By Bob Hoye
These 2 Debt Instruments Pose Peril to Millions of Investors
A billionaire says the search for yield is overriding credit judgment
Stay informed. Stay prepared. See what we see ahead for U.S. markets — now, via this risk-free offer to the Financial Forecast Service.
[Editor’s Note: The text version of the story is below.]
In a world of low and even negative rates, bond investors are so hungry for yield they’re willing to accept high levels of risk.
For example, bond investors are increasingly embracing debt instruments known as covenant lite loans, which provide minimal protection should the issuer get into financial trouble.
Investors should pay close attention to this development, because this is exactly what happened before the 2007-2009 financial crisis.
Our April 2007 Elliott Wave Financial Forecast warned subscribers beforehand:
The only reason that the crisis has yet to spread to the corporate debt market in general is that lenders continue to slacken underwriting standards, just as they previously did in the mortgage sector. Consider, for instance, the latest boom instrument, a corporate product known as “covenant lite,” bank loans that “subject borrowers to few of the usual performance requirements that have been standard in the past.” Standard & Poor’s says that $41 billion in lite loans have already been issued in 2007, a figure that is greater than that of the last 10 years combined.
Remember, cov-lite loans free the debt issuer from meeting normal fiscal disclosures and financial metrics, so the risk to lenders is high.
With that in mind, consider this (Bloomberg, Sept. 27):
Just 35 percent of new leveraged loans issued in 2016’s first half had traditional covenants that require regular financial check-ups, compared with 100 percent in 2010.
A billionaire investor noted that “the fact that there are no covenants tells you that people are substituting yield for credit judgment.”
But financial optimism is also reflected in the popularity of yet another high-risk debt instrument.
Here’s a chart and commentary from our October Financial Forecast:
Another bond market revisitation from the last credit mania is the “red-hot” market for payment-in-kind (PIK) bonds. … PIK bonds allow the issuer to pay interest in additional debt rather than cash. September is set to become the busiest month ever for PIK issuance, led by German auto component maker Schaeffler AG’s $1.5 billion issue, the largest in history. Similar to the heightened risk associated with buying cov-lite loans, seasoned investors acknowledge the peril of buying PIK bonds.
As we’ve noted before, credit implosions develop when lenders relax credit standards and investors reach for yield.
This might well be the time to play it safe.
|Unleash the power of the Wave Principle
Much like a great sports play; to appreciate a great market forecast, you have to see it. In fact, we’d like to show you four. Our examples do indeed show what can happen when Elliott analysis meets opportunity. But we’re not asking you to attend a class in ‘good calls.’ In each of these four markets, the unfolding trends have (once again) reached critical junctures. You really, really want to see what we see, right now.
Energy Stocks Above Prior Resistance
When investors are more confident about economic and market outcomes, they typically prefer to own growth-oriented sectors, such as energy, over more defensive-oriented bonds. The chart of energy stocks (XLE) relative to long-term Treasury bonds (TLT) is trying to hold above an important point of prior resistance. The longer XLE can hold the breakout relative to TLT, the more meaningful it becomes.
Deterioration In Numerous Asset Classes
Many interest rate sensitive assets, including gold, bonds, and REITS, sold off last week. This week’s video looks at the deterioration in the context of risk management. Updated longer-term charts are also covered for the S&P 500 and broad NYSE Composite Index.
The chart of stocks (SPY) relative to bonds (TLT) is sending similar messages to those seen in the energy/bonds ratio. The SPY/TLT ratio was rejected at the thick blue trendline three times in 2015 (see orange arrows) and again in September 2016. The longer SPY can hold the breakout relative to TLT, the more meaningful it becomes.
Tech Trying To Clear A Long-Term Box
The chart below shows the performance of technology stocks relative to intermediate Treasury bonds (IEF). The ratio entered the long-term orange consolidation box in December 2013 (almost three years ago). The ratio was near the lower end of the box as recently as June 2016. The breakout sends signals about the economy and interest rate expectations.
Rate Hike Odds
On October 4 following some strong economic data, asset class behavior started to signal two things: (1) the odds for a Fed rate hike in December were increasing, and (2) the economy and markets might be able to withstand the hike this time. Obviously, with quite a bit of time between now and the Fed’s December meeting, 1 and 2 above fall into the TBD category.
Similar Messages From High Beta
The High Beta ETF (SPHB) has higher weightings in materials (XLB), energy (XLE), and financials (XLF) relative to the S&P 500’s weightings (SPY). As shown in the chart below, this economically-sensitive investment is trying to hold the recent break above an area that has acted as resistance for a year. As recently as June 28 (point A below), SPHB looked to be on the ropes. Since then, SPHB has made a higher low (point B) and a higher high above point C.
The longer SPHB can hold above point C, the more meaningful it becomes.
A smart bond guy speaks, post-FOMC. Amazingly, this interview is jumping right to a foregone rate hike conclusion in December and speculation about the Jawbone-o-rama we are going to be subjected to in the interim. Always good to hear Gundlach, though. Other good observations here.
“The bond market is sniffing out a pivot to fiscal stimulus…” Gee, where have I heard that before? Oh yes, in my own post at NFTRH.
Also, rock star bond guy Bill Gross weighs in, post-FOMC. I didn’t say smart, I said rock star. There’s a difference. I see rock stars and promoters (cough… Gartman… cough cough) all over the financial market media landscape but very few smart people. Anyway, I have not yet listened to Gross, but he’s Bill Gross… always worth a listen if not a laugh.
By Bob Hoye
“The Fed gets the accounts of out line. Mister margin gets them in line.”
