“The bond bubble is going to pop. But the bond bubble I’m talking about is in junk bonds, not Treasury bonds.” -The Wolf
Today brought an absolute shocker to the mainstream news media. GT Advanced Technologies, a component supplier to Apple (and junk bond issuer), filed for bankruptcy protection. On Friday, the stock closed with a $1.4 billion market capitalization, and that has now vanished. Investors in highly indebted companies better get used to this, though, because GT’s bankruptcy is just the tip of the iceberg if our call for junk bonds is correct (see JNK chart).
Sidebar: Chart Review
Five waves down in 2007-2009 are visible, and the bounce from the ’09 low looks like a corrective (A)(B)(C). This count is valid as long as prices remain below Critical Resistance at $41.45. Even a break of that level wouldn’t change the idea that the larger trend was down, but just that wave 2 was still ongoing, or that a leading diagonal was forming to the downside.
Junk Bond Bubble
First, some background. The Federal Reserve sets monetary policy for the country through its influence over banks partly via open market operations. When it wants the economy to “grow,” it buys Treasuries with money it creates out of thin air, hence lowering interest rates. In the mind of the ivory tower PhD’s at the Fed, lower interest rates lead to “growth” which allows cash to flow freely in the economy. And, flow freely it has.
The Fed has repeatedly lowered rates in an effort to spark growth, and in the process, it has been culpable in creating three recent bubbles. First, the Fed lowered rates after the Russian default and subsequent Long Term Capital Management/Wall Street bailout in 1998. This led to an oversupply of capital which flowed into a bubble in technology stocks in 1998-2000. Next, after September 11, 2001, the Fed lowered the Fed Funds rate all the way down to 1% in 2002, where it left them for a year. This, in part, spawned the housing bubble, as the Fed was never able to get rates up quick enough to stem the massive oversupply of capital it helped create. So, what’s the third bubble?
The Federal Reserve has left the overnight lending rate at 0% for so long now (almost six years), that many unviable businesses have borrowed themselves into oblivion – GT is the first major case in point. But, it isn’t alone. The Fed’s reckless monetary experiment has not only taken money out of the pockets of elderly savers (due to low rates on savings accounts and CDs), but it has fostered a third bubble – this time in junk bonds.
By keeping rates at unattractive levels, the Fed has provoked investors to take more risk. An investor unhappy with rates in a savings account moves to CDs to get more income. Short-term CD buyers have moved to longer dated CDs. Longer dated CD buyers now buy Treasuries. And former Treasury buyers buy junk bonds – oh, wait, excuse me – “high yield bonds.” This entire risk taking mechanism has happened because investors are attempting to replace the lost income that the Fed removed when it took rates to 0% in 2008. Prior to 2008, one could simply invest in a money market with a 4% yield – imagine that.
So, back to GT, and why junk bonds are in a bubble that’s going to pop. So many investors were tired of low rates, that massive inflows have been seen into junk bond funds. These inflows have allowed junk bond managers to fund companies like GT Advanced Technologies, who raised $205 million in September 2012 (through 3% 5-year bonds via UBS, BofAML and CS) and another $190 million in December 2013 (through 3% 7-year bonds via MS and GS). So, the company that just declared bankruptcy, with over $1 billion in liabilities, received about $400 million in the last 24 months. Whoops!
Investors have loaded up on junk bonds, because they see them as a can’t miss opportunity. One gets close to a 6% yield from JNK, which is certainly more than Treasuries or money markets today. And, since the economy is growing again, there’s upside potential too, right? The Wolf recently met with a mutual fund manager from a very well know shop, extolling the value in junk bonds today, “because default rates are low.” My polite reply was that default rates are always low at the top of the cycle (like at the 2007 top), and defaults are high at the bottom (like at the 2009 low), and that I thought we were a bit late in the cycle. His retort was that the cycle might extend for 7 years (we’re 5.5 years into the cycle already). Might not.
But, what happens if we aren’t in a seven year cycle, and junk bonds fall by 5-10%? Are investors going to sit patiently for the long term? Or, is there going to be a stampede out of junk, which will cause prices to fall further? At that point, you can forget about funding new deals, and that withdraw of capital will cause other bond defaults.
Make no mistake, when junk bond prices fall there will be redemptions and defaults. And, when prices are back near the 2009 low, and default rates are high , that will be the time to turn bullish – not today.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.