According to Bloomberg, there are 496,956 actively traded bonds on the world’s markets.
Of those, Standard & Poor’s and Moody’s rates 7,711 of them as non-investment grade.
That may not seem like much. After all, just 1.6% of the overall bond market is non-investment grade.
The problem is — to butcher an old clichéd saying — no bond is an island.
Every bond in the bond market is intricately linked. If you can imagine the bond market as a family tree, US government bonds would be at the top.
Beneath you would get German bunds, UK gilts, and Japanese bonds.
Beneath that ‘generation’ you would have French bonds, Canadian bonds, and Australian bonds.
Beneath that you’d get top quality corporate bonds and lower rated government bonds.
Beneath that you’d get lower rated corporate and government bonds. And so on, until you arrived at the bottom of the family tree, where you would find the 7,711 ‘junk’ bonds rated by S&P and Moody’s.
The point here is that whatever happens at the top filters down to the bottom. But, by the same token, whatever happens at the bottom filters up to the top too.
At the moment, most investors and analysts are focusing on the US Federal Reserve and the tiny impact it will have on government bond yields.
However, these same investors and analysts are ignoring a bigger problem — the knock-on effect of higher government bond yields on the ‘junk’ bond market.
Let me see if I can make this clear.
I’m sure you remember the story from the past few years. The idea has been that low interest rates have forced investors out along the risk curve.
Investors who needed a certain income or return, say of 5% per year, had to take bigger risks than in the past. Where once they may have been able to get 5% from a relatively safe stock, now they have to invest in a less safe stock.
You get the point.
So, now don’t you think the same thing will happen in reverse?
If the Fed raises interest rates (which is by no means guaranteed) investors who were forced to invest in a higher risk invest to get their 5% return, can now ‘trade up’ to a lower risk investment.
And if you know anything about bonds, you’ll know that bond yields move inversely to bond prices. As investors start selling the higher risk bonds with the higher yield…that will push the yields even higher…all the way down the ‘family tree’ of bonds.
Now, you may think, so what? The current yield on a bond doesn’t have an impact on the company. Except it does. Companies issue bonds because they need to raise capital to invest in the business.
If a company’s current bond yields 12% and the company wants to issue more bonds to raise capital, it will have to issue the bond with a 12% interest rate.
That’s a big financing cost, and it could have a major detrimental impact on the company’s finances.
That’s why the potential interest rate rise by the Fed in December means so much more than most folks think.
But here’s the thing, you shouldn’t think that investors plan on waiting until the Fed does something before dumping junk bonds.
The chart below shows the increase in trading activity on distressed debt, otherwise known as junk bonds. You can see that the migration away from junk bonds began as early as mid-2014. It has really started to gather pace this year.
What do you think will happen if the Fed goes ahead and raises interest rates?
You’ll likely see a tremendous increase in volume and skyrocketing bond yields across the entire risk curve.
If you think that’s not worth worrying about, and it’s still OK to have all your money in stocks, all I can say is, good luck to you.
I think what we do as a business shows how different we are from the mainstream, and from our competitors.
We publish more than a dozen investment advisories. Most of those investment advisories contain stock recommendations. And yet, I don’t think there’s a single one of our editors who advocates being fully invested in stocks.
I don’t think there’s a single one of our editors who hasn’t warned about the possibility of a major stock market correction.
And I’m certain that, because of this advice, we’ve scared off thousands of investors over the years who don’t want to listen to the ‘waffle’, because they just want to know which stock to buy.
Over the past year, we have more than doubled the number of paying subscribers on our books. That’s despite launching Strategic Intelligence, which warns about a coming collapse of the global currency system.
And it’s despite launching The Gowdie Letter, which unashamedly warns about The End of Australia.
I can tell you that, without any doubt at all, if we had put all our attention on telling folks that stocks only ever go up and that you should put all your money in stocks, we would have quadrupled our subscriber numbers this year.
But we won’t say that…because we don’t believe it. Besides, that’s not how we want to do business. Quadrupling subscriber numbers that way may have looked good in the short term, but in the long term it would have been disastrous. Our subscribers would have (rightly) lost all trust in us.
So, rather than trying to pull the wool over your eyes, we prefer to explain the markets to you as they are. In the long run, that’s much better for you, and if it’s better for you, odds are it will be better for our business too.
Publisher, The Daily Reckoning
Ed Note: The above article is an edited extract that was first published in Port Phillip Insider.