A Major Bombshell in the Credit Markets

This is how the end begins... A major bombshell in the credit markets... Another sign of trouble in this risky market... Even allegedly safe debts have become toxic waste... This is 'Franken-money'... What you can do about all this 'froth' today...

Editor's note: We explained yesterday that Digest editor Justin Brill is away on vacation for the next two weeks. In his absence, we'll be sharing some never-before-seen essays from Stansberry Research's top analysts – like Mike Barrett's take yesterday on why ignoring millennials' concerns could hurt your investment portfolio.

Today, we're sharing insights from Mike's colleague, Extreme Value editor Dan Ferris. If you've been with us for long, you'll likely recall Dan's regular contributions to the Digest. He'll be "pinch hitting" for Justin as part of our coverage of the markets over the next two weeks, starting with this essay about a "recipe for disaster" that's unfolding right now...

This is how the end begins...

Longtime readers know we've talked at length about leveraged loans in the Digest.

These loans to debt-laden companies have proliferated over the past few years, as investors scramble for yield amid global interest rate suppression, and businesses seek to take advantage of looser underwriting standards.

The leveraged loan market hit $1.6 trillion earlier this year, according to Bloomberg. That's double the amount at the end of 2008.

But as we've said in the past, these low-quality debt instruments have been priced for nothing but the best of times ahead. And they're growing increasingly lower in quality.

It's a recipe for disaster.

And they're starting to blow up...

Chicago-based Clover Technologies is a company that refurbishes electronics. And until last week, everything appeared to be running smoothly... On that note, its $693 million leveraged loan traded at around $970.

But then, on July 9, Clover dropped a bombshell... It announced the loss of two important customers (one of which was wireless telecom AT&T, according to the Wall Street Journal). It has also hired Jones Day, a law firm known for helping creditors of struggling companies.

Since July 9, Clover's loan has lost about one-third of its value, according to Bloomberg – with most of the losses occurring within hours on that first day. Take a look at this chart...

The Clover loan is typical of the era we're in today...

San Francisco-based private-equity firm Golden Gate Capital bought Clover in 2010. Then it did what all private-equity firms do... It borrowed a bunch of money to pay itself.

A report from credit-ratings agency Moody's indicates Golden Gate took at least $278 million in dividend payments out of Clover – all funded by new debt. It also borrowed $100 million for an acquisition in 2014.

The Clover loan is "covenant lite." That means it contains fewer protections for investors. And as Stansberry's Credit Opportunities editor Mike DiBiase noted in the April 30 Digest...

The number of covenant-lite leveraged loans has soared... Today, more than 85% of leveraged loans are considered covenant-lite, up from just 17% in 2007.

Former Federal Reserve Chair Janet Yellen sounded the alarm on leveraged loans last October. She's worried about "the systemic risk associated with these loans."

A typical loan or bond covenant would require the company to perform quarterly stress tests and inform investors of signs of weakness. But the way things are nowadays with covenant-lite loans surging, Clover's investors didn't know anything until the announcement on July 9.

Clover isn't the only sign of trouble, though. Investors are starting to get nervous...

On July 8 – the day before the Clover loan plummeted – credit-ratings agency Standard & Poor's announced that retail investors had withdrawn capital from leveraged-loan exchange-traded funds ("ETFs") and other funds for a 33rd straight week.

That's the longest streak of outflows for these ETFs since the data had been followed starting in 2007. Investors withdrew a total of $31.8 billion... nearly double the previous streak, which saw $17.6 billion flow out of leveraged loans starting in July 2015.

Of course, that's just a drop in the bucket for the $1.6 trillion market. And default rates on leveraged loans remain stubbornly low – at around 1.2% as of last month.

However, it's clear that investors should tread lightly with leveraged loans. The Clover loan is the perfect example.

But today, even allegedly safe debts have become toxic waste...

I'm talking about the sovereign bonds of some of the world's most trusted debt issuers – countries like Switzerland, France, Japan, and Germany.

As Justin explained last week, we just set a shocking new record in June with $13 trillion in negative-yielding corporate and government debt worldwide. The total amount of negative-yielding debt has doubled since December. And it now represents about 25% of global outstanding debt.

