By Dan Steinhart
Individual investors take note….Some of the world’s best money managers are betting on the biggest financial disaster since 2008. You won’t hear about this from the mainstream media. Networks like NBC or CBS don’t have a clue… just like they didn’t have a clue the US housing market would collapse in 2007.
Carl Icahn, a super successful investor who’s the 31st richest person in the world, said this investment is in a bubble. He said that it’s “extremely overheated”… and that “there’s going to be a great run to the exits.” And this investment isn’t some complex derivative that only Wall Street and hedge funds can buy. Millions of investors hold it in their brokerage accounts.
The dangerous investment is junk bonds.
Junk bonds are usually issued by companies with shaky finances. They pay high interest rates to compensate investors for their high risk. Low interest rates have pushed investors into these risky bonds. Junk bonds are one of few places where investors have been able to get a decent income stream.
In 2008, the Federal Reserve cut interest rates to near zero to fight the financial crisis. It has held rates near zero ever since. Right now, a 10 year US government bond pays just 2.3%. That’s half its historical average, and near its all time low.
Investors looking for income have turned to junk bonds. This chart shows the growth in junk bonds since 2002. As you can see, junk bonds didn’t grow much from 2002 to 2008. But when the Fed cut rates to zero in 2008, junk bond issuance took off:
JPMorgan reports that the number of junk bond issues soared 483% between 2008 and 2014. You might be thinking that you don’t own junk bonds… so why should you care? It’s true that many investors don’t own junk bonds directly. But many do own them through junk bond ETFs.
The Financial Times recently explained why junk bond ETFs are dangerous.… junk bond ETFs give the illusion of liquidity. Not all that long ago, bankers and asset managers promised to turn subprime mortgages into gold plated, triple A rated bonds.
Today, the apparently miraculous transformation is of deeply illiquid credit instruments, such as junk bonds and leveraged loans, into hyper-liquid exchange traded funds. Junk bonds are not “liquid.” That means there aren’t many investors buying and selling them every day. The Wall Street Journal reported that each of the top 10 bonds in the largest junk bond ETF traded just 13 times a day on average.
That’s not a typo. Investors only buy and sell these junk bonds 13 times per day on average. For comparison, investors buy and sell 47 million shares of Apple (AAPL) on average every day. Junk bond ETFs are extra dangerous because they make junk bonds appear liquid. HYG, the largest junk bond ETF, trades more than 6.8 million shares per today on average. That’s more than McDonald’s stock.
But as Howard Marks, hedge fund manager and one of the most respected investors in the world recently explained:
No investment vehicle should promise greater liquidity than is afforded by its underlying assets. If one were to do so, what would be the source of the increase in liquidity? Because there is no such source, the incremental liquidity is usually illusory, fleeting, and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times.
Now, none of this has been a problem yet because junk bonds have been in a bull market. According to Bank of America, junk bonds have gained 149% since 2009. But as Howard Marks added, ”Nothing is learned in the investment world in good times.” … “Most of these vehicles haven’t been tested in tough times.”
All bull markets eventually end. When this one ends, junk bonds could cause huge losses to investors who don’t know about these risks. Junk bonds could easily drop 15% or more in one month.
And here’s the craziest part….Some of the world’s smartest and most successful investors are are betting on this exact outcome. They’re betting that the junk bond market will crash.
They’re calling it “The Next Big Short.”
You probably heard about the few hedge fund managers who made a killing when US housing collapsed in 2007. Dallas-based hedge fund manager Kyle Bass made $500 million by betting against housing. John Paulson made $4.9 billion by betting against mortgages. Today, one of the largest private equity firms in the world is raising money to bet against junk bonds... just like Bass and Paulson bet against housing in 2007.
The Wall Street Journal reports:
Apollo [one of the world’s largest private equity firms] has been raising money from wealthy investors for a hedge fund that snaps up insurance-like contracts called credit-default swaps that benefit if the junk bonds fall. In marketing materials reviewed by The Wall Street Journal, Apollo predicted: “ETFs and similar vehicles increase ease of access to the high yield [junk] market, leading to the potential for a quick ‘hot money’ exit.”
As you can see from the chart of HYG’s (the largest junk bond ETF) price, junk bonds are down since June:
There’s no way to know if this is the beginning of the end of the junk bond bull market. But if it is, huge losses could come very soon. If you’ve made money investing in junk bonds, it’s time to cash in. Don’t bet against some of the best investors in the world who expect junk bonds to crash. We recommend selling junk bonds now.
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The article The Next Financial Disaster Starts Here was originally published at caseyresearch.com.
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