A bad sign for the bond market... How Porter knew this was coming... More signs of 'contagion'... What you should know about the Volkswagen scandal... More bad news for oil companies... The most important thing to remember...
The corporate bond market is starting to flash "caution signals," according to the Wall Street Journal.
In an article this morning, the Journal noted that the "spread" – or the difference in interest rates – between U.S. Treasurys and bonds of America's strongest companies has been shooting higher. This trend has foreshadowed serious economic problems in the past.
According to the article, the spreads in investment-grade corporate bonds – bonds from companies rated "BBB-" or higher – are on pace to move higher for the second year in a row. This would be the first time that spreads moved higher for two straight years since the financial crisis in 2007-2008. The last time before that was 1997-1998, during the Asian financial crisis.
The article also noted that spreads in the high-yield (or "junk") bond market are even more concerning. More from the article (bold emphasis is our own)...
Spreads in the junk-bond market – which are viewed as even more sensitive to broader economic conditions because firms rated below investment-grade carry more debt and have less cushion to withstand a downturn – started moving more sharply higher in 2014 as oil prices collapsed, from 3.82 percentage points at the end of 2013 to 5.88 percentage points as of Thursday.
As investors grow more skittish, companies looking to sell new debt are being forced to pay up. Altice NV on Friday reduced the size of a junk-bond deal backing its purchase of Cablevision Systems Corp. from $6.3 billion to $4.8 billion and paid higher yields than initially expected, according to S&P Capital IQ LCD. The company also increased the size of a term loan to help finance the $10 billion acquisition.
"Clearly, the fact that spreads have been widening since the middle of 2014 is a very worrisome trend," said Krishna Memani, chief investment officer at OppenheimerFunds, which oversees some $220 billion. "We continue to scratch our heads as to the driver of that."
Fortunately, regular Digest readers aren't scratching their heads...
Porter has been warning about the corporate bond market – and junk bonds in particular – for more than two years. As he noted in the May 10, 2013 Digest...
Now... let me give you another "outlandish" prediction. The U.S. bond market – particularly junk bonds – is going to crash. When this crash occurs, it will be the largest destruction of wealth in history. There has never been a bigger bubble in U.S. bonds.
How do I know? It's simple. Junk bonds (aka high-yield bonds issued by less creditworthy companies) have never yielded less than 5% annually. But they do today. Likewise, the difference between the yields on junk bonds and the yields on investment-grade bonds has almost never been smaller. That means credit is more available today than almost ever before for small, less-than-investment-grade firms. The last time credit was this widely available – and at such low costs – was in 2007. And you know how that turned out...
The coming collapse in the bond market will be far worse than it was last time, too. This time, the Federal Reserve's actions have driven forward the huge bull market in bonds. The Fed is printing up almost $100 billion per month and buying bonds. That has forced the other buyers of bonds to buy riskier debt that, historically, offered much higher yields.
Today, those yields have been incredibly "compressed." You can imagine the high-yield segment of the bond market to be like a spring whose coils have been driven together by the force of the Federal Reserve's market manipulation. As soon as the Fed's buying stops, the yields on those riskier bonds will soar again. As bond yields rise, the price of bonds will fall sharply.
Of course, we know now that this is exactly what happened. Porter shared his latest thoughts on the situation in last Friday's Digest...
We are approaching a period of vast credit default. Credit-market troubles are different than equity market troubles. Credit-market troubles are "contagious" and are amplified by leverage. Companies funded with equity go bankrupt and nobody notices. But when companies (or countries) funded with huge amounts of debt go bankrupt, it triggers a chain reaction. Institutions that would otherwise be sound can end up in default because they've invested in toxic debt.
That's what's about to happen all around the world. Far, far, far too much money – mind-boggling amounts – has been borrowed by people and countries that are not creditworthy. These debts are going bad. The chain reaction is starting. And nobody knows exactly what will happen next because the world has never seen so much bad debt before. This will be the greatest legal transfer of wealth in history.