Remember... negative yield means if you hold the bonds to maturity from their current prices, your total return (the principal plus interest payments) will be less than what you paid. It's a guarantee that you'll lose money holding these debt instruments to maturity.

Half of all European bonds have negative yields today... 85% of Germany's sovereign debt issues are negative-yielding, according to the Washington Post... And with the exception of Switzerland's 50-year bonds, all outstanding debt from the country is negative-yielding.

These central banks pushed interest rates into negative territory on purpose. They thought they were penalizing bankers for parking money instead of putting it to work in the real economy.

Bankers might not have souls, but they do have brains...

They know if you're pushing rates into negative territory, the real economy must be a lot weaker than you're letting on. So negative rates are still with us.

Lots of folks buy this stuff because they have no other choice. For example, maybe they're running a bond-index fund and they have to buy whatever is in the index – negative-yielding or not. Or maybe they have capital rules that dictate the number of certain types of instruments they're allowed to own.

So far, the only major sovereign issuer with no debt in negative territory is the U.S., with about $16 trillion outstanding. But with the Federal Reserve seriously discussing negative interest rates for the first time, I wonder how long that will last.

Beyond that, some euro-based high-yield – or 'junk' – debt even has negative yields today...

No kidding.

The Wall Street Journal issued an "oxymoron alert" about it earlier this week... Fourteen companies' outstanding junk bonds are trading at negative yields in Europe.

This is the stuff you buy when you're willing to take on more risk for more yield. You don't buy junk bonds if you're going to have to pay for the "privilege" of owning them. The No. 1 reason that investors buy these bonds – like any risk asset – is to make more money.

I can almost wrap my head around the extreme levels of groupthink that resulted in the buying and holding of negative-yielding sovereign debt. But junk debt?! That's deep in territory that even George Orwell might not recognize.

I have no idea how this will all end, but I don't see how it can be good.

Negative yields mean extremely high prices, since bond prices move opposite bond yields. Yields fall when investors bid prices up. It's a sign of a frenzy in the bond market.

But this frenzy started with the world's central banks... It's not a result of investors' fears of missing out on a big return, like with a popular initial public offering ("IPO").

No, this is "Franken-money." It's negative-yielding by design. Of course, the folks who designed it all think everything will go swimmingly... Christine Lagarde, the head of the wonky, weird, wacky, and totally unnecessary International Monetary Fund, recently said – in public, with a straight face – that negative-yielding debt was a "net positive."

Of course, she hedged it all in cautionary language like, "we're on alert, not alarm," and that potential "side effects warrant vigilance," but we all know that's baloney...

It is Lagarde's way of saying she doesn't have any idea how this will all turn out, either. But later on, at least she'll be able to say: "Hey, remember, I said that thing about vigilance and side effects, so I'm off the hook here."

The unfortunate truth is that this has happened before...

By the early 2000s, it was well-established that the 30-year mortgage was the crown jewel of U.S. investments. It yielded a bit more than U.S. Treasurys, but it was backed by the nation's enviable housing stock – which had never lost its value going back longer than any living person could remember.

Then Wall Street economists, salesmen, traders, and other criminals got together, and sliced and diced it all into leveraged instruments called "collateralized debt obligations" (CDOs). By doing that, these supposedly smart folks turned the 30-year mortgage into toxic waste.

That's how it goes, doesn't it? It's not the risky stuff you need to worry about...

For example, everybody knows cattle futures and junior mining stocks are risky. That's why investor demand for them is always pretty low... Few people are interested in taking those kinds of risks.

It's the allegedly safe, "can't lose" investments that you need to watch out for.

Sure, most times sovereign debt is really as safe as advertised. But now, some of it has turned into toxic waste... It's guaranteed to lose you money if you hold it to maturity. And it could wind up losing you a ton of money if things don't go as swimmingly well in the global economy as they'll need to for investors not to get destroyed owning this stuff.

And what can you expect investors to do when debt – the safest part of the capital structure – is yielding little or nothing like it is today?

They'll buy more of the riskiest part of the capital structure – stocks... The benchmark S&P 500 Index recently soared past 3,000 for the first time in history.

