Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
“We’ve had a lot of QE and we are not sure if it works.”
– Former Dallas Fed President, Richard Fisher (Source)
One of the best reads for me this week came from the creative pen of Danielle DiMartino Booth. She was an analyst at the Dallas Federal Reserve for Richard Fisher and, boy, do I admire her wit and moxie.
In what may be one of my all-time favorite reads, Danielle titled the piece The Bond Market: Beware of Junkyard Dogs. Danielle brilliantly connects singer-songwriter Jim Croce’s passion for junkyards and his love for cars to the sad fundamental state of the high yield junk bond market. Croce’s junkyard obsession lead to his hit song “Bad Bad Leroy Brown.” Do you remember it?
Well the South side of Chicago
Is the baddest part of town
And if you go down there
You better just beware
Of a man named Leroy Brown
And it’s bad, bad Leroy Brown
The baddest man in the whole damned town
Badder than old King Kong
And meaner than a junkyard dog
Well, being that I’m a high yield junk bond guy, Danielle’s piece caught my attention. Maybe because I’m in Chicago this week, maybe because my dad was a big Jim Croce fan (I can just picture the vinyl album cover), maybe because Croce strolled a number of Philadelphia junkyards, but mostly because of the following chart courtesy of the St. Louis Fed.
The chart tracks the delinquency rate on commercial and industrial loans from all commercial banks on a percent change from the prior year (blue line). It then compares that change to Bank of America/Merrill Lynch US High Yield spread (red line). The spread is simply the current yield minus the comparable yield for a safe investment, like U.S. Treasurys, that has a similar maturity. If the average maturity is five years on the ML HY Index, then the spread is that yield less the five-year Treasury yield.
But don’t get hung up on that. What this chart is telling us is that over time, when delinquencies increase, we see an increase in high yield bond yields. Makes sense, as investors flee the risk they sell. More sellers than buyers causes prices to decline and yields to rise. In 2008, as high yield bond prices collapsed, the yield on high yield bonds rose from 6% to over 20%. What a great buying opportunity that presented. I believe another such opportunity is on the horizon.
Ok, back to the chart. Notice how closely the red line (yields) tracks the blue line (bank loan delinquencies). Also, look at the recent separation (far right). What this is showing is that something has to give. Fundamentals are breaking down. If higher quality and highly collateralized bank loans are seeing a spike in delinquencies, can you imagine what might be going on beneath the surface for little collateralized high yield junk bonds? Defaults are going to rise.
From Danielle DiMartino Booth:
As for high yield bond analysts, they aren’t exactly known for catchy turns of phrase. However, in recent weeks, they’ve shed the dry and donned the dramatic, as you’ll soon see. Such is the overheated state of the junk bond market this sweltering summer.
In his latest missive, Deutsche Bank’s Oleg Melentyev, arguably the best-in-class high yield analyst among his sell-side peers, warned of the perils of investing in this “frenzied market.”
Legendary high yield investor Marty Fridson shares Melentyev’s concerns and has for some time. By his best estimate, high yield was already in “extreme overvaluation” territory on June 30th, defined as being one standard deviation above fair value. Flash forward two weeks, and he calculates that the standard deviation has doubled.
(A quick Statistics 101 refresher: standard deviation tells you how tightly clustered or wide-of-the-center individual components of a given data set are from their mean. Remember the grade bell curve the engineering undergrads blew in business school? When all of the test scores came in on top of each other, the bell curve was super steep; when there was vast divergence, the bell curve was low and wide.)
…In the event your eyes have rolled into the back of your head, listen up! This is important folks, your sweet grandparents could well own junk bonds in their desperate need to generate yield on their atrophying retirement funds!
With that preamble posited, on July 15th the option-adjusted spread on Bank of America Merrill Lynch’s High Yield Index was 542 basis points. That compares to 621 bps on June 30th. The lower the spread, the less extra compensation investors are demanding for taking on the added risk of being exposed to, well, junky bonds.
Of the compression in spreads, an incredulous Fridson could only characterize the overvaluation which begat more overvaluation as, “more staggering.”
I’ve been tactically trading high yield bonds since 1991. It is a trend following trading strategy — disciplined and rules based. Trade into high yield funds on uptrends, move to short-term Treasury bills on downtrends.
In a few hours, I will present at a large advisor conference. I’m going to try to do my best to explain what is going on and what it means for their clients’ portfolios. For example, let’s say that your client has 15% allocated to high yields. If defaults rise, as I suspect, the collateral and promises from the borrower to pay the bond loan back offer the investor little chance of recovery. I expect a 50% price decline during the next recession. That is good news, not bad – unless one is caught on the wrong side of the trade.
If you have 15% of your money in high yield bonds, expect a 7.5% hit to your overall portfolio depending on the speed of the decline. Declines of this nature tend to happen quickly (over days and months – not years).
Now, if you are in a trend following trading strategy with an experienced manager or you have the guts and conviction to follow a process, then you are smelling great opportunity here. Sidestepping the vast majority of the decline will enable you to trade back in at much lower prices and much higher yields to maturity.
Interest rates are near record lows with the 10-year Treasury at 1.50%. Bonds offer little support to help drive return in a portfolio. Equity market valuations are ultra-high, signaling low 2% to 4% returns, before inflation, over the coming 10 years. Seventy-five percent of the money will be in the hands of pre-retirees and retirees by 2020 (according to BlackRock research). I don’t believe that investors will be content looking at their account statements when interest rates rise and another major correction kicks their portfolio in the pants. But there are ways to make money should what I expect to unfold occurs.
At dinner last night, one of our advisor clients came up to me and was complimentary but critical of OMR. His comments were helpful to me and, if you are a client, I hope helpful for you. I attempt to answer his question below. If you are not a client, please feel free to skip the section called What OMR Means as it Relates to Our Strategies and