Best of the Week
Most Popular
1.US Paving the Way for Massive First Strike on North Korea Nuclear and Missile Infrastructure - Nadeem_Walayat
2.Trump Reset: US War With China, North Korea Nuclear Flashpoint - Video - Nadeem_Walayat
3.Silver Junior Mining Stocks 2017 Q2 Fundamentals - Zeal_LLC
4.Soaring Inflation Plunges UK Economy Into Stagflation, Triggers Government Pay Cap Panic! - Nadeem_Walayat
5.The Bitcoin Blueprint To Your Financial Freedom - Sean Keyes
6.North Korea 'Begging for War', 'Enough is Enough', is a US Nuclear Strike Imminent? - Nadeem_Walayat
7.Bitcoin Hits All-Time High and Smashes Through $5,000 As Gold Shows Continued Strength - Jeff_Berwick
8.2017 is NOT "Just Another Year" for the Stock Market: Here's Why - EWI
9.Gold : The Anatomy of the Bottoming Process - Rambus_Chartology
10.Bitcoin Falls 20% as Mobius and Chinese Regulators Warn - GoldCore
Last 7 days
Comfortably Numb: Surviving the Assault on Silver - 17th Oct 17
Are Amey Street Tree Felling's Devaluing Sheffield House Prices? - 17th Oct 17
12 Real-Life Techniques That Will Make You a Better Trader Now - 17th Oct 17
Warren Buffett Predicting Dow One Million - Being Bold Or Overly Cautious? - 17th Oct 17
Globalization is Poverty - 17th Oct 17
Boomers Are Not Saving Enough for Retirement, Neither Is the Government - 16th Oct 17
Stock Market Trading Dow Theory - 16th Oct 17
Stocks Slightly Higher as They Set New Record Highs - 16th Oct 17
Why is Big Data is so Important for Casino Player Acquisition and Retention - 16th Oct 17
How Investors Can Play The Bitcoin Boom - 16th Oct 17
Who Will Be the Next Fed Chief - And Why It Matters  - 16th Oct 17
Stock Market Only Minor Top Ahead - 16th Oct 17
Precious Metals Sector is on Major Buy Signal - 16th Oct 17
Really Bad Ideas - The Fed Should Have And Defend An Inflation Target - 16th Oct 17
The Bullish Chartology for Gold - 15th Oct 17
Wikileaks Mocking US Government Over Bitcoin Shows Why There Is No Stopping Bitcoin - 15th Oct 17
How to Wipe Out Puerto Rico's Debt Without Hurting Bondholders - 15th Oct 17
Gold And Silver – Think Prices Are Manipulated? Look In The Mirror! - 15th Oct 17
Q4 Pivot View for Stocks and Gold - 14th Oct 17
Gold Mining Stocks Q3’17 Preview - 14th Oct 17
U.S. Mint Gold Coin Sales and VIX Point To Increased Market Volatility and Higher Gold - 14th Oct 17
Yuan and Gold - 14th Oct 17
Tips for Avoiding a Debt Meltdown - 14th Oct 17
Bitcoin Hits New All-Time High Above $5,000 As Lagarde Concedes Defeat and Jamie Demon Shuts Up - 13th Oct 17
Golden Age for GOLD, Dark Age for the Stock Market - 13th Oct 17
The Struggle for Bolivia Is About to Begin - 13th Oct 17
3 Reasons to Take Your Invoicing Process Mobile - 13th Oct 17
What Happens When Amey Fells All of a Streets Trees (Sheffield Tree Fellings) - Video - 13th Oct 17
Stock Market Charts Show Smart Money And Dumb Money Are Moving In Opposite Directions—Here’s Why - 12th Oct 17
Your Pension Is a Lie: There’s $210 Trillion of Liabilities Our Government Can’t Fulfill - 12th Oct 17
Two Highly Recommended Books from Bob Prechter - 12th Oct 17
Turning Point Nations On The Stage - 11th Oct 17
The Profoundly Personal Impact Of The National Debt On Our Retirements - 11th Oct 17
Gold and Silver Report – Several Interesting Charts - 10th Oct 17
London House Prices Are Falling – Time to Buckle Up - 10th Oct 17
The S&P Is A Bloated Corpse - 10th Oct 17
Are Gold and the US Dollar Rallying Together? - 10th Oct 17

Market Oracle FREE Newsletter

3 Videos + 8 Charts = Opportunities You Need to See - Free

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

© 2005-2017 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

Catching a Falling Financial Knife