According to economist and money manager John Hussman, the S&P 500 is at levels not seen since the top in 1929. It's more expensive even than the peak of the dot-com bubble in 2000.

Hussman adjusts earnings to account for the cyclical nature of profit margins, so that makes stocks look more expensive. But with "easy money" flowing at little or negative yield all over the world – and with corporate profit margins consistently bumping against all-time highs – maybe he's not so crazy to think that way.

And after all, money manager Jeremy Grantham calls profit margins, "the most dependably mean-reverting [data] series in finance." So it makes sense to adjust data for extreme craziness... except that extreme craziness can go on for a lot longer than anyone ever guessed.

So what can you do about all this 'froth' in the debt and equity markets today?

Hussman's "Exit Rule for Bubbles" is simply to "panic before everyone else does."

He likens it to the advice of firefighters, who note that your best chance of surviving a fire is to get out early... essentially to panic before the fire gets out of control.

Heading for the exits – selling stocks – is an extreme measure. It's tantamount to calling a top, which I promise you is so hard to do that it's effectively impossible.

I don't think you need to do that at all... If you're a sane, rational, long-term investor, you'll buy the stocks of good and great businesses at reasonable prices when you find them.

You don't need to call tops and bottoms.

You'll naturally find yourself holding more cash near tops and deploying it near bottoms. You'll buy gold when yields shrink to nothing... or worse. You'll just behave like a rational investor, and you'll avoid the catastrophic losses so many folks experience in tough times.

One sane rational investor I've heard about recently is Rob Lamoureaux...

He's a Stansberry Alliance member who retired at age 52 thanks in part to the money he made investing in high-yield bonds – the type of research my colleagues do in Stansberry's Credit Opportunities.

Every month, the editors in charge of Stansberry's Credit Opportunities –Mike DiBiase and Bill McGilton – crunch a mountain of numbers. They're looking for mispriced bonds – "outliers," as they call them – that are priced much lower than you'd expect given the level of safety that they offer.

As longtime Digest readers know, Porter has been begging folks to use this approach for years. He knows you can do a lot better investing with these outliers than you can with most stocks.

But it has been really difficult to sell people on this idea... Most folks just simply aren't familiar with corporate bonds. They've never bought one, and they don't understand how the whole process works.

The good news is... it isn't that hard.

In fact, on the latest episode of my Stansberry Investor Hour podcast, Rob told me he's not very sophisticated when it comes to investing. But he echoed what Porter has said for years... Anybody can do it.

To prove that, we recently handed the microphone over to Rob to tell his story. He revealed exactly how this strategy helped him retire. But that isn't all...

As part of the deal with Rob, we've agreed to do something we've never done before. Get all the details right here.

New 52-week highs (as of 7/15/19): American Express (AXP), First Trust Nasdaq Cybersecurity Fund (CIBR), Dollar General (DG), Disney (DIS), VanEck Vectors JPMorgan Emerging Markets Local Currency Bond Fund (EMLC), Home Depot (HD), Invesco Value Municipal Income Trust (IIM), Kirkland Lake Gold (KL), Coca-Cola (KO), Legg Mason (LM), McDonald's (MCD), MarketAxess (MKTX), Motorola Solutions (MSI), Procter & Gamble (PG), Royal Gold (RGLD), ProShares Ultra Technology Fund (ROM), Starbucks (SBUX), ProShares Ultra S&P 500 Fund (SSO), Travelers (TRV), Under Armour (UAA), Vanguard S&P 500 Fund (VOO), Walmart (WMT), and W.R. Berkley (WRB).

A relatively quiet mailbag today... One reader writes in with feedback on yesterday's Digest from Extreme Value analyst Mike Barrett about millennials and "ESG" investing. E-mail your thoughts, comments, and questions to feedback@stansberryresearch.com.

"Great Digest. Who needs traditional media when you guys continually produce this sort of high-quality analysis and thinking. Keep up the great work. I aim to always read the daily Stansberry Digest." – Paid-up subscriber John E.

Good investing,

Dan Ferris
Vancouver, Washington
July 16, 2019