He also reminded readers how to "track" this coming crisis in real time as it develops...
How will you know if this dark view of the world is correct? Just keep your eye on the exchange-traded funds (ETFs) that hold vast quantities of speculative debt.
For example, I track the iShares iBoxx High Yield Corporate Bond Fund (HYG) every day. I've been warning you about it since May 2013. Since then, it has fallen from $95 to less than $85... And it just made a new low.
As long as this downtrend remains in place, you can know for certain that I'm 100% right.
HYG shares declined again today. Shares were down more than 1.5% as of midday trading, and are trading at levels not seen since Thanksgiving 2011...
And there are reasons to believe they could be headed even lower soon...
As Porter noted in the September 11 Digest, ratings agency Standard & Poor's recently downgraded Brazil's country rating from investment grade to "junk." This downgrade also pushed all of the country's corporate bonds to junk status, too, including the bonds of giant state-owned oil company Petrobras.
But emerging markets aren't the only concern today...
Porter has also explained how credit "stress" in subprime lending – specifically auto loans and college student loans – and the oil and gas sector are driving the turmoil in the markets today. And the news here could be getting worse, too...
You likely saw the headlines about German automaker Volkswagen's "emissions scandal" last week. In short, the company allegedly misled regulators, consumers, and investors about its so-called "clean diesel" engines.
Reports say the company intentionally installed software to fool emissions tests by the U.S. Environmental Protection Agency ("EPA"), and that its cars' emissions actually contain levels of pollutants that were up to 40 times higher than allowed by law.
If you aren't a Volkswagen shareholder – or don't own one of their diesel cars – you likely weren't too concerned about the news. But the scandal has now put Volkswagen's current "A" credit rating in question.
According to multiple reports last week, all three "big" credit ratings agencies – Standard & Poor's, Moody's Investors Service, and Fitch Ratings – have warned a downgrade could be coming. Moody's, in particular, noted that while the company currently has plenty of cash to cover the initial costs of a recall – estimated at $7.3 billion – it could face criminal charges... and the scandal could have a severe, long-term effect on the company's reputation and sales. And it appears the market agrees...
According to financial-news website Bloomberg, the "stress" could be starting to spread across Europe's credit markets. The article notes that the Bank of France stopped trading two securities backed by Volkswagen auto loans on Friday.
Porter and the Stansberry's Investment Advisory team explained what these "asset-backed securities" ("ABS") are – and why they're so important – in the September issue...
The other major enabling factor in this boom was the creation of specialized securities, called subprime auto asset-backed securities – or subprime auto ABSs, for short. There are now more than $20 billion worth of subprime auto ABSs.
These securities package together thousands of subprime loans, worth hundreds of millions of dollars – in some cases, more than a billion dollars. Grouping large numbers of loans together and adding significant amounts of "credit protection" – extra cash put into escrow to cover any potential credit losses – gives conservative investors a safe way to own subprime auto loans. Despite the risks of individual loans going into default, not a single subprime auto ABS defaulted during the last credit crisis.
These kinds of securities organize the loans they hold into categories – or "tranches" – based on risk. Because their recent history is free of default... the upper tranches of these securities, which have large amounts of credit protection, are considered even safer than triple A. Banks and other financial institutions can invest in these securities while holding almost no reserves for losses. So these investments are almost surely highly leveraged. And that means any losses to subprime auto ABSs could pose a serious threat to the financial system, despite the relatively small ($20 billion) issuance.
Bloomberg reports that Volkswagen's financing arm – Volkswagen Financial Services – has €22.8 billion ($25 billion) of outstanding asset-backed debt.
The primary risk with subprime ABS is that the individual loans were made to borrowers with bad credit... so many of them are likely to default. And only a fraction of Volkswagen's loans are likely subprime. But here we see another risk...
In this case, the recent scandal puts the value of the underlying assets for those loans – the actual cars – in question. How much is a diesel car that can't legally be driven in the U.S. or Europe worth?
In related news, a new report suggests next month could be a bad one for many oil and gas companies...
