Crashes, collapses, and panics never start where people think they will.
In 2007, very few people thought there would be a housing collapse. There had never been one before, and houses have always been a mainstay of the U.S. economy and relatively stable in price.
All it took was a small percentage of failed mortgage loans (3% of new loans went into foreclosure in 2007), and the entire economy collapsed.
In 1998, some people saw the potential for the Russian government to default on its bond payments. But virtually nobody knew that one hedge fund, Long Term Capital Management, had leveraged a position in Russian bonds to the tune of about $1 trillion (which was actually a lot of money back in 1998).
The S&P 500 had crashed 20% by the time the Fed stepped in and helped organize a rescue for LTCM.
In 1987, the Dow Industrials ramped up 44% before Black Monday. Sure, investors knew stocks were overvalued. But the 22% drop on Monday, October 19 was kicked off when Iran hit two ships with Silkworm missiles and a freak hurricane hit London.
Even the most recent correction for biotech and tech stocks may have had an unforeseen catalyst…
Biotech company Gilead Sciences (NASDAQ: GILD) received FDA approval for its new Hepatitis C drug, Sovaldi, in December. Sovaldi is far better than any other hepatitis drug. It can cure 90% of cases with minimal side effects.
It might sound incredibly bullish for Gilead that it will charge $80,000 for the 12-week treatment. After all, with 3.2 million cases of hepatitis C, that’s a boatload of cash for the company. Problem is, it might be too good.
On March 20, three members of Congress sent a letter to Gilead, asking why the drug had to be so expensive. After all, the vast majority of that $80,000 treatment cost would fall on either insurance companies or Medicare
Now, a simple letter shouldn’t set off a correction. Or should it? The iShares Nasdaq Biotech Index (NASDAQ: IBB) fell nearly 8% in the two days after that letter from Congress. By the second week in April, the IBB was down 17%.
Why? Because investors became worried that Congress might actually start talking about price controls for what amounts to a monopoly for pharmaceutical companies.
Shots Across the Bow
My point here is that we never really know what will start a correction or a crash. But we can say that the potential for a small spark to start a stock market bonfire gets higher as valuations get higher.
Today, investors are watching China for signs of a breakdown. Russia’s imperialistic moves around Ukraine have certainly raised the geopolitical risk to economies and stock markets around the world.
And of course, there’s always the Fed’s $3 trillion balance sheet. I’m sure you’ve heard plenty about how the Fed’s QE bond purchases have created imbalances and bubbles in the economy due to ultra-low interest rates.
People say low interest rates have created a bubble in housing, in emerging markets, and in stocks. But the bubble claims tend to deflate when you check the numbers. The trailing P/E for the S&P 500 is 18. Housing prices are well below peak levels, even with low interest rates. And with the exception of Wells Fargo (NYSE: WFC), banks have lowered their reliance on mortgage income.
If you want to find the source of a crash or a correction, look for a place or sector where cash flow could change very quickly.
Right now, the corporate bond market — especially the junk bond market — is a good place to look…
Why Junk is REALLY Junk
Corporate America is on a borrowing spree. They are taking on debt like there’s no tomorrow…
In 2012 and 2103, companies borrowed something like $2.5 trillion dollars. And around $600 billion of that is high-yield junk bonds. For comparison’s sake, just $43 billion in junk bonds were issued in 2008.
Junk bonds are rated BBB and below. Standard & Poor’s calls them “speculative grade” bonds — speculative because the companies have to pay a higher interest rate because the risk of default is greater.
And Wall Street can’t get enough of them. If you’re thinking this is similar to the way mortgage bonds traded in 2005 and 2006, well, I’m thinking the same thing.
It’s easy to see why Wall Street wants junk bonds. Interest rates are so low, you can’t make any money off Treasury bonds. As usual, Wall Street is happy to take on more risk to make more money. The financial crisis didn’t change that.
In 2013, the default rate for junk bonds was just 2.4%. On average, the default rate for junk bonds is 4.8%. A return to that level would mean $30 billion in losses on bonds issued in the last two years. But the actual risk of junk bonds could be much worse…
Consider the case of BMC Software. BMC sold $750 million in bonds that pay 9% in order to pay a special dividend to its shareholders, which includes private equity firm Bain Capital. And these bonds have a provision that if cash levels for the company fall below a certain level, it can sell more bonds and take on more debt to pay the interest.
What could go wrong?
Standard & Poor’s said this bond sale would “…result in a further deterioration in BMC’s ‘highly leveraged’ financial risk profile following its [leveraged Buyout].”
Another company, Asurion LLC, did the same thing, selling bonds to pay its private equity owners $1.7 billion. Bloomberg reports that companies have sold $21 billion so far this year to pay special dividends to their private equity owners.
What are the odds these companies will be bled dry and then default? Pretty darned high, I’d say. And the fact that anyone is willing to buy these bonds is really unthinkable.
What Happens When Money’s Gone
There is an endgame here. For BMC, the company will have to issue more debt, and at higher interest rates, too. You can see the death spiral coming; it will eventually be broken up and the parts sold to the highest bidder.
Because the money will run out. It’s just a matter of time.
The question we can’t answer is: how leveraged are the bondholders?
Hedge funds and even investment banks will buy bonds and then borrow against that asset to buy more assets. That’s leverage.
But if the asset that is borrowed against falls in value, the company may have to raise cash. If there’s no way to raise cash, the fund or bank fails. That’s exactly what happened during the financial crisis.
More recently, it happened to MF Global, run by former Goldman Sachs CEO Jon Corzine. Corzine loaded up on Greek bonds that were paying something like 7%… and then leveraged those to buy more. When Greece defaulted, MF Global had to raise cash to meet margin calls. If you recall, it stole that cash from customer accounts.
There will be a reckoning for the corporate bond market. It’s inevitable that bond defaults will rise, some companies will fail, and bondholders will lose money.
If you own any “high-yield” bond funds, you should consider getting out. Sure, they’ve averaged something like 17% a year for the last couple of years, but that ends as interest rates go higher.
As you know, I run The Wealth Advisory income and dividend portfolio. And we have exactly zero exposure to high-yield bonds.
It’s far better to stick with solid companies and REITs that grow their dividends.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
