Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
US Interest Rates - When WIll the Fed Pivot - 1st Mar 2024
S&P Stock Market Real Earnings Yield - 29th Feb 2024
US Unemployment is a Fake Statistic - 29th Feb 2024
U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - 29th Feb 2024
What a Breakdown in Silver Mining Stocks! What an Opportunity! - 29th Feb 2024
Why AI will Soon become SA - Synthetic Intelligence - The Machine Learning Megatrend - 29th Feb 2024
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24
How to Profit from the Global Warming ClImate Change Mega Death Trend - Part1 - 17th Feb 24
Why Rising Shipping Costs Won't Cause Inflation - 17th Feb 24
Intensive 6 Week Stock Market Elliott Wave Training Course - 17th Feb 24
INFLATION and the Stock Market Trend - 17th Feb 24
GameStop (GME): 88% Shellacking Yet No Lesson Learned - 17th Feb 24
Nick Millican Explains Real Estate Investment in a Changing World - 17th Feb 24
US Stock Market Addicted to Deficit Spending - 7th Feb 24
Stocks Bull Market Commands It All For Now - 7th Feb 24
Financial Markets Narrative Nonsense - 7th Feb 24
Gold Price Long-Term Outlook Could Not Look Better - 7th Feb 24
Stock Market QE4EVER - 7th Feb 24
Learn How to Accumulate and Distribute (Trim) Stock Positions to Maximise Profits - Investing 101 - 5th Feb 24
US Exponential Budget Deficit - 5th Feb 24
Gold Tipping Points That Investors Shouldn’t Miss - 5th Feb 24
Banking Crisis Quietly Brewing - 5th Feb 24
Stock Market Major Market lows by Calendar Month - 4th Feb 24
Gold Price’s Rally is Normal, but Is It Really Bullish? - 4th Feb 24
More Problems in US Regional Banking System: Where There's Fire There's Smoke - 4th Feb 24
New Hints of US Election Year Market Interventions & Turmoil - 4th Feb 24
Watch Consumer Spending to Know When the Fed Will Cut Interest Rates - 4th Feb 24
STOCK MARKET DISCOUNTING EVENTS BIG PICTURE - 31st Jan 24
Blue Skies Ahead As Stock Market Is Expected To Continue Much Higher - 31st Jan 24
What the Stock Market "Fear Index" VIX May Be Signaling - 31st Jan 24
Stock Market Trend Forecast Review - 31st Jan 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

The Last Time We Saw This Trend Was Before The Financial Crisis

Stock-Markets / Financial Markets 2017 Jun 05, 2017 - 05:10 PM GMT

By: John_Mauldin

Stock-Markets

BY JARED DILLIAN : There has been a bit of a buzz about covenant-lite bonds lately. This isn’t really new news. You can see from the chart below that cov-lite issuance has been high for a few years now.

But the old-timers know that when the cov-lite paper comes out, it is usually toward the end of a cycle.


Source: @tracyalloway

Let Me Define a Few Terms Here, First.

When a company issues bonds, those bonds usually come with a legal agreement called an indenture.

The indenture has covenants which provide constraints on the borrower’s behavior over the duration of the loan.

There are no such restrictions on consumer debt. If you take out a car loan, and then you take out a bunch of student loans on top of it, there is not much the bank can do about it.

But in the world of corporate debt, you can. Bond covenants can take the form of restrictions on taking out additional debt, or maintenance of certain financial ratios, like interest coverage; stuff like that.

If a borrower is found to be in violation of the covenants, the debt can be downgraded by a rating agency or can be pushed into technical default.

Covenant-lite is when a company borrows from the public basically free of any restrictions whatsoever—kind of like your car loan. If they want to borrow from you, and then go and take out a bunch of additional debt, they can.

Here is how credit markets work.

During bear markets, nobody trusts anybody, and bond indentures are full of covenants. In 2009, during the financial crisis, only 2% of bonds that year were considered to be covenant-lite.

Now, about 75% of bond deals are cov-lite, and it’s been that way for a while. At the top of the cycle, all the cov-lite deals come out. And bond investors are usually very sorry a few years later—when default rates rise, and recovery rates are far below where they would otherwise be.

A Disproportional Risk for a 5% Yield

All of this is when yields (and coupons) on debt are at historical lows, and people are taking on this immense additional risk just to get a 5% yield on very risky paper.

Here’s a chart of HYG, which is considered to be the benchmark high-yield ETF. It’s not a complete picture of the high-yield market, but it’s close enough.

What would make those bonds go to default? Well, generally, default rates are low during expansions and high during recessions. In fact, when credit starts to croak, it is usually a pretty good leading indicator of a recession.

During a recession, default rates can skyrocket to 10 or 12 or even 15 percent—annually. The cumulative probability that a given 5-year bond will default is very high. Yields get out to very high—and attractive levels.

I’ve had some success in timing credit cycles over my career. One of my greatest trades (even though it was small because I was still young and poor) was to buy a high-yield convertible bond fund pretty much at the lows of the credit cycle in 2002.

The yields were astounding. I like buying 14% bonds, not 5% bonds. Don’t you?

The Trade

What is the trade?

The trade is to evaluate your holdings of corporate debt, even the investment grade stuff.

A lot of investors have been pushed out the risk curve into high yield by low interest rates, and that’s not good. People have short memories about how exciting credit can get during a downturn.

It’s even worse when you think about some of the possible liquidity issues that the bond market could have in a disorderly market.

Lots of people think you have to short stuff to be a smart investor. Shorting is hard. I don’t like shorting stuff… Most of the time, just not buying it is good enough.

Cash is great. Keep your powder dry until the next downturn, get some of those 12–14% bonds.

It feels like I bring this up every other week—cash cash cash cash cash. Cash is an option to buy something at a lower price later. As the price of nearly everything is high right now, it’s a great time to hang out in cash.

One of the hardest things to do in investing is to wait—especially to wait for an opportunity to come along. You feel like your money isn’t working for you. Yes, it’s a shame that there’s little-to-no interest in a bank account.

That doesn’t mean you have to go out and take stupid risks just to make a couple hundred basis points.

Grab the Exclusive Special Report, The Return of Inflation: How to Play the Bond Bear Market, from a Former Lehman Brothers Trader

Don’t miss out on this opportunity to cash in on the coming inflation.

Jared Dillian, the former head of Lehman Brothers’ ETF trading desk, reveals why inflationary price increases could be much higher than 1% or 2% and how you can position yourself for big profits as the bond market falls.

Download the special report now. 

John Mauldin Archive

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in