High Yield Bonds: The Next Crisis?

05/06/2014 9:00 am EST

Focus: FUNDS

Crashes, collapses, and panics never start where people think they will, cautions Briton Ryle. In Wealth Daily, he questions whether high yield bonds could prove to be the next financial crisis.

In 2007, very few people thought there would be a housing collapse. There had never been one before, and houses have always been a mainstay of the US economy and relatively stable in price.

In 1998, virtually nobody knew that one hedge fund, Long Term Capital Management, had leveraged a position in Russian bonds to the tune of about $1 trillion.

In 1987, the Dow Industrials ramped up 44% before Black Monday, when stocks dropped 22% in one day.

My point here is that we never really know what will start a correction or a crash. But we can say that the potential for a small spark to start a stock market bonfire gets higher as valuations get higher.

Today, investors are watching China for signs of a breakdown. Russia's imperialistic moves around Ukraine have certainly raised geopolitical risk. And, of course, there's always the Fed's $3 trillion balance sheet.

People say low interest rates have created a bubble in housing, in emerging markets, and in stocks. But if you want to find the source of a crash or a correction, look for a place, or sector, where cash flow could change very quickly.

Right now, the corporate bond market—especially the junk bond market—is a good place to look.

Corporate America is on a borrowing spree. They are taking on debt like there's no tomorrow. In 2012 and 2013, companies borrowed something like $2.5 trillion dollars.

And around $600 billion of that is high yield junk bonds. For comparison's sake, just $43 billion in junk bonds were issued in 2008.

Junk bonds are rated BBB and below. Standard & Poor's calls them “speculative grade” bonds—speculative because the companies have to pay a higher interest rate because the risk of default is greater.

And Wall Street can't get enough of them. If you're thinking this is similar to the way mortgage bonds traded in 2005 and 2006, well, I'm thinking the same thing.

It's easy to see why Wall Street wants junk bonds. Interest rates are so low, you can't make any money off Treasury bonds. As usual, Wall Street is happy to take on more risk to make more money. The financial crisis didn't change that.

Hedge funds—and even investment banks—will buy bonds and then borrow against that asset to buy more assets. That's leverage. But if the asset that is borrowed against falls in value, the company may have to raise cash. If there's no way to raise cash, the fund or bank fails.

I think the odds are high that some companies that have issued high yield debt will be bled dry. The money will run out. It's just a matter of time. The question we can't answer is: how leveraged are the bondholders?

Sure, “high yield” bonds have averaged something like 17% a year for the last couple of years. But there will be a reckoning for the corporate bond market.

It's inevitable that bond defaults will rise, some companies will fail, and bondholders will lose money. If you own any “high yield” bond funds, you should consider getting out.

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