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Making Windfall Profits When Junk Bonds Fall from Grace

0 | By Shah Gilani

“It’s all good until it isn’t.”

That should be the mantra of investors in junk bonds and leveraged loans, especially in ETF products.

If it isn’t, it will be when the next downturn hits the rapidly expanding high-yield bond and loan universe.

And, while a shellacking won’t be pretty for investors who directly own high-yield paper, it’ll be downright ugly for investors who think they’re safer piling into high-yielding junk bond and leveraged loan ETF products.

Here’s what’s happening in high-yield land now, how bad it’s going to be for ETF investors, and how to turn the next high-yield crash into a mega windfall for yourself…

Old News…

It’s old news now. Everyone knows the Federal Reserve lowered interest rates to help big banks get back on their feet and to force investors into riskier assets, meaning equities.

The Fed’s gargantuan $4 trillion “quantitative easing” program tanked interest rates, buoyed equity markets, pumped up retirement accounts and spawned the “wealth effect” to buoy consumer spending.

It also forced yield-hungry investors into riskier and riskier junk bonds and leveraged loans. So much so that issuers have had a field day issuing hundreds of billions of dollars of sub-investment grade paper to meet the ever-increasing demand from high-yield hunting investors.

The size of junk bond and leverage loan markets today is just shy of double what they were in 2007.

One source of demand has been ETF sponsors.

According to Bloomberg, assets in debt ETFs have doubled to $600 billion in the past five years. Junk bond and leveraged loan funds account for more than $75 billion of that total.

What Happens When Rates Rise…

In late 2014, the Fed stopped adding new bonds to its balance sheet. While they weren’t expanding their balance sheet, they weren’t shrinking it either. Whenever bonds, notes, or bills the Fed held in inventory matured, they bought an equivalent amount to maintain balance sheet assets at close to $4.4 trillion.

In the fall of 2017, the Fed announced they’d be winding down their balance sheet as part of a “normalization” process to let rates get back to where they might be under normal market conditions.

That means the Fed’s not in the market buying anymore, and interest rates will eventually start rising, possibly quickly at times.

When rates rise, the market discounts prices of outstanding bonds until they fall enough to make their value in the secondary market, their price and yield, close to what new bonds will be worth when they come to market with higher yields, because rates have risen.

Besides hitting the price of outstanding bonds, higher rates increase borrowing costs for issuers, especially sub-investment grade issuers who may need to roll over maturing debt or raise more money.

That double whammy could hit junk bonds and leveraged loans hard.

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It happened in 2014, as leveraged loan and junk issuance peaked in the energy arena. Oil prices collapsed, taking down cash flow for debt service and panicking investors into widespread selling. Prices for energy-related high-yield loans and bonds dropped 56% over the next 18 months.

Smart investors are already loading up their coffers in anticipation of the next HY drubbing.

According to the Financial Times, distressed investing funds have amassed more than $74 billion – $15 billion since the beginning of 2018, in dry powder, to swoop in when the HY market crashes and they can pick up very distressed debt at pennies on the dollar.

Analysts cite the increasing issuance of covenant-lite bonds and loans as proof demand’s been trumping safety concerns and frothiness is building.

It’s Not A Matter of If It’ll Happen…

In 2007, about 17% of leveraged loans were covenant-lite issues. Today, more than 75% of outstanding loans are covenant-lite in some areas.

Covenants are the protections embedded in bond and loan indentures. They may be provisions that stipulate how much equity an issuer can raise, what its credit ratings must be, how much more debt they can raise, and other safeguards that protect investors from potential issuer moves that could adversely impact the price and credit quality of their issued debt instruments.

Crazy covenant-lite bonds and loans might allow issuers to issue new debt in lieu of making interest payments. PIK, or payment-in-kind, “toggles” as they’re called are back in style after being shunned in the last junk bond downturn.

High demand, for years now, has given issuers the upper hand, and they’ve been lightening up on protective covenants they otherwise would have had to package into their issues.

Problems are piling up.

A lot of institutional investors, along with retail investors, have been piling into high-yielding ETF products chasing yield wherever they can find it.

They believe they’re safer in ETF products than buying bonds or loans because they can sell their ETF shares at any time the market is open. And that’s generally true.

But, it may not be. Besides ETFs feeling the impact of falling prices instantly, ETF investors don’t seem to realize many junk bonds and leveraged loans don’t regularly trade, meaning constant pricing isn’t possible.

Some bonds and loans “trade by appointment,” which means they only get priced when there’s an actual transaction between a seller of the loan or bond and a buyer.

In a distressed market, buyers aren’t going to step up and ease prices down a controlled runway. They’re going to disappear and cause prices to slide prices low enough to make them look cheap.

We’ve seen it before, ETFs can and have stopped trading, or couldn’t be opened for trading because underlying portfolio positions couldn’t be priced.

Imagine ETF investors not being able to dump their shares because dealers are trying to sell bonds and loans by appointment to absent buyers. When they do open for trading, there’s no guarantee share prices won’t be devastated.

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It’s not a matter of if that’s going to happen. It’s a matter of when.

Looking at a few junk bond and leveraged loan ETFs now, I see they’re trading at support levels.

If support gets broken, a lot of retail investors will have to scramble to get out of their shares after more proactive institutional players hit their sell buttons.

Look at SPDR Blmbg Barclays High Yield Bd ETF (NYSEArca:JNK) and iShares iBoxx $ High Yield Corp Bd ETF (NYSEArca:HYG) and you’ll see what I mean.

Now look at SPDR Blackstone / GSO Senior Loan ETF (NYSEArca:SRLN). If that’s the canary in the coal mine, it’s time to get out – better yet; it’s time to load up on some puts.

And we’re doing just that in my Zenith Trading Circle research service.

We’re gearing up to put on new trades as soon as this coming Monday, so if you haven’t already checked out how we rake in profits from situations like this, now is the time. I’ve used my system over the past year to show my members consistent double-, triple-, and yes, even quadruple-digit gains.

Here’s how I do it.

Sincerely,

Shah

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