Junk is still junk.

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.

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.

According to Ed Altman, a professor at the New York University Stern School of Business who created the Altman Z-Score to measure financial distress, a big chunk of so-called investment-grade bonds should be in the junk category already.

Altman examined 350 BBB-rated U.S. companies as of the end of 2019 and determined that more than 30% of them, with $600 billion or more of bonds, should have been rated “junk.”

If you needed a fourth reason to steer clear of high-yield bonds, here it is…

The Junkiest of Junk

The oil and gas industry accounts for an outsized percentage of the market. Energy companies collectively carry $174 billion of junk debt on their balance sheets — or about 12% of the entire market. For perspective, the energy sector represents less than 3% of the S&P 500 Index.

The dire outlook for energy-sector debt became downright disastrous earlier this week, when the oil price plummeted to minus $37 a barrel.

After examining the new stresses affecting the high-yield bond market, every major brokerage firm on Wall Street issued a dire forecast for this year and next.

To generalize, these firms are looking for corporate default rates to double from their current levels around 5% to about 10% by year-end. But the carnage does not end there. These Wall Street firms predict the default rate will rocket above 20% in 2021.

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.

The credit rating agencies like Moody’s and Standard & Poor’s seem to agree with these grim forecasts.

Trying to get out in front of the falling dominoes of default, the rating agencies are wasting no time in downgrading the credit rating of corporate borrowers.

And since 50% of investment-grade corporate debt is just one notch above junk levels, a lot of bonds are sure to become “fallen angels” — companies that lose their investment-grade debt ratings and fall into the junk category.

In March alone, $92 billion worth of investment-grade debt became fallen angels by dropping onto the junk heap. Many more investment-grade bonds are sure to follow. Investment firm Guggenheim recently estimated that $1 trillion of high-grade bonds could become fallen angels during this downgrade cycle.

Despite this credit chaos, the Federal Reserve boldly charged into the high-yield market two weeks ago with a promise to buy billions of dollars’ worth of high-yield bonds and exchange-traded funds (ETFs).

The shocking news converted a selling panic into a buying panic.

Don’t Buy “Return-Free Risk” From High-Yield ETFs

Investors started pouring record-breaking billion-dollar sums into high-yield ETFs like the iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG)and the SPDR Bloomberg Barclays High Yield Bond ETF (NYSEARCA:JNK).

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.

Yes, high-yield ETFs like HYG are providing an “indicated yield” of nearly 6% per year. But the actual yield could amount to far less as additional bonds default on their interest payments.

Furthermore, if the share price of HYG fell 6%, the total return this ETF provided would be zero. Of course, if the share price dropped more than 6%, the total return would be negative.

That’s the outcome I expect over the coming months, no matter how many junk bonds the Fed buys.

Here’s the thing: Just because the Fed might buy a few of these bonds, the price of those prospective purchases is unknown. The Fed might make its purchases somewhere near prevailing prices, or it might buy 10% below prevailing prices… or even lower.

There are at least two additional problems with the “Fed as savior” scenario of the high-yield market.

First, according to estimates from Bank of America, the Fed’s high-yield ETF purchases probably won’t top $8 billion. That number might seem significant, until you realize that $8 billion is less than one week’s trading volume in just one of the high-yield ETFs on the New York Stock Exchange (NYSE).

Further, $8 billion 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 10 cents for it.

The milk doesn’t care what you paid for it, and neither does a junk bond. Both of them will do what they do, no matter what you paid.

Best case, the deeply distressed high-yield market will muddle along — delivering neither sizable losses nor gains. That’s the best-case scenario, in my opinion.

The wave of downgrades and defaults is just getting underway, as the chart below shows.

The current default rate of around 5% would triple if it hit the 2009 peak and stopped there. But remember, the Wall Street brain trust predicts the peak default rate for this cycle will reach 20% in 2021 — or four times the current level!

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.

Regards,

Eric Fry

P.S. Politicians across the country are beginning to plan for the “restart of America.” But according to The Wall Street Journal, “[the] restart… suggests that back to normal will be anything but… The reemergence over the coming weeks will be fitful, fragile, and partial — and a bit dystopian.” One thing is for sure: When America finally reopens for business, it’s going to be a whole new world.

If you want to know how it will affect you and your money… including what happens next in the weeks and months to come… please take a few minutes and watch this short clip now. And if everything goes accordingly, you’ll learn about a handful of extraordinary opportunities for potential 131%… 3,041%… even 6,170% gains to come from “The Great American Restart.” That’s why I urge you to take a few minutes right now to  watch it here.

Eric Fry is an award-winning stock picker with numerous “10-bagger” calls — in good markets AND bad. How? By finding potent global megatrends … before they take off. And when it comes to bear markets, you’ll want to have his “blueprint” in hand before stocks go south. Eric does not own the aforementioned securities.