The Case Of The High-Yield Bond Market

The Case Of The High-Yield Bond Market

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Market psychology around corporate debt is strangely optimistic

Corporate bankruptcy can happen very quickly.  And while the very recent situation regarding the unfortunate predicament of a California utility is a current event in this area, I am focused as usual on something beyond this stock or that stock.  I am looking at the larger issue that I believe is a severe threat to wealth in the coming months and years, one that Wall Street and retail investors seem to be shrugging off at an uncommon level of complacency.  Now, the details…

Pacific Gas and Electric (PG&E) is a public utility that operates in northern and central California.  Their businesses include electricity, natural gas and related business lines.  The company’s stock has plunged, based on its possible role in the California wildfires, and its bond rating was cut…but still maintains an “investment grade” rating as of this writing.

And that is my point: less than a year ago, the bond rating for PG&E was in the A-range.  Then it was cut to BBB, and perhaps soon it will be cut to BB, which crosses it over from investment grade to “junk” or high yield, depending on the vernacular you want to use.  Sure, the stock price fell, but the issue I see is that this is likely one of many situations in the corporate bond market where BBB bonds are really junk bonds masquerading as investment grade.

I am not the one to walk you through the inner workings of the bond market and how bond ratings are assigned.  I look at it as an investor who is entrusted to care for the hard-earned assets of other investors.  And to me, the trend here is one that piques my interest.  We are not too far removed from Puerto Rico’s bond mess, in which the U.S. territory avoided outright bankruptcy, but in restructuring its debt, screwed over a lot of bond fund holders…who had no idea their bond funds were caught up in that process, until the prices of their funds cascaded down quickly.

The high yield bond market has yet to show severe stress beyond some recent blips.  The market for Preferred stocks and Convertible securities.  BBB-rated bonds have been teetering a bit, but these market segments have not completely broken down 2008-style.  But market price activity around the ETFs that track these market segments are increasingly sending the message that all is not right there.  That makes this is good time to take account of what is going on.

And remember this blow-your-mind stat: about 50% of the money in corporate bond funds is rated BBB.  That’s double what it was several years ago and tells you that managers of such funds have been reaching for yield for a long time.  That game is ending or over.

This creates an odd situation for bond investors, as well as asset allocation types and long-short investors like me.  I am more willing than I have been for 10 years to own U.S. Treasury securities and even have some exposure to the bonds of other governments as an alter-ego to a stock market that prompted me to move my firm’s market climate indicator to its most bearish level (“Stormy”) nearly a year ago. 

But as for corporate bonds issued by less than pristine corporations?  No thanks.  Furthermore, I think we are heading into a period in which stock performance will depend largely on the creditworthiness of the company behind the stock.  In our own research process at Sungarden, we are putting much greater emphasis on owning the stocks of companies whose bond ratings are rated AAA, AA and A.  The combination of rising interest rates that businesses have to pay if they borrow heavily, and the potential for a sharp slowing of the global economy over the next year prompts that higher level of risk-awareness, on top of an already risk management-driven investment process.

For you own situation as an investor, this is all a matter of connecting two things:

  1. Know who you are as an investor…I mean really know…the stress test period is upon us.
  2. Know what you own and why you own it or find someone who can help you understand that.

This is a great time to focus on risk management, because if you do that now, you will be in a solid position to pick up the pieces when your neighbors are still figuring out what went wrong, not only with their stock portfolios, but with major segments of their bond portfolios as well.

 

For research and insight on these issues and more, click HERE.

#HighYieldBond #Market #Portfolio #PG&E #Treasury

 

 

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