Home > Financial Crisis 2016: High Yield Debt Tells Us That Just About EVERYTHING Is About To Collapse

Financial Crisis 2016: High Yield Debt Tells Us That Just About EVERYTHING Is About To Collapse

February 15th, 2016

debtDid you know that there are more than 1.8 trillion dollars worth of junk bonds outstanding in the United States alone? 

With interest rates at record lows all over the world in recent years, investors that were starving for a decent return poured hundreds of billions of dollars into high yield debt (also known as junk bonds).

This created a giant bubble, but at first everything seemed to be going fine.  Defaults were very low and most investors were seeing a nice return.  But then the price of oil started crashing and the global economy began to slow down significantly.

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Energy company debt makes up somewhere between 15 and 20 percent of the junk bond market, and the credit rating downgrades for that sector are coming fast and furious.

But it isn’t just the energy industry that is seeing a massive wave of defaults, debt restructurings and bankruptcy filings.

Just like with subprime mortgages in 2008, investors are starting to wake up and realize that the paper that they are holding is not worth a whole lot.

So now investors are rushing for the exits and we are starting to see panic on a level that we have not witnessed since the last financial crisis.

Money Tornado - Public Domain

Just look at what has been happening in recent days.  Investors took nearly 500 million dollars out of the largest junk bond ETF (iShares HYG) last week alone.  The following chart shows that HYG has now fallen to the lowest level that it has been since the last financial crisis

HYG February 2016

During the last financial crisis, junk bonds starting crashing well before stocks did.  In fact, many consider junk bonds to be a sort of “early warning system” for stocks.  For many analysts, when you see high yield debt collapse that is a huge warning sign that you need to get out of stocks as soon as possible.

And this makes perfect sense.  When financial trouble erupts, it is going to hit more vulnerable companies first usually.

Blue chip companies are typically not in the high yield debt market.  Normally, high yield debt is only for companies that have more risk associated with them.  And it is risky companies that typically start to crumble the quickest.

Another high yield ETF that I watch very closely is JNK.  As you can see, the chart for JNK looks nearly identical to the chart for HYG…

JNK - February 2016

What these charts are telling us is that a new financial crisis began during the second half of last year and that it is now accelerating.

At this point, yields have reached levels that we have not seen since the collapse of Lehman Brothers.  The following bit of analysis comes from Wolf Richter

The average yield of CCC or lower-rated junk bonds hit the 20% mark a week ago. The last time yields had jumped to that level was on September 20, 2008, in the panic after the Lehman bankruptcy, as we pointed out. Today, that average yield is nearly 22%!

Today even the average yield spread between those bonds and US Treasuries has breached the 20% mark. Last time this happened was on October 6, 2008, during the post-Lehman panic:

Junk Bond Spreads - Wolf Richter

At this cost of capital, companies can no longer borrow. Since they’re cash-flow negative, they’ll run out of liquidity sooner or later. When that happens, defaults jump, which blows out spreads even further, which is what happened during the Financial Crisis. The market seizes. Financial chaos ensues.

After junk bonds crashed in 2008, virtually every other kind of investment followed suit.

Just about the only thing that didn’t crash were precious metals.  Gold and silver soared, and that is what you would expect to happen during a major financial crisis.

Another thing that I am watching closely is margin debt.

During past financial bubbles, we have seen lots of people borrow lots and lots of money to buy stocks.

If that sounds like a really bad idea, that is because it is a really bad idea.

Whenever margin debt peaks and then starts to decline precipitously, that is a signal that a stock market crash could be imminent.  The following chart comes from James Stack

Margin Debt - James Stack

After looking at that chart, I can’t understand how anyone couldn’t see the pattern.

We keep making the same mistakes, but we never seem to learn from history.  In fact, the mainstream media keeps telling us that this new financial crisis “isn’t 2008″ over and over again.  Even though the exact same patterns are happening once again, they still believe that this time will somehow be different.

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  1. R. Thomas
    March 13th, 2016 at 03:49 | #1

    I appreciate this article sir, my family and I are preparing for the days ahead. But from an opportunity perspective, doesn’t this seem like a good time to prepare for shorting the market?

  2. steve
    February 20th, 2016 at 20:27 | #2

    Clayton, Dubilier, and Rice needs to do something about Brand Energy, one of the companies it invests in. Their junk bonds are being sold off like crazy. It’s a disaster. They need to get rid of the GE castoffs that run it. Some are only there because of nepotism and are despised within the company. They have executives who have to be shuffled around because they don’t get along with anyone. They hide behind ridiculous titles like “development.”

    GE castoffs make terrible executives. They have a nepotism problem. They never get fired and are often despised in the companies they work in. Their performance is often a joke. People at Home Depot have all kinds of negative things to say about what the GE castoffs did to that company.

    Brand Energy can’t go public with these GE castoffs in charge. A good PE firm gets rid of bad management. It’s clear what Clayton, Dubilier, and Rice should do. The Houston area of Brand Energy is a an example of terrible management and the executives there should be removed.

  3. gman
    February 16th, 2016 at 13:04 | #3

    “Just About EVERYTHING Is About To Collapse”

    dunno man, been hearing that since 2007, heh, been hearing it since 1976. whatever, wake me up if it happens.

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