Junk Bonds Are Going To Tell Us Where The Stock Market Is Heading In 2015

Dominoes - Public DomainDo you want to know if the stock market is going to crash next year?  Just keep an eye on junk bonds.  Prior to the horrific collapse of stocks in 2008, high yield debt collapsed first.  And as you will see below, high yield debt is starting to crash again.  The primary reason for this is the price of oil.  The energy sector accounts for approximately 15 to 20 percent of the entire junk bond market, and those energy bonds are taking a tremendous beating right now.  This panic in energy bonds is infecting the broader high yield debt market, and investors have been pulling money out at a frightening pace.  And as I have written about previously, almost every single time junk bonds decline substantially, stocks end up following suit.  So don’t be fooled by the fact that some comforting words from Janet Yellen caused stock prices to jump over the past couple of days.  If you really want to know where the stock market is heading in 2015, keep a close eye on the market for high yield debt.

If you are not familiar with junk bonds, the concept is actually very simple.  Corporations that do not have high credit ratings typically have to pay higher interest rates to borrow money.  The following is how USA Today describes these bonds…

High-yield bonds are long-term IOUs issued by companies with shaky credit ratings. Just like credit card users, companies with poor credit must pay higher interest rates on loans than those with gold-plated credit histories.

But in recent years, interest rates on junk bonds have gone down to ridiculously low levels.  This is another bubble that was created by Federal Reserve policies, and it is a colossal disaster waiting to happen.  And unfortunately, there are already signs that this bubble is now beginning to burst

Back in June, the average junk bond yield was 3.90 percentage points higher than Treasury securities. The average energy junk bond yielded 3.91 percentage points higher than Treasuries, Lonski says.

That spread has widened to 5.08 percentage points for junk bonds vs. 7.86 percentage points for energy bonds — an indication of how worried investors are about default, particularly for small, highly indebted companies in the fracking business.

The reason why so many analysts are becoming extremely concerned about this shift in junk bonds is because we also saw this happen just before the great stock market crash of 2008.  In the chart below, you can see how yields on junk bonds started to absolutely skyrocket in September of that year…

High Yield Debt 2008

Of course we have not seen a move of that magnitude quite yet this year, but without a doubt yields have been spiking.  The next chart that I want to share is of this year.  As you can see, the movement over the past month or so has been quite substantial…

High Yield Debt 2014

And of course I am far from the only one that is watching this.  In fact, there are some sharks on Wall Street that plan to make an absolute boatload of cash as high yield bonds crash.

One of them is Josh Birnbaum.  He correctly made a giant bet against subprime mortgages in 2007, and now he is making a giant bet against junk bonds

When Josh Birnbaum was at Goldman Sachs in 2007, he made a huge bet against subprime mortgages.

Now he’s betting against something else: high-yield bonds.

From The Wall Street Journal:

Joshua Birnbaum, the ex-Goldman Sachs Group Inc. trader who made bets against subprime mortgages during the financial crisis, now has more than $2 billion in wagers against high-yield bonds at his Tilden Park Capital Management LP hedge-fund firm, according to investor documents.

Could you imagine betting 2 billion dollars on anything?

If he is right, he is going to make an incredible amount of money.

And I have a feeling that he will be.  As a recent New American article detailed, there is already panic in the air…

It’s a mania, said Tim Gramatovich of Peritus Asset Management who oversees a bond portfolio of $800 million: “Anything that becomes a mania — ends badly. And this is a mania.”

Bill Gross, who used to run PIMCO’s gigantic bond portfolio and now advises the Janus Capital Group, explained that “there’s very little liquidity” in junk bonds. This is the language a bond fund manager uses to tell people that no one is buying, everyone is selling. Gross added: “Everyone is trying to squeeze through a very small door.”

Bonds issued by individual energy developers have gotten hammered. For instance, Energy XXI, an oil and gas producer, issued more than $2 billion in bonds just in the last four years and, up until a couple of weeks ago, they were selling at 100 cents on the dollar. On Friday buyers were offering just 64 cents. Midstates Petroleum’s $700 million in bonds — rated “junk” by both Moody’s and Standard and Poor’s — are selling at 54 cents on the dollar, if buyers can be found.

So is there anything that could stop junk bonds from crashing?

Yes, if the price of oil goes back up to 80 dollars or more a barrel that would go a long way to settling things back down.

Unfortunately, many analysts are convinced that the price of oil is going to head even lower instead…

“We’re continuing to search for a bottom, and might even see another significant drop before the year-end,” said Gene McGillian, an analyst at Tradition Energy in Stamford, Connecticut.

As I write this, the price of U.S. oil has fallen $1.69 today to $54.78.

If the price of oil stays this low, junk bonds are going to keep crashing.

If junk bonds keep crashing, the stock market is almost certainly going to follow.

For additional reading on this, please see my previous article entitled “‘Near Perfect’ Indicator That Precedes Almost Every Stock Market Correction Is Flashing A Warning Signal“.

But just like in the years leading up to the crash of 2008, there are all kinds of naysayers proclaiming that a collapse will never happen.

Even though our financial problems and our underlying economic fundamentals have gotten much worse since the last crisis, they are absolutely convinced that things are somehow going to be different this time.

In the end, a lot of those skeptics are going to lose an enormous amount of money when the dominoes start falling.