Boston Fed President Eric Rosengren recently rattled markets when he warned that low-interest rates were increasing the temperature of the U.S. economy, which now runs the risk of overheating. That sunny opinion was echoed by several other Federal Reserve officials who are trying to portray an economy that is on a solid footing. And thus, prepare investors and consumers for an imminent rise in rates.But perhaps someone should check the temperatures of those at the Federal Reserve, the idea that this tepid economy is starting to sizzle could not be further from the truth.
In fact, recent data demonstrates that U.S. economic growth for the past three-quarters has trickled in at a rate of just 0.9%, 0.8%, and 1.1% respectively. In addition, tax revenue is down year on year, S&P 500 earnings fell 6 quarters in a row and productivity has dropped for the last 3 quarters. And even though growth for the second half of 2016 is anticipated with the typical foolish optimism, recent data displays an economy that isn’t doing anything other than stumbling towards recession.
The Institute for Supply Management Purchasing Manager’s index for the manufacturing sector during August fell into contraction at 49.4, while the service sector fell to 51.4 compared to 55.5 in July, which was the lowest reading since February 2010 and the biggest monthly drop in eight years. And the recent jobs report was also full of disappointment too, with just 151,000 jobs created in August and a decline in the average work week and aggregate hours worked.
The 1994 case demonstrates the longer stocks go sideways, the bigger the move we can expect after a successful breakout. However, even under the successful breakout scenario, a retest of prior resistance may be in the cards, which is exactly what happened in early 1995. In 2016, the Dow Jones Industrial Average (below) may be in retest mode.
Given the high levels of global debt, the lesser of the evils alternative typically is to try to inflate it away. The chart below, showing the performance of materials stocks (XLB) relative to Treasuries (TLT), is one way to monitor the battle between inflation and lingering concerns about deflation.
Like the XLB/TLT ratio above, the ratio of energy stocks (XLE) to Treasuries (TLT) also has some work to do. With a Fed statement coming Wednesday and one from the Bank of Japan before the end of the week, these ratios should provide some insight into the market’s reaction.
Stocks vs. Bonds
The S&P 500 (SPY) has not yet broken out relative to long-term Treasuries, but has made some progress relative to intermediate-term Treasuries (IEF). If the SPY/IEF breakout below holds, it will improve the odds of the S&P 500’s recent push above 2,134 holding.
Having spent a chunk of his youth “shopping” them, Jim Croce came to know a thing or two about junkyards. In those youthful days, should his clunker de jour be missing some vital part or parts, a trolling expedition through South Philly’s scrap heaps was always the enterprising Croce’s preferred method of procurement.
Amid all of Croce’s parts foraging, it was a universal joint for a ‘57 Chevy and a ‘51 Dodge transmission, two must have and must-be-cheap or, better yet, free, parts that the legendary folk singer still recalled. He also reminisced that junkyards could and would provide a no frills, but highly motivated and easy way to get in some cardio, as in running for your life.
“I got to know many junkyards well, and they all have dogs in them,” the late Croce said in a 1973 interview. “They all have either an axle tied around their necks or an old lawnmower to keep ‘em at least slowed down a bit, so you have a decent chance of getting away from them.”
So was born the junkyard dog yardstick by which to measure the meanness of one Bad, Bad Leroy Brown, Croce’s hit which landed at the top of the charts 42 years ago this week.
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.”
Broad Stock Market Back To Familiar Area
While the S&P 500 (SPY) was able to push to a new high during Monday’s trading session, the broad NYSE Composite Stock Index (VTI) was still looking for a close above an area that acted as resistance in the past.
Are Stocks Set To Rocket Higher?
This week’s video looks at the narrative for stocks breaking out and pushing higher, as well as the impact of slowing credit growth on asset class behavior.
Like the NYSE Composite, the ratio of the S&P 500 (SPY) to a diversified basket of bonds (AGG) was testing a key area Monday. If the ratio can push above the downward-sloping blue trendline, it would be a positive development for stocks relative to bonds. Conversely, if the ratio fails to push/hold above the blue line, it increases the odds that Monday’s stock breakout may be followed by relatively tepid price action.
Today’s bond market is defying just about every comparison known to man. Never before have traders paid so much to own trillions of dollars in debt and gotten so little in return. Jack Malvey, one of the most-respected figures in the bond market, went back as far as 1871 and couldn’t find a time when global yields were even close to today’s lows. Bill Gross went even further, tweeting that they’re now the lowest in “500 years of recorded history.” Lackluster global growth, negative interest rates and extraordinary buying from central banks have all kept government debt in demand, even as yields on more than $8 trillion of the bonds dip below zero.
Last Week’s Intraweek Stock Reversal Muddies Bullish Waters
On Wednesday, June 8, the S&P 500 was up 20 points for the trading week that began on Monday, June 6. By the time the closing bell came on Friday, June 10, the S&P had given back all its gains for the week, finishing the 5-day frame down 6 points. This week’s video covers numerous markets that have yet to “prove it” from a bullish perspective.
The S&P 500 ETF (SPY) dropped sharply last week on well-above average volume. Even in that context, according to J. Lyons Fund Management, “smart money” commercial bond traders have placed the largest bearish bet in eighteen years on defensive bonds. Economic data has been mixed in recent weeks, adding to the need to remain open to the bullish and bearish case for equities. With a Fed statement coming Wednesday and numerous economic releases (PPI, industrial production, CPI, housing starts, etc.), the market will have plenty to assist with bullish and bearish choices.
The bullish case for stocks would greatly improve with a sustainable and confident move above 2,134 on the S&P 500 Index. Confidence can be measured via ETF leadership, market breadth, and trading volume.