July 25, 2014
By Steve Blumenthal
The risk in the high yield bond market is off the charts. Yields are near record lows, bonds that shouldn’t be getting funding are and at terms unfriendly to investors. A default cycle is in sight and unfortunately the nature of liquidity has changed. This one is shaping up to provide an even greater investment opportunity than the last.
Dodd-Frank has pushed the dealer out of “broker-dealers” meaning that there is much less inventory the dealers are willing to hold. As GMO’s Ben Inker points out in one of this week’s posts, “the likelihood of a nasty shock occurring from even a temporary imbalance between the number of buyers and sellers has surely gone up from pre-crisis days”. The result is that there will be little floor beneath the high yield market when the selling wave hits. I can just see the number of distressed debt funds beginning to chomp at their bits.
Further, covenant-lite loans now represent half of all corporate bonds outstanding, according to Barclays. In the chase to find yield, investors are forgetting about the underlying credit risk. Complacency reins – a default crisis of mass proportion lies ahead.
Seen through my lens, another “once in a generation” buying opportunity is fast approaching. I remember saying the same thing in 1999 and 2007. The lines between generations must be shrinking as such opportunities seem to appear about once every seven years or so.
With a focus this week on high yield, I published a piece in Forbes and share it with you today by link below. You’ll find a few secrets (gained from more than 20+ years of tactically trading the high yield bond market’s cyclical trends) that may help you to position for growth and risk protect while you patiently wait for the next opportunity to arrive. Note, it may look easy to do on the surface but it takes time, attention and a tremendous amount of emotional discipline.
Included in this week’s On My Radar:
- Forbes – Code Red In High Yield
- Grantham Sees Record Takeovers and Possible 2250 Bubble Target on S&P 500 Index
- Trade Signals – Up Trend, Risk High
Forbes – Code Red In High Yield – Positioning for the Coming Default Wave
In my 20 years of managing high yield bond investments, I’ve never seen so many signals that scream caution. Desperate to find yield, investors have poured billions into high yield bond funds and ETFs driving the yield on the Barclays High Yield Bond Index is yielding just 5.54% — the lowest level in history. Investors are positioning in a risk they may not fully understand.
Let’s look at what will lead to the next default wave and discuss a tactical strategy that may help you further participate in price gains and also protect your wealth during periods of significant price loss. Here is the link to the full article.
Grantham Sees Record Takeovers and Possible 2250 Bubble Target on S&P 500 Index
“In early July, Janet Yellen made an admirably clear statement that she is sticking faithfully to the Greenspan- Bernanke policy of extreme moral hazard. She will not use interest rates to head off or curtail any asset bubbles encouraged by the extremely low rates that might appear. History is clear: very low rates absolutely will encourage extreme speculation. But Yellen will, as Greenspan and Bernanke before her, attempt to limit only the damage any breaking bubbles might cause.
Well, it is a clear policy and in my opinion clearly wrong. I had thought that central bankers by now, after so much unnecessary pain, might have begun to compromise on this matter, but no such luck, at least in the case of the Fed. The evidence against this policy after two of the handful of the most painful burst bubbles in history is impressive; but not nearly as impressive as the unwillingness of academics to back off from closely held theories in the face of mere evidence.
This affirmation of moral hazard – we will not move to stop bubbles, dear investors, but will help you out when things go badly wrong – should be of great encouragement to speculators and improve the odds of having a fully-fledged equity bubble before this current episode ends.” Jeremy Grantham from Bubbles Again: Setting Up for a Deal Frenzy (pages 6-12).
Jeremy adds that he sees the S&P 500 reaching a bubble level of 2250 driven by, among other things, a wave of M&A deals. I think you’ll really enjoy his discussion about the mistakes he has made over the last 47 years (see page 10). It is a great personal story expressed in a wonderfully humble and transparent way.
Trade Signals – Up Trend, Risk High
A look at the most recent investor sentiment and market trend charts. Sentiment is again excessively optimistic yet both the equity market and fixed income cyclical trends, while aged, remain bullish.
I keep thinking that as governments continue to find ways to confiscate wealth (aka my new favorite term “Cyprus Flu”), foreign capital and domestic capital may find U.S. corporations (equities) to be the choice asset class and push stock prices even higher.
From the IMF, “In the exceptional situation of an imminent state bankruptcy a one-time capital levy could but cheaper cut than the then still relevant options” if higher taxes or drastic limitations of government spending did not meet or could not be implemented.” See – A Debt Trap
The IMS proposals to allow governments to change the terms on existing sovereign bonds and the Fed’s discussion on placing exit penalties on bond funds are real life examples of the dire state governments have found themselves in. Lacking zero interest to focus in on internal structural reform, the plan is the take more from their citizens. Borrow and spend has reached a tipping point. You can’t make this stuff up. Madness!
There just may be a “melt up” in stock prices as investors rush to the exit doors fleeing bonds. I don’t know for sure but it has been more and more in the front of my mind. One of the reasons I favor price momentum is that it helps you see and position towards price leadership. On this front, our tactical strategies are mostly long equities, our high yield strategy moved to a sell more than a week ago, our bond indicators continue to signal lower interest rates and our equity strategy is long with tail risk protection always in place.
I was in Florida this week visiting Ned Davis Research and I felt like a kid in a candy store. We are working on a CMG customized version of the Big Mo indicator. Not sure where we go with it except to post it weekly and help you (and me) position our portfolios with an eye towards both growth and wealth preservation. As you probably know by now, I’m a big NDR fan. I like them because they are independent, off Wall Street and smart. For many years and continuing today, one of my favorite models is their Big Mo (Momentum). It is a weight of evidence approach to identifying cyclical trends. You will find it in this week’s Trade Signals (link above). It was a highly productive trip and pretty cool stuff for a quant geek like me.
Susan and I are sneaking away to Nantucket for a week. It has been years since I’ve been there and I hold fond memories of my three kids running around when they were young. We are staying in a quiet end of the island (upper green dot, Wauwinet, on the right) in a tiny inn. The inn sits with the harbor on one side and the ocean on the other.
Our boys are growing quickly, too quickly, and Brie is finishing her internship in New York. She’s working for Blackrock and what an experience that has been for her. I enjoy our daily calls and watching her lights turn on. It is nice to see her so happy.
We ride this journey through life and sometimes get far too caught up in the pace (that’s been me lately). It’s time to recharge. I am so looking forward to being away and getting lost with my beautiful wife. Some wine, some fishing, some great food and some mindless reading on the quiet beach are ahead for me. I hope you too are able to escape and recharge soon.
I believe it is Code Red on High Yield Bonds and that another outstanding opportunity is ahead. Stay tuned as I’ll update on those conditions as time moves forward. Next week’s post is already lined up. It’s from my longtime friend and writer extraordinaire, John Mauldin (John, I borrowed Code Red from you). It is short and insightful and I hope you find it helpful.
Wishing you another great summer weekend!
With warm regards,
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
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