Corporate Bonds: What a Mess!

[The Machine]

 

 

Why are people lending – at such poor interest rates – to a company that went bankrupt five years ago...?

 

ON MAY 7, the yield on the Barclays US Corporate High Yield Index fell to a record low of 4.97%, writes Porter Stansberry in the Daily Wealth eletter.

 

It was the first day in the history of the US junk bond market (where less creditworthy companies borrow) that the index yield fell to less than 5%.

 

The next day, yields fell again to 4.96%.

 

Watching the action that week, we simply couldn't believe our eyes... General Motors issued new debt paying a yield of only 3.75%. General Motors is sitting on roughly $100 billion in pension obligations. It went bankrupt less than five years ago. And it operates in a sector that's still suffering from massive overcapacity. To say GM's five-year note isn't investment-grade could be the punch line of a joke.

 

At yet... there it was. You should imagine us sitting at our desk, rubbing our eyes in disbelief.

 

It is impossible to justify the high price of junk bonds (and their correspondingly low yields). You must remember that the default rate on these bonds will soar, sooner or later.

 

In March 2009, the default rate on this category of debt hit 14.9%. And of course, default rates rise when more bonds are issued. Issuance hit an all-time record in 2012. Through the beginning of May, the high-yield sector was on pace to beat that record this year.

 

In other words, never before in modern American finance have so many investors placed so much capital in riskier assets with less compensation. 

 

Believe it or not, that's not even the worst sign that the debt market is headed for an enormous crash.

 

Not only are investors no longer being compensated adequately for the risk of default, issuers of these debts have also succeeded in placing clauses in the contracts that allow them to repay investors with additional debt securities rather than cash.

 

So-called pay-in-kind (PIK) toggle notes allow corporate borrowers the option of issuing still more debt rather than paying bondholders interest in cash. These kinds of terms were invented during the last credit bubble, at the height of the market in 2006 and 2007.

 

Needless to say, a borrower who requires the option to repay you with still more debt isn't likely to repay you. These investments are sure to end badly, too.

 

The default rate on high-yield paper hit what appears to be a low in April at 3%. The default rate has now begun to tick up, inching to 3.1% in May. This will surely increase. The cycle will turn (as it always does). Higher rates will come. Refinancing terms will be tougher and tougher. Defaults will soar.

 

And so, in the May 10 edition of our e-letter, the S&A Digest, we issued our warning:

 

The coming collapse in the bond market will be far worse than it was last time, too. This time, the Federal Reserve's actions have driven forward the huge bull market in bonds. The Fed is printing up almost $100 billion per month and buying bonds. That has forced the other buyers of bonds to buy riskier debt that, historically, offered much higher yields.

 

Today, those yields have been incredibly 'compressed.' You can imagine the high-yield segment of the bond market to be like a spring whose coils have been driven together by the force of the Federal Reserve's market manipulation. As soon as the Fed's buying stops (and it must stop one day, or else it will trigger hyperinflation), the yields on those riskier bonds will soar again.

 

As bond yields rise, the price of bonds will fall sharply.

 

We were right. Since early May, the iShares High-Yield Bond Fund (HYG) has given up all the capital gains it made in the previous seven months. And on June 6, market research firm Lipper released data showing a record volume of investor redemption from mutual funds and exchange-traded funds holding high-yield bonds. Investors pulled $4.6 billion out of the high-yield market.