The Next Credit Crisis Is Right Around the Corner

A giant house of cards... Who holds the key to keep it from falling... The credit bubble's biggest enemy... The next credit crisis is right around the corner... Make money from 'fear'... Another huge win for Stansberry's Credit Opportunities...

The economic skies look bright today...

Some form of a U.S.-China trade deal is likely... The Federal Reserve has been busy cutting interest rates, and there are no obvious signs of a recession... Corporate earnings were surprisingly strong last quarter... And the benchmark S&P 500 is up 25% this year and has been hitting new highs.

You might be thinking... What, me worry?

I'm here today to say that you should be worried. I (Mike DiBiase) hate to be the bearer of bad news, but my job is to tell you what I'm seeing. That's what I'd want you to do if our roles were reversed.

In today's Digest, I'm going to share some alarming numbers and charts. And I'll tell you who holds the key to keeping this grand bull market going.

If you want to know where the stock market is headed, it's wise to pay attention to the credit markets...

Problems often appear in the credit markets before the stock market. And as Porter likes to say, problems in the credit markets are contagious. Their problems spread to all parts of the economy.

In this case, I'm talking about the corporate bond market... where the debt of corporate America is traded.

Regular Digest readers know that $10 trillion in corporate debt is at an all-time high...

It's a high both nominally and as a percentage of gross domestic product ("GDP"). In a Digest earlier this year, I warned that the next bear market will be triggered when the corporate credit bubble pops.

It's a matter of when, not if...

If I could share only one chart that shows the inevitability of the corporate-credit bubble popping, it's this one...

The chart shows how many U.S. companies can't pay their debt (the high-yield default rate) versus total corporate debt. Total debt is measured against U.S. GDP. The shaded areas show bear markets...

As you can see, the default rate (black line) normally rises and falls with levels of corporate debt (blue line), only on a slight lag.

That makes sense. As debt levels balloon, interest costs rise and many companies struggle to repay their loans. The most leveraged companies begin to default.

First debt rises, then the default rate rises. Notice that during credit crises, the default rate spikes higher than 10% and triggers recessions and bear markets (shaded areas).

But that normal relationship has broken down following the last financial crisis.

Corporate debt has ballooned to all-time highs. But the default rate hasn't followed it higher. It's still near historic lows. Except for a brief spike back in 2016 when oil and gas prices cratered, it's held steady in the 1.5% to 3% range. Today it's at 2.4%.

The Fed's fingerprints are all over today's credit bubble...

The central bank's easy-money policies forced interest rates lower. Companies borrowed like never before. Their balance sheets are now bloated with debt. Ultra-low interest rates have kept defaults at bay.

But this disconnect simply can't last. All the Fed has done is delay the day of reckoning for corporate America.

There's only two ways this can end. Corporate debt must fall, or defaults must rise.

If you think companies will be able to pay down their debt on their own, you're sadly mistaken. Except for a few tech giants, corporate America doesn't have the cash to pay down its debt. The only logical way this can end is with defaults rising... And that won't be a happy ending.

In other words, the U.S. corporate-debt market is a giant house of cards...

The debt's credit quality is the lowest it's ever been. Many "zombie" companies – which I first wrote about in April – can barely afford their interest. They're being kept alive by lenders willing to refinance their debt as it comes due.

These zombies can only pay off maturing debt by borrowing more. They're completely dependent on the credit market. The willingness of lenders to extend credit to dubious borrowers is the only thing keeping this bubble from popping.

The credit bubble's biggest enemy is fear...

It's important to understand that fear can take hold of the markets incredibly fast. Fear causes investors to sell without asking questions. Fear causes banks to tighten credit – a process that I'll get into below – and it causes the credit market to dry up.

Fear can bring the entire "house of cards" down.

We saw a brief glimpse of what can happen last December. Investors worried that the Fed was raising interest rates too fast. Fear suddenly gripped the credit markets. Lenders started tightening credit. Not a single high-yield bond was issued that month.

Including investment-grade bonds, the number of new bonds issued was 92% lower than average.

The Fed saw what was happening and acted quickly. It quelled the fear by reversing its interest rate policy. Instead of hiking rates, it began lowering them. Since then, it has lowered rates three times from 2.5% to 1.75%.

It worked. As a result, corporate bonds have been ripping. Investment-grade bonds – the highest-quality corporate bonds as measured by the iShares iBoxx Investment Grade Corporate Bond Fund (LQD) – are up 17% this year. Even lower-quality high-yield or "junk" bonds are up 13%, as measured by the SPDR Bloomberg Barclays High Yield Bond Fund (JNK).

Sure, defaults are low today. But don't be fooled.

The best way to see where the default rate is headed is by looking at the number of credit downgrades. Companies' credit ratings are downgraded before they default. So the number of downgrades is a good leading indicator of the health of the credit market.

And this metric is telling us that trouble is right around the corner.

Credit downgrades are on the rise...

So far this year, credit ratings agency Standard & Poor's ("S&P") has downgraded 875 North American companies. That's on pace for the most since 2009. It's nearly double the number of downgrades in 2007 leading up to the last financial crisis. We estimate there will be 1,100 downgrades by the end of the year. Take a look...

In 2016, most of the downgrades were in the oil and gas sector. This time, it's spread much more among all industries.

But it's not just the rising number of downgrades that's a concern.

