Fixed Income Challenges and Opportunities

Jay Peroni, Lead Analyst, CEO and FounderBlog (Public), Crisis Investor

Economic Turbulence Means It’s Time to Cut Back on Bonds

Here’s an uncomfortable truth: bonds are likely to perform poorly – maybe very poorly – in the coming global turbulence. For this reason, it’s time to get out of low-quality bonds, and even to get out of the bond funds and exchange traded funds (ETFs) that invest in them.

When times get tight, and that’s clearly happening right now, the ability of bond issuers to make good on those liabilities will deteriorate. You don’t want to be holding those securities when that happens.

Let’s do a deep dive on this very important, very timely, and surprisingly complicated investment class called bonds.

Bond Basics

A bond is a debt of the issuer. It differs from the kind of debt that individuals and organizations owe to banks, in that it comes about as a result of debt securities – bonds – that are sold on the bond market in order to raise capital for the issuer.

Generally speaking, bonds are long term in nature – typically 10 years to as many as 30 years. The issuer is under no obligation to redeem those bonds prior to maturity, though many can be sold on the secondary market. You are paid interest on your investment during the term of the bond, but the return of principal invested doesn’t take place until the maturity date of the bonds.

There are three primary institutions that issue bonds – federal or state governments, municipalities (towns and counties), and corporations. Debt issued by all three sectors has exploded in recent years, out of all proportion to the growth of the total US economy.

For example, according to numbers from the US Treasury, the national debt has more than tripled between 2000 and 2015. Meanwhile, the US economy as measured by gross domestic product (GDP) has increased from about $10.3 billion in 2000 to about $18 billion today. That’s an increase in GDP of less than 80% in 15 years, compared to a more than 200% growth in the national debt.

The municipal bond market has also exploded in size. According to the Securities and Exchange Commission, the nationwide municipal bond market grew from $361 billion in 1981 to $3.7 Trillion in 2014. That represents a more than tenfold increase in the amount of municipal debt outstanding nationwide. By contrast, the US GDP grew from about $3 Trillion in 1981, to about $18 Trillion today, representing only a sixfold increase.

The situation is similar with corporate bonds. An article published by Bloomberg cited corporate bonds reaching $49 Trillion in 2014, triple what they were in 2000. And that was as of two years ago. Once again, a 200% growth in debt over just 14 years, easily outpaced GDP growth of less than 80%.

Worse, much of that increase in corporate debt was used to buy back shares of stock. That practice – now widespread – boosts share prices without improving the company’s financial strength, or their products and services. It’s purely to manipulate the price of the company’s stock, to make its performance look better than it really is – but I digress.

All three forms of bond indebtedness have grown faster than the national economy, and by a wide margin at that.

How solid is all of that debt? We generally address that issue by checking the credit ratings issued on the debt by the major credit rating agencies, like Moody’s, Fitch and Standard & Poor’s. They report government and corporate debt ratings in much the same way that Experian, TransUnion and Equifax report credit scores for individuals.

Top rated bonds are rated AAA. Generally, if a bond is rated below BBB it is considered to be junk-bond status. For that reason, I recommend that any bonds that you invest in be rated AAA, period. Anything less, and it is likely that you are taking on far greater risk than you generally assume.

And as we found out a few years ago in the Financial Meltdown, the ratings assigned to various types of debt by the agencies proved to be less than accurate. But that’s exactly what happens once the dominoes start to fall.

The Brewing Sovereign Debt Crisis

We’ve just discussed how US national debt has been growing out of all proportion to the growth in the nation’s GDP. But that’s not just a problem in the US – it’s happening throughout the world. That includes both wealthy nations and emerging market countries. Governments have been using debt to pay for spending that is no longer covered by tax revenues. Tax revenues have been growing more slowly than expected, due to a weaker economy than has been generally assumed.

In addition to weaker government balance sheets, the explosion of debt has caused an increase in financial speculation. This is essentially money chasing more money, without actually adding anything real to the economy. And it has become rampant. We’ve been watching the financial markets boom since 2009, despite persistent and under-reported weakness in the real economy.

As the fallout from that speculation continues to increase, we can expect to see a crisis of confidence in governments around the world, even here in the US.

There are five factors that will lead to this crisis of confidence:

  1. As discussed above, debt is growing out of all proportion to real economic growth. That alone is why the debt has become unsustainable.
  2. Increasingly, the real economy can no longer support global debt burdens, including those of national governments; governments have been maintaining the façade of being able to service their debts only through eight years of artificially low interest rates.
  3. The excess money being pumped into the economy through government debt and Federal Reserve intervention is largely ending up in the stock markets, which are now seriously overvalued. Once they correct in a major way, confidence in the system could collapse in a matter of months.
  4. Central Banks have lost control of the system and have run out of options to combat the current crisis. For example, Deutsche Bank has derivatives exposure greater than the entire European GDP. This one bank could bring down the entire financial system. Another example is the widespread discussion of negative interest rates. This strategy is bald-faced desperation, and represents some of the best evidence that central bank efforts to prop up the economy and the financial markets are near the end of the line.
  5. Geopolitical instability. Syria, North Korea, Iran, ISIS, Ukraine, the Baltic States, and the South China Sea, are only some of the most well-known of the world’s many tinder boxes. A single miscalculation in any of those regions could lead to war on a magnitude not seen since World War II. Even neutral Sweden is openly contemplating the possibility of war.

It’s hard to imagine the global financial situation coming out unscathed against this combination of circumstances. And if there is a collapse, bonds will be one of the hardest hit sectors.

