It’s Called ‘Junk’ For Good Reasons

I talk to investors all the time and one of the most common complaints I hear these days is about low-interest rates.

I can’t count the number of people who have diligently contributed to their 401(k)s and who have saved money their whole lives so they could have a comfortable retirement.

However, the Federal Reserve has pushed interest rates so low that all those responsible savers must face two bad options:

Option #1: Starve! With interest rates just a few baby steps above zero, a portfolio of CDs, bonds, and Treasuries barely pays anything. At a 1% yield, a $500,000 portfolio would only pay out $5,000 a year! Even $1 million would only generate $10,000 a year in net income. Who can live on that?

Option #2: Take A Lot of Risk. Since starving isn’t a very appealing option, most investors choose to take on more risk to generate more income. For many, that means jumping into the stock market. But too many savers have begun buying low-credit low-quality bonds because they pay a higher yield.

I’m talking about junk bonds.

The reason that junk bonds pay more is because the issuing company has lousy credit. Just like with people, the worse your credit rating … the higher the interest rate you are charged to borrow money.

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And for good reason. People and businesses with lousy credit scores often fail to pay back the money that they borrow. Junk bond investors get paid more, but the odds are significantly higher that they lose their principle.

That’s a pretty severe downside, but investors don’t seem to care. Proof: the issuance of sovereign debt from junk-quality companies has skyrocketed in 2017.

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Of course, Wall Street is more than happy to oblige those yield-hungry investors.

Get this. The yield on European junk bonds is now lower than the yield on similar maturity U.S. Treasury bonds. Strange but true. European junk indeed yields less than Treasury bonds.

Who in their right mind would buy junk bonds when U.S. Treasury bonds pay a higher yield?

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However, I think that enthusiasm for junk bonds has reached the point of insanity and that the next major move will be lower.

Moreover, the danger isn’t limited to just junk-bond investors. Historically, trouble in the junk-bond market has served as a reliable warning sign of stock market trouble.

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And the junk-bond market has started to disengage from the stock market. Junk bonds have traded more like equities than bonds, so this divergence is a warning sign for both the stock market and junk bonds.

In fact, it looks like the junk bond market is throwing off a big red warning sign for the stock market.

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Junk-bond prices have started to turn down and some of the hot money is fleeing the junk-bond market. Lipper Analytics reported that investors pulled out $621 million from junk bond funds last week and another $1.2 billion the week before.

One of my early mentors in this business told me, “When it comes to crappy credit quality, he who panics first … panics best.”

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