The Most Dangerous Bubble - High Yield Bonds


ur investment thesis for 2020 has been “Betting on a Bubble”. We formed this thesis at the beginning of the year when the economy was strong and the Federal Reserve was “only” printing $1 trillion to finance US government deficits. We maintained this thesis as the economy weakened due to COVID-19 but the Fed’s money printing accelerated to more than $3.5 trillion (please see the link to our August 24th video – “Money Printing 101).

Thus far we have focused our bubble commentary on US equity, housing, and commodity markets. In this report we expand our analysis to look at high yield corporate bonds.

Most financial markets are in the early stages of a potential bubble and the downside risks of a bursting bubble are well into the future, in our opinion. We believe that investors could face a more immediate threat of substantial losses in high yield bonds.

Fed Purchases are Propping Up High Yield Bonds

High yield bonds, also known as “junk” bonds, are loans to companies that carry a higher than average risk of default. As the name suggests, high yield bonds compensate investors for this default risk by offering higher yields than most other fixed income investments.

We believe current Fed policy could be distorting the market mechanisms that increase junk bond yields and lower prices as default risks increase.

The Fed has purchased over $3.5 trillion bonds in recent months and has for the first time committed to purchasing high yield bonds. Fed purchases have driven interest rates to historic lows for high quality bonds, increasing demand for yield elsewhere.

That search for yield, combined with potential support from Fed purchases, is causing junk bond investors to ignore warning signs that defaults could spike to more than twice the current yield of their portfolio.

Bankruptcy filings are an obvious indicator of potential defaults. As shown in the chart below, the current rate of bankruptcy filings has historically pushed interest rates on high yield bonds to more than 14.4%. Instead, junk bonds currently yield about 5.6%. This yield not only fails to anticipate a likely rise in defaults, it is also the first time in our experience that junk bonds yield less than the current default rate (6%).

High Yield Bubble Could be First to Pop

Bubbles in equity, housing and commodity markets typically do not burst until the monetary policies that helped inflate the bubble are reversed.

We think the Fed has little choice but to keep supporting big government deficits throughout 2021 and possibly into 2022.

If we are correct, then for most financial markets any potential bubbles could continue for a couple of years. By contrast, bubbles in high yield bonds can burst when defaults rise to dangerous levels. Such a spike in defaults can occur despite the Fed continuing to aggressively print money.  

The major equity indices (e.g. S&P 500, Dow Jones and NASDAQ 100) consist primarily of large, financially stable companies. The stock prices of these companies may go up and down but very few of these companies typically go bankrupt.

By contrast, junk bond portfolios consist of companies with high levels of debt and relatively weak financial stability.

As shown in the chart below, even in good economic conditions, an average of 2% to 3% of high yield companies can be expected to default every year. During economic recessions, default rates on high yield bonds can spike to more than 12%. Once a company defaults, unsecured junk bond holders typically lose 55% to 60% of their investment.

Equity investors also experience that kind of loss in a severe market decline. However, provided the company does not bankrupt, investors can hope for an eventual recovery in the price of their investment.

High yield bond defaults, on the other hand, tend to be permanent losses without much hope for future recovery. This explains why, if defaults rise high enough, high yield investors start selling and prices can collapse. This price action can be slowed by an aggressive Fed, but in a high default environment no amount of Fed accommodation can prevent painful losses in junk bonds, in our opinion.

Defaults Could Spike to 12%

Like all highly indebted borrowers, high yield companies default when no one will lend them more money. As banks tighten lending standards, high yield borrowers are cut off from further loans and defaults tend to rise.

As shown by the blue bars in the chart above, US banks have tightened lending standards in 2020 about as much as they did in 1991, 2001 and 2008 recessions.

Based on those prior periods of restricted loan access, junk bond defaults can be expected to rise to more than 11% over the next 12 to 18 months. Both Moody’s Corp. and S&P Global Inc., the two biggest credit ratings firms, are predicting that defaults for U.S. high yield corporations will double from the current 6% rate to 12% by early 2021.

Conclusion: Recommended Strategy – Sell High Yield Bonds

We believe that we are in the early stages of bubbles in equity, housing and commodity markets. Investors should have a risk management plan but should not yet be thinking of selling assets in these markets, in our opinion.

By contrast, high yield bond defaults can impose losses before a bubble in prices has deflated. Once investors experience these losses, Fed policy support for high yield bonds could be swamped by a wave of investor selling. We recommend investors swap their junk bond investments for a comparable risk portfolio of about 60% equities and 40% cash. We believe this combination of stocks and cash offers more upside if the bubble continues to inflate, and less downside if defaults begin to rise.

Follow Us on Social Networks!

Our latest publications
& news straight to your inbox!

Email us at
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
More Posts

You Might Also Like