Last month I called to attention that junk bond ETF’s were yielding below 5% ( a truly astonishing stat) in this post:
Junk Debt Yielding Under 5%? Yeah That’s Not a Problem
Turns out as expected, that didn’t last. Notice the trading in the popular JNK high yield bond ETF (no position) over the past week:
Source: Yahoo Finance
If this keeps up, we’ll have yields back to more respectable levels in no time. Even the most ignorant neo-Keynesian would have to worry about the distortions caused by the Federal Reserve’s Zero Interest Rate Policy (ZIRP) when junk bonds are yielding below 5%. Remember, these are the bonds that historically can default at a rate greater than 5% on an annual basis.
This is what Buffet talks about when he says when the tide goes out we see who’s swimming naked. And as I mentioned in a tweet last week, ZIRP has made everyone a chartist as fundamentals don’t matter (until they do):
Don’t get me wrong, if you’re not managing too big a pile of money and can trade nimbly, JNK was a heck of a trade. Look at the longer term chart:
Source: Yahoo Finance
It wasn’t a bad trade. Earn 6-7% yield and ride the price up from 38-41. Traders added with others (likely retail) buying for the “high” dividend. As long as people felt that 0% was here to stay, 5% looked great. But as soon as a whiff of a hint that rates might rise came around, people started scrambling out of yielding investments. Look at the preferred stock ETF PFF:
6 month chart PFF – Source: Yahoo Finance
It basically gave up much of the gain that it crawled to earn over the past 4 months in just a few days (excluding dividend). Other income paying sectors have reacted similarly including utilities and REITs.
Where Do We Go From Here?
I don’t think these will collapse fully – I think some soothing words from Fed officials and a possible market correction (the small variety) may scare people back into these vehicles. In past relentless rallies (2007 for example) we had a preliminary scare or two before the real break. I still remember a mini dump early in 2007, and the market’s strong buying response to that making me think my market thesis was wrong by cutting back. I had to watch stocks climb until later in 07 when they began their slow retreat heading into the 08 crash.
For now, these could hold up and it wouldn’t surprise me. But as I saw in 07 (not that every correction is a possible 08 crash), it could be a preview of coming attractions. And this is how a major 1987 event could happen. This market is not liquid when trouble hits. It’s liquid (meaning numerous buyers and sellers) on regular up 100 point days but when trouble hits, some markets go no bid. If people got the idea that rates were really going to rise, and especially not by choice (market forces them higher for example), then we would see VERY HARD corrections in all kinds of assets. Everything is interest rate sensitive if the move is big enough (percentage-wise) and when rates are 0%, a move to 1 or 2% is HUGE .
For now, be careful out there. It’s time to evaluate all of your trades and/or investments for risk and perhaps weed out subpar ideas. Even if it means concentrating more on your good ideas if you don’t want to go to cash. But volatility is rising and Vol is no friend of trends (great for day traders though).
Homework – what is your plan and response to the following questions (not an exhaustive list):
- Do you have interest rate super sensitive holdings, like REIT’s, MLPs, and high dividend stocks? What will you do if they drop 20% or have that risk of dropping 20 or 30%?
- is your portfolio concentrated without you realizing it? If you are short the dollar and long gold, that is correlated. You are not likely diversified. Find out if you have not so obvious correlated holdings and come up with a plan
- Do you have low quality, highly levered stocks? What will happen to profits if rates rose?
- What is your risk management plan for each position and portfolio as a whole? And let’s review – for investors, a risk management plan is knowing the value of the companies you own and having a margin of safety. For traders, it’s having a stop loss plan or a take profits plan.
Good luck and feel free to drop any questions and comments!
Note: at the time of this writing, I or my clients owned the following securities mentioned in this article: PFF, gold
High Yield Bonds Yielding Under 5%? We Knew it Couldn’t Last
Last month I called to attention that junk bond ETF’s were yielding below 5% ( a truly astonishing stat) in this post:
Junk Debt Yielding Under 5%? Yeah That’s Not a Problem
Turns out as expected, that didn’t last. Notice the trading in the popular JNK high yield bond ETF (no position) over the past week:
Source: Yahoo Finance
If this keeps up, we’ll have yields back to more respectable levels in no time. Even the most ignorant neo-Keynesian would have to worry about the distortions caused by the Federal Reserve’s Zero Interest Rate Policy (ZIRP) when junk bonds are yielding below 5%. Remember, these are the bonds that historically can default at a rate greater than 5% on an annual basis.
This is what Buffet talks about when he says when the tide goes out we see who’s swimming naked. And as I mentioned in a tweet last week, ZIRP has made everyone a chartist as fundamentals don’t matter (until they do):
Don’t get me wrong, if you’re not managing too big a pile of money and can trade nimbly, JNK was a heck of a trade. Look at the longer term chart:
Source: Yahoo Finance
It wasn’t a bad trade. Earn 6-7% yield and ride the price up from 38-41. Traders added with others (likely retail) buying for the “high” dividend. As long as people felt that 0% was here to stay, 5% looked great. But as soon as a whiff of a hint that rates might rise came around, people started scrambling out of yielding investments. Look at the preferred stock ETF PFF:
6 month chart PFF – Source: Yahoo Finance
It basically gave up much of the gain that it crawled to earn over the past 4 months in just a few days (excluding dividend). Other income paying sectors have reacted similarly including utilities and REITs.
Where Do We Go From Here?
I don’t think these will collapse fully – I think some soothing words from Fed officials and a possible market correction (the small variety) may scare people back into these vehicles. In past relentless rallies (2007 for example) we had a preliminary scare or two before the real break. I still remember a mini dump early in 2007, and the market’s strong buying response to that making me think my market thesis was wrong by cutting back. I had to watch stocks climb until later in 07 when they began their slow retreat heading into the 08 crash.
For now, these could hold up and it wouldn’t surprise me. But as I saw in 07 (not that every correction is a possible 08 crash), it could be a preview of coming attractions. And this is how a major 1987 event could happen. This market is not liquid when trouble hits. It’s liquid (meaning numerous buyers and sellers) on regular up 100 point days but when trouble hits, some markets go no bid. If people got the idea that rates were really going to rise, and especially not by choice (market forces them higher for example), then we would see VERY HARD corrections in all kinds of assets. Everything is interest rate sensitive if the move is big enough (percentage-wise) and when rates are 0%, a move to 1 or 2% is HUGE .
For now, be careful out there. It’s time to evaluate all of your trades and/or investments for risk and perhaps weed out subpar ideas. Even if it means concentrating more on your good ideas if you don’t want to go to cash. But volatility is rising and Vol is no friend of trends (great for day traders though).
Homework – what is your plan and response to the following questions (not an exhaustive list):
Good luck and feel free to drop any questions and comments!
Note: at the time of this writing, I or my clients owned the following securities mentioned in this article: PFF, gold
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About The Author
Chris Grande