Blindsided by the Housing Bust? Don’t Miss the Junk Bond Bubble’s

There’s a reason The Wolf continues to harp on the Junk Bond Bubble, and the Dosimeter, which lists over 100 defaults now. That’s right, I’ve capitalized it, turned it into a proper noun, hashtaged it to death and won’t stop talking about it. That’s because it’s the SINGLE MOST IMPORTANT ISSUE for this next down cycle, whenever it occurs.

To understand the Junk Bond Bubble today, is akin to understanding the absurdity of Pets.com and AOL shares in March 2000, and like knowing the absurdity of no-doc/stated income 120% LTV mortgage loans that were turned into AAA MBSs in late 2007. Today, it’s hard to believe that those valuations existed and people loaned money like that. And, after the junk bond bubble pops, people will be amazed that everyone didn’t see it coming. Remember, it’s not the asset that bankrupts, it’s the leverage; and junk bonds are leverage exactly like subprime loans were.

First a story, The Wolf will never forget staring at a news story as it crossed the wire. In December 2006 Merrill Lynch acquired First Franklin, one of the largest subprime lenders. At the time The Wolf was short a basket of subprime lenders, including Novastar and New Century Financial which would declare bankruptcy within the next couple of months. Staring at the screen, The Wolf knew, “One of us is absolutely crazy.” As it turned out, it wasn’t The Wolf.

Staring at the screen, The Wolf knew, “One of us is absolutely crazy.”

Here’s was the reality at the time:

  1. Homebuilding stocks had topped over a year ago (Summer ’05), and some were down 35-40%.
  2. Home sales had started to slow.
  3. Home prices had begun to turn down.

Because so many resources, capital and employment had flowed into the “bubble sector” of housing, there was no way the economy was going to avoid a recession once the bubble popped. But, it wasn’t obvious to the masses, Merrill Lynch, or a dancing Chuck Prince even 9-months later.

It took a while for the housing bubble to bust and morph into the Great Recession, but it happened eventually. And, if you missed the technology bust or the housing bust, don’t worry. The Wolf believes your going to see another bust that is just as large:  the bursting of the Junk Bond Bubble.

If you haven’t read our previous reports on the Junk Bond Bubble, here are the links for background:

I don’t want to revisit the same ideas, instead, what I want to show is an updated chart below of the weakest junk bond debt, the CCC’s spread versus Treasuries:

Fed Doesn't Control These Bonds
Fed Doesn’t Control These Bonds

The above chart is the long term view, for perspective. Notice that in 2009 CCC credits were basically not getting funded with the interest rate 35% above Treasuries. That was a credit crisis. Below, though is a troubling development for the massive amount of bonds that have been issued over the past five years:

Five Up & Three Down Suggest Spreads Are Headed Higher
Five Up & Three Down Suggest Spreads Are Headed Higher

What we see is that after bottoming last summer, interest rates for sketchy credit issuers has started to rise dramatically. But, it’s the form of that rally, a five wave move, that is troubling for the Junk Bond Bubble. It suggests that the trend for spreads is higher, and, we think, dramatically higher. It’ll take a push beyond the wave B top to confirm another push higher is underway, and if that happens, look out below for junk bonds. As we can see below, although the decline from last summer is overlapping, the decline is in five waves. A three wave bounce leaves our junk bond ETF (JNK) very vulnerable. In addition, there’s two head and shoulders tops visible, and prices have retested the upper of the two necklines. The patterns project into the low 30s.

Five Down, Three Up for Junk Bonds Since Last Summer
Five Down, Three Up for Junk Bonds Since Last Summer

The increase in spreads since this summer coincided with one sector of the economy that is in big trouble – energy. Based on our balance sheet work, we think we’ll see at least 10 public company bankruptcies in that sector in the coming year, if oil remains below $65/barrel (Stay tuned to the Dosimeter!). Will that be “contained?”

No, just like problems in subprime begat problems in Alt-A loans, then house prices, the stock market, employment and the economy, oil’s problems are just the tip of this cycle’s debt iceberg. A central bank can’t leave rates at 0% for six years and increase its balance sheet by $3 trillion dollars without consequences.

I know there’s plenty of money to be made shorting (and buying puts on) highly leveraged stocks (and bonds) in the next down cycle, and I’d like for our readers to avoid some mistakes I personally witnessed last cycle (Like fortunes being lost by Citigroup employees) by not heeding my advice of the coming financial crisis. It was easy to see back then, but you had to be patient for it to play out. After all, even in May 2008, the S&P 500 was only down by 11% from its all-time high. It may play out in slow motion this time too, but it might be quicker. Get long term positions defensive now.

We encourage you to share this piece with your friends, especially those invested in “high yield” bonds, and use the #JunkBondBubble for any bond payment defaults, or news stories, we might have missed.

Happy Trading!

The Wolf

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.

About The Wolf

Twenty years is a long time to be involved in the trading business. Through many battles in every asset class known to man, knowledge has been gained; and, this project is a way to share that knowledge.
The Wolf is a big fan of repeatable market work, or the creation of a “process.”

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