Recognizing and Avoiding Ominous Formations
The greatest danger I have faced in the mountains followed the willful disregard of a warning. Our Designer equipped us with a keen ability to perceive danger, most notably through fear, a healthy human attribute respect by the wise. The challenge with investing is fear instigates a herd mentality in a counterintuitive market, the most capital-destructive combination possible. Many notable investors, Warren Buffet included, profess the avoidance of catastrophic risk is the single most important aspect of successful investing. Let’s practice Mr. Buffet’s advice by recognizing and avoiding one of the biggest dangers in the market today.
In the 2010’s, following the Fed’s prolonged suppression of interest rates near zero percent, the risk/reward formation for Treasury Bonds was accurately described on Wall Street as “return-free risk”. A 10Year Treasury bond purchased at that time virtually guaranteed a loss of value against inflation for a decade, and was yet exposed to a large potential loss of principle should interest rates rise, which they did. The regional banks which failed in 2022 did so because they bought too many 10Year Treasury bonds. Consider the factors which might make today’s setup for High Yield corporate (‘Junk’) bonds even more dangerous:
‘Junk’ bonds are issued by companies with low credit ratings and the highest probability of debt default and are the riskiest bond type.
The spread between the higher interest rate ‘Junk’ bonds must pay investors to compensate for default risk and the lower interest rate government bonds enjoy paying is just 3.26%, the lowest spread since Fed rate hikes began two years ago.¹
An unprecedented wall of maturing corporate debt must be refinanced in the next three years at a far higher interest rate. Forensic accountant, Joel Litman, recently estimated 30% of these companies do not possess the earnings to support their debt at present rates.
There’s a fair probability of recession in the next three years, which would cause the credit market to tighten, which would cause yields on ‘Junk’ bonds to rise, which would cause the value of existing ‘Junk’ bonds to fall, potentially a lot.²
The worst performing phase of the ‘Junk’ bond market cycle is the tight credit market recession, which might lie dead ahead. In spite of this risk, the yield on ‘Junk’ bonds, presently 5.78%,³ is insultingly low, which suggests that those who own them are misjudging risk. Why would an investor risk being stampeded in a mass exodus for less than 1% additional interest than a risk-free Treasury Bill? Let’s heed the warning ‘Junk’ bond owners are sending us, be happy with 5% risk-free interest, and reconsider an investment in ‘Junk’ bonds when they are on sale at a later date. Let’s also recognize a large discount may be forthcoming, and keep this asset class on our financial radar.
Think about it, Shaun.
“The prudent sees danger and hides himself, but the simple go on and suffer for it.” ~Proverbs 27:12
1 As measured by ICE Bank of America U.S. High Yield Index Option-Adjusted Spread 2 Daily Wealth, “The Worst Deal in All of Finance”, by Brett Eversole, February 29, 2024 3 Yahoo Finance, HYG Yield, March 8, 2024 https://finance.yahoo.com/quote/HYG
The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
The opinions expressed in this material do not necessarily reflect the views of LPL Financial.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.
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