We Just Witnessed The Worst Week For Global Financial Markets In 3 Years

Global Financial Markets Crash - Public DomainIs this the start of the next major financial crisis?  The nightmarish collapse of the price of oil is creating panic in financial markets all over the planet.  On June 16th, U.S. oil was trading at a price of $107.52.  Since then, it has fallen by almost 50 dollars in less than 6 months.  This has only happened one other time in our history.  In the summer of 2008, the price of oil utterly collapsed and we all remember what happened after that.  Well, the same patterns that we witnessed back in 2008 are happening again.  As the price of oil crashed in 2008, so did prices for a whole host of other commodities.  That is happening again.  Once commodities started crashing, the market for junk bonds started to implode.  That is also happening again.  Finally, toward the end of 2008, we witnessed a horrifying stock market crash.  Could we be on the verge of another major one?  Last week was the worst week for the Dow in more than three years, and stock markets all over the world are crashing right now.  Bad financial news continues to roll in from the four corners of the globe on an almost hourly basis.  Have we finally reached the “tipping point” that so many have been warning about?

What we witnessed last week is being described as “a bloodbath” that was truly global in scope.  The following is how Zero Hedge summarized the carnage…

  • WTI’s 2nd worst week in over 3 years (down 10 of last 11 weeks)
  • Dow’s worst worst week in 3 years
  • Financials worst week in 2 months
  • Materials worst week since Sept 2011
  • VIX’s Biggest week since Sept 2011
  • Gold’s best week in 6 months
  • Silver’s last 2 weeks are best in 6 months
  • HY Credit’s worst 2 weeks since May 2012
  • IG Credit’s worst week in 2 months
  • 10Y Yield’s best week since June 2012
  • US Oil Rig Count worst week in 2 years
  • The USDollar’s worst week since July 2013
  • USDJPY’s worst week since June 2013
  • Portugal Bonds worst week since July 2011
  • Greek stocks worst week since 1987

The stock market meltdown in Greece is particularly noteworthy.  After peaking in March, the Greek stock market is down 40 percent since then.  That includes a 20 percent implosion in just the past three trading days.

And it isn’t just Greece.  Financial markets all over Europe are in turmoil right now.  In addition to crashing oil prices, there is also renewed concern about the fundamental stability of the eurozone.  Many believe that it is inevitable that it is headed for a break up.  As a result of all of this fear, European stocks also had their worst week in over three years

European stock markets closed sharply lower on Friday, posting their biggest weekly loss since August 2011, as commodity prices continued to fall and and shares in oil-related firms came under renewed pressure from the weak price for crude.

The pan-European FTSEurofirst 300 unofficially ended 2.6 percent lower, down 5.9 percent on the week as the energy sector once again weighed heavily on wider benchmarks, falling over 3 percent.

But despite all of the carnage that we witnessed in the U.S. and in Europe last week, things are actually far worse for financial markets in the Middle East.

Just check out what happened on the other side of the planet on Sunday

Stock markets in the Persian Gulf got drilled Sunday as worries about further price declines grew. The Dubai stock index fell 7.6% Sunday, the equivalent of a 1,313-point plunge in the Dow Jones industrial average. The Saudi Arabian market fell 3.3%.

Overall, Dubai stocks are down a whopping 23 percent over the last two weeks, and full-blown stock market crashes are happening in Qatar and Kuwait too.

Like I said, this is turning out to be a truly global financial panic.

Another region to keep an eye on is South America.  Argentina is a financial basket case, the Brazilian stock market is tanking big time, and the implied probability of default on Venezuelan debt is now up to 93 percent

Swaps traders are almost certain that Venezuela will default as the rout in oil prices pressures government finances and sends bond prices to a 16-year low.

Benchmark notes due 2027 dropped to 43.75 cents on the dollar as of 11:35 a.m. in New York, the lowest since September 1998, as crude extended a bear market decline. The upfront cost of contracts to insure Venezuelan debt against non-payment for five years is at 59 percent, bringing the implied probability of default to 93 percent, the highest in the world.

So what does all of this mean for the future?

Are we experiencing a repeat of 2008?

Could what is ahead be even worse than that?

Or could this just be a temporary setback?

Recently, Howard Hill shared a few things that he looks for to determine whether a major financial crisis is upon us or not…

The first condition is a serious market sector correction.

According to some participants in the market for energy company bonds and loans, such a correction is already underway and heading toward a meltdown (the second condition). Others are more sanguine, and expect a recovery soon.

That smaller energy companies have issued more junk-rated debt than their relative size in the economy isn’t under debate. Of a total junk bond market estimated around $1.2 trillion, about 18% ($216 billion, according to a Bloomberg estimate) has been issued by energy-related companies. Yet those companies represent a far smaller share of the economy or stock market capitalization among the universe of junk-rated companies.

If the beaten-down prices for junk energy bonds don’t stabilize or recover a bit, we might see the second condition: a spiral of distressed sales of bonds and loans. This could happen if junk bond mutual funds or other large holders sell into an unfriendly market at low prices, and then other holders of those bonds succumb to the pressure of fund redemptions or margin calls and sell at even lower prices.

The third condition, which we can’t determine directly, would be pressure on Credit Default Swap dealers or hedge funds to make deposits as the prices of the CDS move against them. AIG was taken down when collateral demands were made to support existing CDS agreements, and nobody knew it until they were going under. There simply isn’t a way to know whether banks or dealers are struggling until the effect is already metastasizing.

I think that he makes some really good points.

In particular, I think that watching how junk bonds perform over the next few weeks will be extremely telling.

Last week was truly a bloodbath for high yield debt.

But perhaps things will stabilize this week.

Let’s hope so, because this is the closest that we have been to another major financial crisis since 2008.

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