'The Seven Worst Words in the World'
Editor's note: Nobody can predict exactly when a volcano will erupt...
But you don't need to. You just need to know it'll happen soon to avoid catastrophe.
The same can be said about the financial markets... Nobody knows the precise moment when the next bear market will begin. We just know it'll happen soon.
In this weekend's Masters Series, we're sharing a two-part essay – adapted from the November issue of Stansberry's Credit Opportunities – to help you prepare for the coming storm... no matter when it arrives. In the first half, editor Mike DiBiase discusses a warning from one of the world's best investors and takes a "surface level" look at the bond market...
'The Seven Worst Words in the World'
No one knows exactly when the next bear market will arrive...
Not even the best and most experienced investors – like Howard Marks. Even Marks admits it's impossible to predict the timing and severity of the next bear market.
Regular readers know all about Marks... He's the world's best distressed-debt investor.
In 1988, Marks started the first institutional distressed-debt fund. Today, he runs Oaktree Capital (OAK) – an alternative asset-management firm he founded in 1995... Oaktree manages nearly $120 billion for its clients, with most invested in distressed debt. After fees, Marks' distressed-debt funds have returned 16% annually for about three decades.
When Marks speaks, it's wise to listen...
Each year, he writes several memos. These memos are crammed with powerful market insights and investing wisdom. (You can find them on Oaktree's website right here.)
Marks' memo from last September – "The Seven Worst Words in the World" – is a must-read... To spoil the punchline, according to Marks, the seven worst words in the investment world today are "too much money chasing too few deals."
He's sounding an alarm about today's debt market...
Marks points out that new deals are getting done at prices that are far too high, with returns that are far too low, with weak credit protections for investors, and with loads of risk. In other words... everything favors the debtor today, not the investor. We're now a decade beyond the last financial crisis, and its lessons have been long forgotten.
Back in February 2007, Marks wrote a similar memo – "The Race to the Bottom." That memo struck a similar chord to his recent note. And it proved to be remarkably prescient...
The financial markets began collapsing later that year. In the memo, Marks described how bad money was chasing out good money... how investor euphoria and risk tolerance was replacing prudence and caution... and how loan covenants were disappearing.
In his September memo, Marks once again sounded the same alarm.
And then last October, Marks published a new book, Mastering the Market Cycle: Getting the Odds on Your Side. In it, he shares a simple message... It's impossible to predict the future, but you can greatly increase your odds of success as an investor if you understand where we are in the cycle. As he writes...
While superior investors – like everyone else – don't know exactly what the future holds, they do have an above-average understanding of future tendencies... if we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.
Marks explains that our odds of success change as our position in the cycle changes...
With that said, let's look at our position in the current cycle. Knowing where we are will help us figure out where we're headed. And in turn, it'll increase our odds of success...
Today, we'll look at three primary metrics that help us "take the temperature" of the overall bond market. We're talking about the high-yield credit "spread," defaults and downgrades, and inflows and outflows of exchange-traded funds ("ETFs") that focus on high-yield bonds.
You can think of these as surface-level measurements that help us recognize the current state of the bond market. And tomorrow, we'll go deeper... We'll show you the problems lurking beneath the surface that tell us where we're headed from here.
The high-yield credit spread is the first surface-level measurement...
It's the difference between the so-called "risk free" yield of U.S. Treasury notes and the average yield of noninvestment-grade (or "junk") corporate debt.
The U.S. government has never defaulted on a loan. So when you lend money to the government, it is considered to have no risk. The same can't be said for all corporations...
Sometimes, companies default on their bonds (when a company can't make all of its interest or principal payments on time). This possibility makes corporate bonds riskier, so they always yield more than U.S. Treasury notes.
When the credit spread is wide, it tells us that investors are concerned about defaults. They demand higher yields to compensate them for the elevated risk. When the spread is low, it means investors aren't nearly as worried about defaults.
Today, the high-yield credit spread sits at about 380 basis points ("bps")...
A basis point equals one-hundredth of 1% (0.01%). So the difference between the average yield of junk bonds and five-year U.S. Treasury notes is roughly four percentage points today. (Junk bonds yield around 6.1% now, compared with 2.3% for five-year U.S. Treasury notes.) And as you can see, it's far below the long-term average spread of about 600 bps...
Notice how cyclical the high-yield credit spread has been over the past two decades... It goes from peaks of more than 1,000 bps to lows of less than 400 bps (where it is today).
Also notice how quickly this spread has widened before... That tells us that fear can return rapidly to the market, causing corporate-bond prices to plummet and yields to spike. (Bond prices and yields are inversely related... So as bond prices fall, yields rise.)
Today, the high-yield credit spread shows that bond investors aren't worried about defaults.
We can't predict exactly when this spread will widen during this cycle. And we can't predict how far it will widen, either. But we do know with near certainty that it will widen.
