Last week, millions of investors got burned by oil. Today, just as many are at risk of getting burned by junk bonds. Here’s what to know

 

Let’s just be blunt — investors do stupid stuff.

I can be judgmental, because my investment history is littered with stupid stuff.

Millions of investors learned a hard lesson last week.

As oil prices were crashing last Monday and Tuesday, a slew of investors tried to capitalize by pouring money into the United States Oil Fund ETF (USO).

These investors believed they were buying a fund that was a proxy for the “spot” price of oil.

It’s not.

Without bogging us down in the details, USO tracks oil-futures — specifically, the front-month oil futures contract.

Beyond that, USO itself has some structural challenges in the way it’s engineered. It’s unnecessary to delve into those details for this Digest — the point is that investors thought they were buying one thing yet got another … and it ended poorly.

To illustrate, look at the rebound in West Texas Intermediate crude (WTI) last week. While WTI soared 46%, USO actually went down 9% …

 

Now, let’s pull back and show you all of last week.

Any investor who bought into USO early in the week, expecting a bounce alongside WTI, has been sorely disappointed.

 

 

Bottom line, in our haste to make an investment buck, many of us act without really thinking things through … and it comes back to bite us.

***Many investors are at risk of making a similar mistake in the high-yield bond market — commonly referred to as the “junk bond” market

 

For any readers less familiar, a junk bond is a bond that’s riskier than what is called an “investment grade” bond. Specifically, the risk is that the issuing-company will default on its owed interest payments to investors.

Because of this risk of default, investors require a higher yield from junk bonds. This is to offset the greater risk these investors are assuming by lending their money to these risky companies.

Today, we’re seeing a surge of new junk bond issuances from struggling companies.

The Wall Street Journal reported that last Thursday alone, at least seven “junk” companies began marketing new bonds.

This isn’t surprising, as national lockdowns have squelched out operational cash-flow for countless businesses. Given this, executives are having to turn to bond-issuance to generate enough cash to keep the lights on.

***But unless an investor does his/her homework before buying into these junk bonds, the outcome could be as painful as what USO investors are experiencing

 

Our macro investment expert, Eric Fry, editor of Fry’s Investment Report, warned his subscribers about this in his update last week:

The prices of high-yield bonds — aka junk bonds — have bounced sharply from their March lows, but that doesn’t mean they are any less junky now. On the contrary, the risks in this sector are extreme.

The high-yield bond sector has become a proverbial mine field that is likely to blow up hundreds of billions of dollars, no matter how quickly the economy revives.

Just to make sure we’re all on the same page, bond prices and bond yields are inversely correlated. So, as investors flood into bonds, it pushes their price higher, which simultaneously drags yields downward.

In recent days, investors’ appetite for risky bonds has raced higher.

We can see evidence of this in the “spread” between yields of junk bonds versus what’s consider “safe,” which are U.S. Treasury bonds.

Last week, we saw this spread drop to 7.61 percentage points — down from 11 percentage points back in late March.

***Translation — investors are loading up on risky bonds, and it’s unlikely to end well

 

Back to Eric:

There are three big reasons to steer clear of high yield … even if a pandemic-induced recession was not heading our way:

• Record-high corporate bond issuance. Thanks to a decade of extremely low interest rates and buoyant economic conditions, non-financial corporate debt has soared by 78% since mid-2009 to $6.6 trillion. As this mountain of debt comes due, many of the issuing companies will struggle to refinance it.

• Record-high percentage of high-yield credits are low tier. According to Standard & Poor’s, a hefty 30% of junk bonds carry a rating of “B” or lower. That’s five notches below investment grade.

• Record-high percentage of investment-grade debt is one notch above junk. Even in the investment-grade bond category, a record 51% of those bonds are just one notch above junk-bond levels.

Eric goes on to note how every major brokerage firm on Wall Street has now issued a dire forecast for this year and next about potential defaults.

In general, these brokerage firms are looking for corporate default rates to double from their current levels around 5% to about 10% by year-end. But it only gets worse from there …

In 2021, estimates are the default rate will soar above 20%.

Back to Eric:

To put that in plain English, a 20% default rate would mean that one out of every five corporate bonds would go into default during the next two years.

***But what about the Federal Reserve stepping in to buy high-yield debt? Won’t that protect investors?

 

The Fed expanded its bond-buying activity to include junk-bond purchases, as part of the “bazooka of liquidity” it fired at the Coronavirus market slowdown.

This is unprecedented here in the U.S., and many investors have viewed it as a green light to charge into high-yield.

Here again, Eric sees danger:

Undoubtedly, many of these investors assume the Fed is providing an implicit guarantee to backstop the high-yield market. They believe the Fed has “de-risked” junk bonds and provided an opportunity to pick up additional risk-free return.

The reality, I predict, is that investors have picked up additional “return-free risk,” to borrow a clever phrase from Jim Grant.

Eric goes on to explain that just because the Fed might buy some junk bonds, the price of those prospective purchases is unknown. Will the price be at prevailing prices? Or perhaps 10% lower? Maybe 20%?

***But this uncertainty isn’t the only reason to avoid junk today

 

Back to Eric:

First, according to estimates from Bank of America, the Fed’s high-yield ETF purchases probably won’t top $8 billion …

(That) represents barely more than 0.5% of the total high-yield market. And remember, the size of the high-yield market is certain to grow even larger as many low-rated investment-grade credits become fallen angels by dropping into junk bond hell.

Second, no matter how aggressively the Fed buys junk bonds, it can’t convert a distressed bond into a healthy bond simply by purchasing it.

Buying a junk bond that’s heading toward default would be a little like buying a quart of milk on its expiration date. You can pay $5 for that quart of milk if you wish, but it’s going to turn sour just as quickly as if you’d paid $0.10 for it.

Today, many investors are trying to capitalize on high-yield junk by piling into high-yield ETFs like the iBoxx High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK).

These are ETFs you want to avoid according to Eric. He explains that while HYG is providing an “indicated yield” of nearly 6% per year, the actual yield could amount to far less as additional bonds default on their interest payments.

And remember, Wall Street predicts the peak default rate for this cycle will reach 20% in 2021 — that’s four times the current level.

Does this sound like a safe gamble to you?

Don’t make the same mistake so many USO investors made last week. Before you sink your hard-earned money into any investment, make sure you know exactly what you’re buying, and what the potential risks are — even if the Fed is allegedly helping.

For more of Eric’s research, click here.

And here he is with the final word:

Obviously, no one knows what the peak default rate will be, but everyone knows the default rate is heading in the wrong direction.

My advice: Steer clear of the high-yield market and high-yield ETFs.

Have a good evening,

Jeff Remsburg