How Bonds Are Likely to Respond to a Debt Crisis

Once the crisis becomes too obvious to ignore, bond prices are highly likely to fall. Many bond issues will default completely. As this process plays out, yields on bonds will rise. That won’t be a problem for debt issuers on existing debt, but it will likely shut down the bond market to new issues. That will create a liquidity crisis across the economic spectrum.

Seeking Alpha cites a report from Fitch that says that high yield defaults are the worst since the financial crisis, confirming that another financial meltdown may already be in progress.

The ongoing energy crisis is creating even deeper problems in the oil industry. The explosion of fracking operations across the country over the past few years has largely been financed with corporate debt. Low oil prices are causing oil companies to become increasingly distressed. There is now widespread expectation of bond defaults.

A recent article in the New York Times, reported that as many as 150 oil and gas companies could file for bankruptcy if oil stays around $28 a barrel or lower. As they do, much of the debt they issued, whether to banks or bondholders, will become uncollectible.

It’s often said that economic crisis builds at the fringes, and then works its way back to the economy’s core. If the energy sector is any indication, the fringes are already on fire.

Is Deutsche Bank the Next Lehman Brothers?

It’s often said that history doesn’t repeat, it rhymes, and maybe we’re seeing an example of that right now. In 2008 Lehman Brothers was the domino that got the financial meltdown rolling. In 2017, we have German based Deutsche Bank.

The firm has been in the news a lot lately, as it teeters on the edge of solvency. It has about $64 Trillion in exposure to the shadowy derivatives market. That’s roughly 16 times larger than the $3.9 trillion German economy, and more than three times the size of the US economy.

The global derivatives market is variably estimated to be worth between $700 Trillion and $1.5 quadrillion – many times the combined economic output of all the countries in the world. Such a wide spread in the estimates confirms that nobody really knows how big the market really is. But what we do know is that $64 trillion of it is currently sitting in Deutsche Bank’s portfolio, and the company can go down at any time. If it does, it could be the catalyst that brings down the entire derivatives market.

What will happen after that is anyone’s guess.

Your Money is No Safer in Bond Funds and ETFs

In recent decades, and particularly with the long bull market in both stocks and bonds, financial experts and individual investors alike commonly assume that mutual funds and ETFs are generally safer ways to holds stocks and bonds than owning the individual securities themselves.

There’s actually a lot of truth to that assumption in the normal course of events, and certainly during bull markets. Funds enable you to hold a portfolio of stocks and bonds, rather than risking your capital on a small number of issues. In addition, the funds are professionally managed by people who invest for a living.

But it’s likely that any safety that’s brought about by investing in funds during good times will work in reverse during times of turbulence. First, it should be understood that a fund is no more secure than the securities that are held in its portfolio. If there is a general decline in the underlying market, and especially if there is a crash caused by a contagion, the value of the fund will fall along with it.

But there’s an even bigger complication. A fund is a trustee that holds the securities within it. That means that you do not actually own the securities themselves, but only a representative share of the fund itself. This can create potential problems in regard to redemptions, that could become problematic in a crisis.

The recent example of Third Avenue Management LLC illustrates the point. The fund was granted permission by the Securities and Exchange Commission to suspend redemptions after losses and redemptions left it unable to repay redeeming clients without resorting to fire sales.

Were that situation to happen with a fund where you held your bond investments, all the while thinking that they were safe, you’d be prevented from getting your money out of that fund.

The problem with all funds is that if you have to liquidate them in a crisis, you wouldn’t even have the underlying securities to sell on the market. Your only option is to liquidate your position in the fund itself through redemption, and if that has been blocked, your money will be tied up for an indefinite amount of time, and you’ll likely recover no more than pennies on the dollar of your original investment.

Do you still think that mutual funds and ETFs are safe way to own bonds?

Making Money When Bonds Collapse

So far we’ve been discussing problems coming upon the bond market. But is there actually a way to make money when bonds collapse – apart from selling out and going to alternative investments before the collapse happens? It is possible.

One way is through the ProShares UltraShort 20+ year Treasury ETF (TBT). Technically speaking, the fund seeks daily investment results that correspond to two times the inverse (-2x) of the daily performance of the Barclays US 20+ Year Treasury Bond Index, before fees and expenses.

In plain-speak, TBT allows buyers to benefit when long Treasury interest rates rise (and the underlying bond prices fall). The index tracks US Treasury bonds with maturities of between 20 and 30 years remaining. TBT shorts the bonds and achieves a return that is twice the loss on the index. This enables you to make money on US Treasury bond investments when they are declining in value due to increases in interest rates. So when the bonds lose, you win – simple.

You don’t want to go too heavily into this fund, even if you anticipate that interest rates will rise. There is currently a lot of talk about negative interest rates in the US, particularly coming from the Federal Reserve. Meanwhile, interest rates have already gone negative in certain countries in Europe. There is no guarantee that that will happen, but as the Fed becomes increasingly desperate, it is always a possibility here as well.

Please don’t dismiss my analysis on bonds lightly. We came very close to a worst possible outcome in 2008-2009, but we may not be so lucky a second time around. Blind faith in bonds this time could result in a significant loss of wealth, especially if you’re counting on your fixed income allocation to protect against losses elsewhere your portfolio. Quite the opposite – bonds could end up being the biggest losers in the next round of economic and financial turbulence.

Additional Reading:

Will Gold Protect You During an Economic Crisis?

How Will You Protect Your Portfolio During a Crisis?

Want to Make a Fortune? Buy Stocks at Depressed Prices!

How to Hedge Your Portfolio

Using Swing Trading to Profit in Volatile Markets

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Disclaimer

While Dual Returns has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.