Now, let's take a closer look at the second surface-level metric we like to follow... the high-yield default rate. The high-yield credit spread rises because investors expect the default rate to rise.
And when the number of companies defaulting begins to rise, once-complacent investors panic. It's like they realize the risk of holding high-yield corporate bonds for the first time.
These investors look to unload their riskiest positions as soon as possible and ask questions later. The selling pressure pushes down prices of high-yield bonds. And in turn, it causes the yields on these bonds to surge. That's what causes the high-yield credit spread to widen.
And that's why it's critical for us to monitor the U.S. high-yield default rate...
Like the high-yield credit spread, the U.S. high-yield default rate sits near a historic low. The trailing-12-month default rate was 2.42% in 2018, according to credit-ratings agency Standard & Poor's (S&P). It has steadily decreased since 2016.
At the end of 2016, the trailing-12-month default rate stood at 5.1% – more than double its current level. Back then, it was much higher because of a rise in bankruptcies across the oil and gas sector. But as oil prices recovered, the high-yield default rate dropped.
S&P only expects the default rate to increase to 3.1% by the end of this year. That's why investors aren't worried... And in turn, it's why the high-yield credit spread is so low.
Now, take a look at the following chart... It shows the high-yield credit spread since 2000 (black line) along with the high-yield default rate across the same period (blue line)...
Notice the similar shape of the two lines...
These two metrics are highly correlated. But you can also see they're on a lag... Recently, the credit spread has widened about 10 months before the default rate. That tells us the bond market isn't dumb. Bond investors spot trouble long before the default rate spikes.
You see, companies don't typically default on their debt overnight...
Bond investors can typically see a lot of warning signs along the way. Important credit measures like leverage ratios weaken long before a default occurs. And bond investors also look at the number of credit-ratings downgrades to forecast spikes in the default rate. That brings us to our next surface-level measurement – the number of downgrades.
In the first quarter of this year, S&P downgraded the credit of 314 North American companies (not including companies being put on a "credit watch"). That's a jump of more than 80% from the 173 companies S&P downgraded in the first quarter of 2018.
It puts us on pace for about 1,300 downgrades in 2019... far more than the 832 downgrades in 2018. Of course, we can't be sure what will happen the rest of the year. But if this pace holds, it would be the most since 2009 (which had more than 1,500 downgrades)...
The recent uptick in credit downgrades tells us that trouble in the credit market could be looming. If this trend continues, we can expect to see investors start to worry about a growing number of defaults... And the high-yield credit spread would widen further.
But for now, as we said, the high-yield default rate remains extremely low by historical measures. Remember, though, that can change rapidly... We must keep a close eye on the number of downgrades and the high-yield default rate to see when the tide begins to turn.
Next, let's look at the flow of capital into high-yield debt today... By following the money, we can gauge investor sentiment for high-yield corporate bonds.
To do that, we monitor the inflows and outflows of the two largest ETFs that focus on high-yield bonds – the iShares iBoxx High Yield Corporate Bond Fund (HYG) and the SPDR Bloomberg Barclays High Yield Bond Fund (JNK). Looking at the flows of capital into and out of these ETFs helps us figure out what retail investors think about high-yield debt...
In 2018, nearly $11 billion flowed out of HYG and JNK. Investors piled out of junk bonds in February and October last year as fear and uncertainty flooded the markets.
But so far this year, $5.8 billion has flowed back into these two ETFs. HYG has seen $3.1 billion in inflows in 2019, while $2.7 billion has flowed into JNK. You can see in the following chart that so far this year, both ETFs have recovered most of their respective values since the beginning of 2018...
That tells us retail investors simply aren't worried about rising downgrades at the moment. They're continuing to put their money into junk bonds through these ETFs.
Overall, we're getting mixed signals from our main surface-level metrics...
As we've shown you, the high-yield spread remains historically low. The high-yield credit default rate also remains near an all-time low. And retail investors are piling back into high-yield-bond ETFs.
But credit downgrades have started to increase sharply. That hints at trouble, despite the credit-ratings agencies' low default-rate forecasts through the end of this year.
Although things appear mostly calm on the surface of the bond market right now, it doesn't mean you should be complacent... Tomorrow, we're going to take a deeper look beneath the surface of the bond market. And as you'll see, a catastrophic event appears to be brewing.
Good investing,
Mike DiBiase
Editor's note: If you wait until the next crash arrives to start protecting your wealth, it will already be too late. The time to prepare is right now... That's why we're hosting the Bear Market Survival Event on Wednesday, May 15, at 8 p.m. Eastern time.
There, you'll learn why the next bear market will be the worst in our lifetimes... how to know when it's arriving... and what to do to actually grow your wealth while others are wrestling with disaster. Reserve your seat right here.