Commodity Trade Mantra

The Next Financial Disaster Starts Here – Junk Bonds

The Next Financial Disaster Starts Here - Junk Bonds

The Next Financial Disaster Starts Here – Junk Bonds

Carl Icahn says this market is in a bubble… and that there’s “going to be a great run to the exits.”

Icahn is one of the world’s most successful investors. He’s worth $21.5 billion. According to Forbes, he’s the 31strichest person on the planet.

Last week, Icahn said that junk bonds are “extremely overheated.”

Junk bonds are usually issued by companies with shaky finances. They pay high interest rates to compensate investors for their high risk.

•  Low interest rates have pushed investors into these risky bonds…

Junk bonds have become popular in recent years. They’re one of few places where investors have been able to get a decent income stream.

In 2008, the Federal Reserve cut interest rates to near zero to fight the financial crisis. It has held rates near zero ever since. Right now, a 10-year US government bond pays just 2.3%. That’s half its historical average, and is near an all-time low.

Investors looking for income have turned to junk bonds. This chart shows the growth in junk bonds since 2002. As you can see, junk bonds didn’t grow much from 2002 to 2008. But when the Fed cut rates to zero in 2008, junk bond issuance began to take off:

JPMorgan reports that the number of junk bond issues soared 483% between 2008 and 2014.

•  Junk bond ETFs create an illusion of safety…

Many investors who own junk bonds don’t own them directly. Instead, they own them through junk bond ETFs.

The Financial Times explains why junk bond ETFs are dangerous…

… junk bond ETFs give the illusion of liquidity. Not all that long ago, bankers and asset managers promised to turn subprime mortgages into gold-plated, triple-A rated bonds.

Today, the apparently miraculous transformation is of deeply illiquid credit instruments, such as junk bonds and leveraged loans, into hyper-liquid exchange traded funds.

Junk bonds are not “liquid.” That means there aren’t many investors buying and selling them every day. The Wall Street Journal reports that “each of its HYG’s [the largest junk bond ETF] top 10 bonds only traded 13 times a day on average.”

That’s not a typo. Investors only buy and sell these junk bonds 13 times per day on average. For comparison, investors buy and sell 47 million shares of Apple (AAPL) on average every day.

Junk bond ETFs are extra dangerous because they appear to be liquid. HYG, the largest junk bond ETF, trades more than 6.8 million shares per today on average. That’s more than McDonald’s stock.

But as Howard Marks, hedge fund manager and one of the most respected investors in the world explains:

No investment vehicle should promise greater liquidity than is afforded by its underlying assets. If one were to do so, what would be the source of the increase in liquidity? Because there is no such source, the incremental liquidity is usually illusory, fleeting, and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times.

Because junk bond ETFs appear liquid, most investors don’t see the danger. They think they can sell their junk bonds ETFs just as easily as they could sell shares of Apple.

But if too many people decide to sell junk bonds at once, it could overwhelm the market and cause prices to crash.

•  Even “The Bond King” is worried …

Bill Gross, who founded the world’s second largest bond fund and is known as “The Bond King,” said:

The obvious risk, perhaps better labeled the “liquidity illusion,” is that all investors cannot fit through a narrow exit at the same time.

None of this has been a problem yet because junk bonds have been in a bull market. According to Bank of America, junk bonds have gained 149% since 2009.

But all bull markets eventually end. And when this one ends, junk bonds could cause massive losses to investors who don’t know about these risks.

As you can see from the chart of HYG’s share price, junk bonds are down since June:

•  And some of the savviest investors in the world are betting that junk bonds will soon crash…

They’re calling it “The Next Big Short.”

A few hedge fund managers made a killing when US housing collapsed in 2007. Dallas-based hedge fund manager Kyle Bass made $500 million by betting against housing. John Paulson made a $4.9 billion by “shorting” mortgages. Shorting is betting that the value of an asset will decline.

Today, some of the savviest investors are starting to place bets against junk bonds… just like Bass and Paulson bet against housing in 2007.

The Wall Street Journal reports:

Apollo [one of the world’s largest private equity firms] has been raising money from wealthy investors for a hedge fund that snaps up insurance-like contracts called credit-default swaps that benefit if the junk bonds fall. In marketing materials reviewed by The Wall Street Journal, Apollo predicted: ETFs and similar vehicles increase ease of access to the high yield [junk] market, leading to the potential for a quick “hot money” exit.”

Other hedge funds like Reef Road Capital and Howard Marks’ Oaktree Capital are also raising money to bet on a junk bond crash.

You don’t want to be on the losing end of this trade. If you’ve made money, investing in junk bonds, now’s the time to cash in. We recommend you exit junk bonds today.

 

 

Courtesy: Casey Research

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The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of Commoditytrademantra.com or Moneyline.co.in.

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