The Fed Just Killed This Sector

On Wednesday, the Federal Reserve gave the markets exactly what they wanted this Christmas — a 0.25 basis point rate hike.

The markets cheered as the Dow Jones Industrial Average added 250 points, and all major indexes soared more than 1%.

But this reaction will be short-lived. In fact, the market has already started to pull back. More importantly, its implications mean that things are only going to get worse before they get better, as Jeff Opdyke explained on Tuesday.

We are actually in the final stages of a bull market that has lasted seven years. And the tipping point is already in play after the Fed raised rates. The following months are going to be critical to the performance of your portfolio, but we will guide you the whole way.

Here’s the first area to avoid … and it’s also going to be one of the first areas to buy near the bottom. Let me explain…

In late October, I warned readers to stay away from the junk bond sector. This is one of the riskiest segments of the market in a normal environment, and is especially risky after the Fed went ahead with raising rates. I was right.

Shares in one of the largest high-yield bond exchange-traded funds (ETFs) — SPDR Barclays High Yield Bond ETF — plunged more than 8% in less than two months, and the selling isn’t over, as I’ll explain in a moment.

But, once the doom and gloom is all priced in, it will be an ideal time to lock in higher-yielding stocks — I’m talking double-digit yields. Just not today.

The Fed Changed the Game

Earlier this month, Third Avenue, a bond mutual fund, stunned its investors when it announced it was liquidating and halted redemptions from the fund.

Then Lucidus Capital Partners, a $900 million high-yield credit fund, announced the liquidation of its holdings, as well as Stone Lion Capital Partners.

The reason these funds are liquidating is tied to the illiquidity of the high-yield bond market. Sure, there are some areas with more liquidity, but, for the most part, the liquidity is drying up — which tells us to expect more liquidations and more volatility tied to the high-yield market.

And it all comes back to the Fed.

The market has been anticipating a return to higher interest rates and the Fed has taken the first step in that direction. These large institutions expect bond yields to rise, and they don’t want to be left holding billions of bonds and stuck selling them at lower prices.

And even though new issuance in the corporate bond market is on pace to set a record for the largest amount of bonds issued in one year as companies look to take advantage of the end of zero-interest-rate policies by the Federal Reserve, primary bond dealers in the U.S. are holding net negative positions of high-grade corporate debt for the first time ever.

This means that the usual bond holders in the market, the ones who provide liquidity when needed, are turning into matchmakers.

Avoid the Pain

Even though the markets cheered the rate hike by the Fed, it’s not going to treat the markets as nice over the next several months. These high-yield bond funds are going to be a sour spot in 401(k)s, mutual funds and other asset management companies. It won’t be a systemic risk to the economy like the leveraged housing market was in 2008, but it will no doubt be a contributor to the coming economic recession.

As liquidity dries up for these riskier operations, they will fail to keep their doors open. It will start with oil-related companies, but it will shift into other businesses that are relying on that capital — not to mention they will have to pay even more to borrow now that the Fed has lifted off the zero bound.

High-yield bonds are just the first chip in the weak economy to fall, but they won’t be the last. Once the dust starts to settle, high-yield bonds or high-yield stocks will actually be the best investment.

You will be able to lock in significant yields and generate capital gains if you grab high-yielding stocks. But, as enticing as it may look at the moment, now is the time to avoid the high-yield sector of the market. Start pulling some money off the table and be ready to pile in after we see a significant correction or an all-out crash. We will let you know when to jump back in.

Regards,

Chad Shoop
Editor, Pure Income