Another installment of “What the Bleep is Going On?”… junk bond yields go lower than inflation… the rise of zombie companies

 

What the bleep is going on?

That’s the question we asked back in May as we marveled at the state of the investment markets.

Our CEO, Brian Hunt, summed it up nicely:

If you’ve followed the financial markets – even casually – over the past year, you’ve seen a parade of weird events. Events that don’t make much sense when analyzed inside most financial models.

Events that make you wonder What. The. Bleep is going on…

To put it simple, we are living in a World That Is Nuts.

As just a few illustrations, we’ve seen the cryptocurrency sector explode then implode… commodities prices skyrocket… inflation zoom higher for the first time in years… the real estate market become white-hot, where an offer price that matches the asking price is laughed off… and the U.S. government print currency and spend at levels that are utterly astonishing.

Well, we have two new stories to add to our running “What the Bleep” list…

***Investors are in record territory when it comes to taking on risk

For the first time ever, the return that investors receive for investing in the riskiest U.S. companies (junk bonds) has fallen below the inflation rate.

In other words, high-yield bond yields can’t even keep up with inflation.

What the bleep?

For readers less familiar, a junk bond (or “high yield” 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. The higher yield offsets the greater risk these investors are assuming by lending their money to these risky companies.

This traditional higher-reward for higher-risk dynamic has now been upended.

From the Wall Street Journal (emphasis added):

A rally in corporate debt rated below investment grade has pushed yields to record lows around 4.54%, according to ICE Bank of America data, while consumer prices rose 5% in May compared with a year earlier.

That marks the first time on record junk-bond yields have dropped below the rate of inflation, according to Bespoke Investment Group.

The move upends the conventional logic of investing in bonds, which are typically prized for protecting investors’ money.

Junk-rated companies include those most likely to miss interest payments or go bankrupt. Buying bonds that yield less than inflation means locking in a loss.

Historically, bonds were considered the safer alternative to the volatility of stocks. And if we focus on U.S. Treasury bonds, they’re thought to offer a “risk-free return,” given the belief the federal government won’t default.

But in this case with junk bonds, we’re inverting things – rather than “risk-free return,” investors are potentially entering into a “return-free risk” scenario.

This shows that investors are hunting for returns, wherever they can find them, even if it means taking dangerous gambles with their portfolios.

To put it simply, this is not wise investment behavior.

Back to the WSJ:

Some worry investors aren’t receiving enough compensation to account for the additional risk they take on buying junk bonds.

The average extra yield, or spread, investors demanded to hold speculative-grade debt instead of U.S. Treasurys was 2.62 percentage points as of July 6, according to Bloomberg Barclays data. That is down from more than 10 percentage points in March 2020.

So, what’s behind this?

Too much cash in the system.

There are too many dollars looking for returns of any kind – even meager returns. And when too many dollars flood an investment, the yield drops. It’s Investing 101.

But it’s still a “what the bleep” moment.

Speaking of too much cash and “what the bleep” …

***All this free money has been helping prop up failing companies

Thanks to the pandemic, the U.S. spiraled into an economic collapse back in 2020.

Now, with so many companies suddenly deprived of revenues, you might have expected a tidal wave of bankruptcies and defaults.

Instead, the opposite happened.

From Bloomberg:

Company failures spiked and then dived around the adoption of a new and more restrictive bankruptcy code in the fall of 2005.

Since then, the total number hasn’t been lower than it was in the last 12 months.

The contrast to the credit crisis in 2007 and 2008 could scarcely be more stark. The year-on-year change looks even more deviant.

Outside of the distortions caused by the law change, it’s the biggest reduction in the number of bankruptcies so far this century — during a brief but brutal recession.

How can this even be possible?

It’s possible because poorly-run companies have been feasting on dirt-cheap credit and free (or near-free) money from the federal government.

This has kept them alive. It’s a bit like a hospital patient surviving only by a ventilator and feeding tubes rather than natural function. Only in this case, we’re talking about companies surviving by cheap debt rather than profitable business operations.

The name for this type of business is a “zombie” company.

I mentioned our CEO, Brian, earlier in this Digest. Last week, he sent out the chart below. It shows the percentage of U.S. companies with higher debt service costs than profits…in other words, zombie companies.

Now, if you’ve been in the markets a while, you see the connection between our two stories today. If you’re a newer investor, here’s the big reveal…

***Many zombie companies are the exact same companies issuing the junk bonds that investors are gobbling up today, locking in a loss relative to inflation

In the rush to find any sort of yield, investors are buying bonds from companies that can’t survive based on normal business operations alone. And the yield these companies are offering is now less than the inflation rate.

Does that sound smart?

Back to Bloomberg:

Logic might dictate that an increase in bankruptcies lies ahead. This should mean that debt investors demand a higher yield to compensate them for the greater risk of defaults.

In the U.S., this is exactly what has not happened.

The spread between the yield on “high-yield” bonds (which might need to be renamed) over five-year Treasury bonds hasn’t been this low since the summer of 2007.

And we know what happened after that.

What the bleep.

***Despite all this, there is a silver lining

For that, let’s return to Brian:

As a CEO of a financial publishing company, I have heard some form of the question What the bleep is going on? asked from a place of intense worry, confusion, and interest on a level I have never seen before. That’s the bad news.

The good news is that I think I have the answer. And I think it can help you make a lot of money while at the same time keeping you safe from the dangers that come with living in a World That Is Nuts.

The good news about the good news is that understanding what the bleep is going on is pretty simple: The U.S. government and the handful of other major world governments are printing, borrowing, and spending money on a colossal level… on a level we’ve never seen before.

I believe this spending spree will push the value of select, high-value stocks higher and higher.

Yes, it’s absolutely logical to look at the world today and think that a market crash must happen. But there’s a key difference we have to factor in…

More government stimulus money flooding the global economy than at any other time in the history of civilization.

Yes, there will be a price to pay eventually. And yes, it will be incredibly painful for those who don’t see it coming.

But between now and then, there is the mother of all bubbles to be created thanks to the monsoon of spending raining down upon the world. And this bubble will create huge wealth…before it destroys huge wealth.

We’ll keep you up to speed as more What the Bleep stories hit the headlines. But for now, stay long.

Have a good evening,

Jeff Remsburg