Don't Run Out Of Gas In Mendocino County

| About: iShares iBoxx (HYG)


Let's take a fresh look at the default cycle, shall we?

Spoiler alert: high yield is still in trouble.

Don't worry, it's "contained." Just like there's another gas station a few miles down the road.

Nearly 20 years ago, my wife and I were driving back to our California home from a summer trip to Oregon. At one point, noting that my gas meter was below a quarter of a tank, I passed a gas station where the price seemed insanely high. I kept on driving. That is when I learned a lesson about markets I never since forgot. The outrageously high price of gas was a signal to me that there was no gas anywhere for miles and miles. And so it is with junk bonds. In this case, you're the gas station owner collecting a high fee because there isn't a decent yield in safer instruments for miles, as it were. But some of the issuers are thrilled to pay the high rates because they're desperate to have one more chance to stay in business (e.g., shaky energy companies) or their corporate treasurers are eager to buy back more company stock so their share prices can rise and they can receive performance bonuses at work.

I assume this website will pardon the lengthy block quote here because... well, because they wrote it. And good for them. It's a fantastic bit of commentary from Gil Weinreich who apparently is an award-winning financial journalist. I'm now a fan.

Actually, I was already a fan. He occasionally refers to my pieces in his daily newsletters which is great because it takes a certain intestinal fortitude to stomach Heisenberg -- even when you know Heisenberg is probably right.

And if there's one thing Heisenberg is right on, it's high yield credit or, in more pejorative terms, junk bonds. Incidentally, I hope Gil appreciates just how spot-on his analysis is: since junk defaults are coming from oil and gas, it would be difficult to conjure a better analogy than a gas station owner. It reminds me of Billy Bob Thornton in the underrated Oliver Stone film "U-Turn":

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See the thing about junk bonds is, retail investors (read: homegamers + mom and pop) shouldn't be allowed to buy them. I know that sounds condescending and paternalistic, but do you know what else is condescending and paternalistic? The law that says you have to wear a seat belt when you're in a car. But we can all agree that's a pretty sensible rule, right?

I've beat the HY horse to death and then beat it some more (see here and here), but the simple fact is, no one seems to get it.

Let me try something else. Do you agree with the following statement? "There's no such thing as a free lunch." If you do, then get the hell out of HY. That is not to say there isn't a time for being in junk -- there is. But this isn't that time. Recall the following visual I showed you earlier this week:

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You're at the beginning stages of a default cycle folks. Here's what the soothsayers will tell you: "If you've picked good credits and plan to hold them to maturity, none of this matters."

They're right. But let me ask you something. If you're reading this and you own HY credit, how many of you went out and did the homework and bought individual junk bonds?

Now let me ask you something else. How many of you just bought a junk bond ETF (NYSEARCA:HYG) instead?

I'm betting most of you fall into the latter category. Well guess what? Your units are backed by actual bonds. Imagine that, right? There seems to be this misconception among retail investors that somehow junk bond ETFs don't involve actual junk bonds. It's like they think they're betting on VIX futures or something. Hello? Common sense, are you there? Come in common sense. Mayday, Mayday! Here, look:

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That's a screengrab from iShares official HYG page.

Are you in HYG? Yes? Well then 13% of your money is in junk energy bonds and another 12% is in cyclicals. Why do you think those bonds yield so much? Oh that's right, because US HY energy is a disaster and cyclicals are too:

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(Charts: Deutsche Bank)

See what I'm saying? You think you're holding the ETF. You think that means something. And you think that ETF is safe. But the ETF is just a figment of BlackRock's imagination. What you actually own is the underlying bonds.

Now ask yourself this: how can a fund pay out a wave of redemptions without selling the underlying bonds? The answer: it can't. You're being lied to. The apparent liquidity in ETFs is an illusion. Nobody on the Street is going to inventory this stuff in a pinch. And don't think BlackRock doesn't know this. That's why Carl Icahn chastised Larry Fink last summer.

Well guess what? Now Goldman is out raising their default forecasts. Are they worried? Well, yes and no:

The 12-month trailing issuer-weighted US HY default rate rose to a six-year high in June to 5.1% with a total of 33 issuers defaulting in the second quarter, according to data from Moody's. The default rate, which includes distressed exchanges, has more than doubled from a year ago and slightly surpassed the upper-bound of our year-end 2016 forecast in the 4.5-5% range. While our forecasts assumed continued distress in HY Energy and Metals and Mining issuers, the magnitude of defaults within commodities-exposed sectors exceeded our expectations.

Even as we revise our default forecast higher, our central 70% thesis "what happens in commodities, stays mostly in commodities," remains intact.

Look folks, I'm going to tell you the truth because apparently some people are reluctant to level with you: that last part is silly. How on earth could it "stay in commodities"? Do you think that sector doesn't have a knock-on effect?

A bunch of people can't just go belly up in isolation. Their businesses support businesses in other sectors. That's how an economy works. I produce widgets, but I need your widgets to produce mine. If I go bust, you might too.

Of course Goldman is right that for now the defaults are generally confined to commodities. Here are the visuals:

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(Charts: Goldman)

But why is that comforting? I mean the defaults have to start somewhere. Taking solace in that is like saying "well, for now the hurricane is confined to the middle of the ocean."

Here's what else Goldman had to say (emphasis mine):

We reiterate our cautious stance towards HY Metals and Mining, as the sustained [spread] compression, both on an absolute basis and relative to the broader HY market, reflects temporary tailwinds in the sector, rather than the still weak fundamental outlook.

Do you know who told you that last Sunday? Let me give you a subtle hint...

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Now then, who's the sucker who wants $10 billion in dilutive new equity?...

(Table: BofAML)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.