Twice a year, the banks that lend to oil companies do a "redetermination," that decides how much each company can borrow.
According to energy law firm Haynes and Boone, nearly 80% of companies could see a reduction in the October redetermination period. The firm says company credit lines could be cut by an average of 39%. From the report...
"What really stood out to us was the contrast between the results of the spring and fall survey," said Houston Partner Jeff Nichols. "In the spring, it looked like the response was a 'wait and see' mentality. But with fall approaching, the 'wait and see' mentality seems to have passed and there is recognition that more action needs to be taken to reduce debt through equity investment, restructuring, or even declaring bankruptcy."
In other words, a significant wave of oil-sector defaults could be just around the corner.
The "bottom line" is that more turmoil is likely... If you're not prepared, you could get wiped out.
But if you are prepared – which includes holding plenty of cash (including short-term U.S. Treasurys) and gold, and taking advantage of the appropriate strategies – there's no reason to be afraid. As Porter reminded readers on Friday...
The world isn't coming to an end. All that's going to change is that these assets are going to shift from the leveraged and foolish to the wise and patient.
The next two or three years are going to be terrible for most investors. But they can be GREAT for you.
New 52-week highs (as of 9/25/15): Activision Blizzard (ATVI).
Loads of reader feedback came in over the weekend – most of it positive – responding to Porter's Friday Digest. If you haven't done so already, let us know what you think at feedback@stansberryresearch.com.
"Porter, I loved Friday's bad news Digest. You explained in simple terms what's happening in today's over-leveraged, debt driven, global and American economy. Thank you! I'm going to be sitting on cash waiting for your advice on the next 3 years." – Paid-up subscriber Mike
"I like Stansberry Distressed. I would also like to add a short comment. Keep writing the Friday Digest exactly as you have been. Do I agree with everything you write. Hell no. Do I respect what you write? Absolutely. I am Canadian and your perspective on the world is refreshing even if I sometimes think you are drinking the Kool-Aid :-). You have been right far too often to ignore. Keep the faith." – Paid-up subscriber Mark H.
"Porter, I had to laugh when I read the Friday Digest and you related how Monday is the day you receive the most cancellations. Perhaps you should rename it Friday's 'The truth, the whole truth and nothing but the truth' Digest. Or to take liberties with a line by Jack Nicholson as the snarling Colonel Jessup in 'A Few Good Men', 'You want the truth, (but) you can't handle the truth!'
"It is understandable that some people might be uneasy after reading 'the truth', but they have to put things into perspective. We recently went through an eight day period where we didn't have any (city) water. Some people in town didn't have water for two weeks! When you are scrounging for water just to flush your toilets, you see some of things going on in the world in a different light.
"I'm sorry but I can't come up with a good name for your new service because I lack imagination. The best line that my first wife ever said about me came about when we were discussing with a contractor on how we wanted to enclose our patio. The contractor asked 'How do you see this when... ' my wife shot back, 'don't ask him, he doesn't have any imagination. His favorite color is gray. What does THAT tell you!' The contractors face froze until my wife and I both burst out laughing.
"I really enjoyed your piece about your wife and family. They are a huge part of what makes life really worth living. My wife and I have been married for 27 wonderful years and in all that time we've never had an argument. She is the best friend I've ever had in my entire life. Being with her has made every day a day of Thanksgiving." – Paid-up subscriber Kevin C.
"I just finished your latest Digest report and I have to say that I will never cancel my subscription to it. Your information always turns out the way you say it will. Yesterday Obama was saying the construction and house sales were booming but as I said about a year ago when you wrote about the lying coming out of the Oval Office and you printed my letter the next day the fact is when construction is good the lumber prices are about $400 plus per thousand board ft. and today they are $217 per thousand. I wish you would run for President and then we could get some true facts out of Washington. Thanks for the best letter in the world." – Paid-up subscriber John Scholfield
Regards,
Justin Brill
Baltimore, Maryland
September 28, 2015
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