most active for junk bond issuance since 1980, when Thomson Reuters began keeping track, with 130 companies floating $75 billion in debt offerings.

Investors can’t get enough of that high-yield stuff, with banks and Treasuries paying just north of zero. “The rally in junk bonds extends an advance that began in early 2009 and can be traced largely to the Federal Reserve’s policy of keeping benchmark interest rates near zero,” writes The Wall Street Journal.

“It’s the only place I can find any yield whatsoever with a reasonable risk,” Lee Hevner, individual investor and first-time junk bond buyer, told the WSJ. High-yield corporate borrowers paid an average rate of 7.98% on bonds they have sold this year, according to Thomson Reuters, the lowest since the junk bond market was created in the 1980s.

Despite the continued strain on state and local government finances, investors are rushing into municipal bond funds as well. Nearly a billion dollars flooded into muni bond funds during the week ended May 9th. According to the Bank Investment Consultant, the muni market “has now seen positive flows for 33 out of the past 36 weeks.”

The Bernanke Fed, combined with the meltdown in Europe, sent the yield on the US Treasury’s 10-year note to the lowest level in history a week ago. The folks at Elliott Wave Theorist point out that the 10-year yield fell 91% from a high of 15.84% in 1981 to 1.438% a few days ago. (The yield has since bounced back to 1.60%.)

This is what bubbles look like at the top: No price is too high for (in this case) “safety.” As investors fret about losing principal in a stock market crash, they instinctively rush into bond funds. Their brokers are eager to earn the stock sale commissions and put them in some seemingly “safe” bond fund kicking off a little yield and supposedly keeping the principal safe.

However, bond and yield mathematics are set to deliver a cruel lesson. When interest rates go up, bond prices go down. Suddenly, what was supposed to be a safe bet looks like 2009 all over again.

The math works this way: Say the coupon (annual payment) on a particular bond is $100. Your broker says the bond you’re contemplating for purchase is yielding 6%. $100/.06=$1,666.67 bond price. Easy enough so far. But when interest rates increase — and they have nowhere to go but up from here — or if your bond issuer runs into financial trouble, bond buyers will insist on a higher yield.

The $100 coupon doesn’t change (except for a default), but if the market demands a yield of 8%, that bond’s principal value will now fall to $1,250 ($100/.08). That 2% interest rate change whacked 25% off the principal value of the bond.

During the Great Depression, high-yield bonds peaked (in price) first in 1930, followed by higher-grade bonds that peaked in 1931. Rates were low and all that, but bond prices crashed and yields soared because of the fear of default.

Despite what the talking heads on TV say, the US economy is no better now than it was in 2008, and Europe’s is considerably worse. Governments are going broke everywhere. While the government says gross domestic product (GDP) is barely positive, John Williams’ Shadow Government Statistics (SGS) version of GDP reflects what we all know from our day-to-day lives: GDP has been negative since 2000, and it actually plunged at a negative 6% rate in 2009.

The SGS alternate GDP reflects the inflation-adjusted, or real, year-to-year GDP change. Williams adjusts for distortions in government inflation usage and methodological changes that have resulted in a built-in upside bias to official reporting.

America’s private economy is shrinking, while the size of government and government debt explodes.

Moody’s indicates that average default rates for high-yield bonds are running at 2.2%, less than half the long-term average of 5.6% and significantly below the recent peak levels of 17.1% in 2009. But remember, more fresh junk debt was issued in the first quarter of this year than ever before. If the economy doesn’t pick up soon — and there is no indication that it will — a fresh new crop of defaults will soon appear.

The Fed and the ECB cannot print money forever and keep rates near zero. The bull market in bonds has lasted for over 30 years. Now is not the time to pile in reaching for yield, because the stock market is scary.

The historic low in interest rates is what Addison Wiggin calls the “Mother of All Financial Bubbles.” “When this next bubble bursts,” says Addison, “it’ll make 500 point swings in the DOW look like good news. It’ll change everything you’ve come to expect from the United States government… from the safety you feel in your city, to the ease in which you’re able to move your money outside the country, to the value of the dollars you hold in your wallet.”

To help you prepare for the “POP!,” Addison’s spent the better half of his 20-year career working on a unique solution set. He’s discovered little-known (and safe) ways designed to multiply your money as the value of the dollar plummets. He’s found hidden opportunities to legally move a portion of your wealth outside the government’s growing reach, and more.

Discover five of Addison’s 47 different solutions, for free, by clicking on this presentation.

Sincerely,

Doug French
Senior Editor for Agora Financial
for The Daily Reckoning