Banks are tightening credit once again...

That means they are demanding higher interest payments, greater credit protection, or worse, cutting off some companies' credit completely.

Banks are the key to keeping the house of cards from falling. They are the foundation of most companies' capital structure. They get paid first if a company goes bankrupt. And their loans are secured by company assets. So they don't have to worry as much about enormous credit losses when a company defaults. They recover far more of their investments than most debt investors.

When banks tighten credit, they are protecting themselves. Everyone else suffers.

If a bank will no longer lend money to a company, no one else will.

The best way to gauge the level of fear about the credit conditions in our economy is to look at banks' lending standards. Every quarter, the Fed surveys U.S banks and asks how their credit standards have changed over the last three months. The central bank wants to know if they've tightened standards or have eased them, or if they've stayed the same.

All of this can be boiled down into a single number... the difference between the percentage of banks tightening credit and the percentage easing credit. If the percentage of banks tightening is higher than the percentage easing, the net score is positive. If the number of banks easing is greater, the score is negative.

In the latest survey for the third quarter, the score was 5%. That means banks are tightening once again. Banks started tightening in the fourth quarter of last year, but when the Fed started cutting rates this year as opposed to raising them last year, banks began easing credit.

But not any longer.

The latest Fed survey shows that despite the interest rate cuts, banks are worried again. That spells trouble. If banks are tightening when the Fed is dovish and lowering interest rates, that's a bad sign. When banks tighten, defaults rise. And when defaults rise, stocks fall.

The chart below shows banks' lending standards over the last 20 years as well as the default rate. Again, the shaded areas are bear markets...

You can see that when banks begin tightening – when the black line rises above 0% – bear markets often follow. That's why it's important to keep a close eye on this trend.

We're already seeing rising defaults. The number of high-yield defaults is up 66% this year. There have been 58 so far in 2019 compared to only 35 defaults last year.

If this trend of tighter lending standards by banks continues, it will likely cause the corporate-credit bubble to pop.

I expect the trend to continue. There's a new tailwind that will force banks to keep tightening credit. And it's something that few people are talking about...

Banks will soon be forced to record much higher credit losses than before...

A new accounting rule is about to go into effect that will radically change the way banks account for loan losses.

Under the accounting rules in effect today, banks only record credit losses when it looks likely that loans will go bad. But starting next year, banks will have to record all expected future credit losses on their loans at the time they are made. They won't be able to wait for loans to go bad.

This is a big deal.

It will mean many banks have to significantly increase their loan loss reserves, starting next year.

One major accounting firm called it "the biggest change to bank accounting – ever."

The new rule will cause banks to tighten credit on the least creditworthy companies... those in the most need of credit lifelines. Many companies will be hung out to dry.

The ironic part of all of this is that the new accounting standard was born from lessons learned during the last financial crisis. It's likely to be responsible for ushering in the next one.

Here's what's important to remember... You can use fear to profit...

You don't have to fear the next credit market crash. You can actually look forward to it because you can earn huge safe profits from it by investing in distressed debt.

When bond investors flee, they throw the babies out with the bathwater.

That's when you can buy safe corporate bonds for pennies on the dollar and earn huge returns. That's the strategy my colleague Bill McGilton and I use in Stansberry's Credit Opportunities, our distressed corporate bond newsletter...

In fact, you don't even have to wait for the next credit crisis.

We already sift through thousands of bonds each month and find the "babies" that have been thrown out. We closed out another huge winner on November 15...

Earlier this year, bond investors were convinced department store JC Penney (JCP) was headed for bankruptcy. Its cash earnings have been cut in half over the past few years, and eight of its bonds began trading at large discounts.

We think JC Penney is headed for bankruptcy, too... just not for another few years. The company can still easily pay all of its interest. And it still had access to borrow another $1.4 billion from its banks.

As we wrote to our subscribers...

We can't envision a scenario where JC Penney doesn't go belly-up. But that doesn't mean none of the company's bonds will be paid on time and in full...

So we recommended a small JC Penney bond due in less than a year with only $100 million outstanding. It was yielding 30% at the time... more than a $500 million bond due in 2097.

That's not a typo... A small bond due next year was yielding more than a large bond due in 78 years! That made no sense.

The bond market finally came to its senses a few months later after seeing improved quarterly numbers, and the bond due next year began trading much higher.

"It looks like we woke up the bond market," we wrote to subscribers in an update.

We sold the bond early and booked a 54% annualized return.

If you're interested in learning more about buying corporate bonds, you're in luck...

For this week only, we've brought back our most popular offer of 2019 to join Stansberry's Credit Opportunities advisory...

In short, there's no better time to become a subscriber. Not only will you get access to this unique brand of investing – and learn how to profit from fear – but you can also grab a $1,200 "holiday bonus" absolutely free.

Click here right now to get all the details before the offer closes on Friday.

New 52-week highs (as of 11/29/19): Blackstone Mortgage Trust (BXMT), Intuitive Surgical (ISRG), Pan American Silver (PAAS), ALPS Medical Breakthroughs Fund (SBIO), Silvercorp Metals (SVM), and Wells Fargo (WFC).

A quiet mailbag today. What's on your mind? As always, send your comments and questions to feedback@stansberryresearch.com.

Good investing,

Mike DiBiase
Atlanta, Georgia
December 2, 2019