Is This The Next Big Financial Bubble?

August 24, 2015 will go down in history as the day the Dow Jones Index suffered its worst one-day point decline ever. The index dropped 1,000 points in the first six minutes of trading.1 The panic selling began overseas, after an apparent bubble in Chinese stocks popped.

After rallying 150% in a matter of months, Chinese stocks entered a violent correction, with the Shanghai Composite Index dropping 8.5% in a single day.2 The Dow has recovered somewhat, so it doesn’t seem the bursting of the Chinese bubble will have a lasting impact on the U.S. market.

However, there’s another potential bubble in the U.S. that could trigger a major crisis. I’m talking about the junk bond market. Companies with shaky finances usually issue these bonds. They have become very popular in recent years – due in large part to the Federal Reserve’s zero interest rate policy.

While the benchmark 10-year Treasury note yields about 2%, junk bonds of extremely low quality could yield about 10% a year. Of course, this higher yield comes with a bigger risk of default on coupon payments or the principal. But, many investors feel they have no choice but to take the extra risk. It’s the only way to get a higher income.

The problem is some of the brightest minds on Wall Street believe investors in junk bonds could end up with massive losses.

Billionaire Investors Warn Junk Bonds Are A Bubble
In a recent interview with Bloomberg, billionaire investor Carl Icahn said the market of high-yield bonds is “a bubble that’s going to burst in the next couple of years.”3

Jeffrey Gundlach, CEO of DoubleLine Capital, agrees with him. Mr. Gundlach, also known as the king of the bond markets, correctly predicted the subprime crisis of 2007-08.4 And now, he says the junk bond market could be in trouble because of two factors: higher interest rates and the so-called “wall” of maturities.5

Most market participants expect the Fed to hike rates this year or early next year. Here’s the problem: $600 billion of junk bonds are set to mature in 2018 and 2019.6 With higher interest rates, many companies with weaker financial conditions may not be able to roll over or refinance that debt. So, this could easily lead to a run on bond funds.

Some institutional investors are already betting against junk bonds. According to The Wall Street Journal, “Apollo [one of the world’s largest private equity firms] has been raising money from wealthy investors for a hedge fund that snaps up insurance-like contracts called credit-default swaps that benefit if the junk bonds fall.”7 Hedge funds Reef Road Capital and Oaktree Capital are also raising money to bet on a junk bond crash.

If they’re right, the drop in prices could be violent because there’s not much liquidity. You see, regulators have been forcing banks to cut the amount of corporate bonds sitting on their balance sheet. Richard Berner, Director of the Office of Financial Research (OFR) at the U.S. Treasury Department, has warned, “liquidity appears to have become increasingly brittle, even in the world’s largest bond markets.”8

As a result, many fear there may not be enough bonds available to go around during a panic. If everyone tries to get out of the junk bond market at once, the exit door won’t be wide enough for everyone to leave.

Careful With Those Junk Bond ETFs
Exchange-Traded Funds (ETFs) that give exposure to junk bonds are especially vulnerable to this liquidity problem. If you invest in junk bonds, there’s a good chance you’re doing it though ETFs, such as the iShares iBoxx USD High Yield Corporate Bond ETF (HYG). This is the largest junk bond ETF with nearly $17 billion in assets.

ETFs give the appearance of liquidity because investors can put in buy and sell orders throughout the trading day. HYG trades more than 7.5 million shares per day on average. While shares of ETFs are liquid, junk bonds are not.

In general, with the lack of liquidity in the junk bond market, meaning they don’t trade as often as stocks, there simply aren’t that many investors buying and selling them every day, so if someone is trying to sell, there may not be a buyer at that particular price. Since the ETF is just a basket of junk bonds, it’s affected by this lack of liquidity. The Wall Street Journal reports that, “each of its HYG’s top 10 bonds only traded 13 times a day on average.”9 This means if too many people decide to sell junk bonds at once, it could overwhelm the market and cause prices to crash. So, make sure you’re managing your risk in this area.

Until the next Daily Pfennig® edition…

Mike Meyer
Vice President
EverBank World Markets, a division of EverBank