The title of yesterday’s talk “summer Insects” is in reference to a quote from the Chinese philosopher Zhuangzi “You can’t discuss ice with a summer insect” This is in reference to the fact that almost everyone active in the bond market today has no experience of trading in a secular bear market. This is a point I have made repeatedly over the last few years not least at The Chart Seminar. If you started out in your career in 1980 and bought the dips in Treasuries for the next thirty five years you would be a wealthy person today and will have cruised into late middle age without experience of a secular bear market.
He then tied this to the fact that high yield bonds as an asset class only really took off after 1980. Until the 1970s the vast majority of bonds issued were investment grade and those trading as junk were those that had lost their investment grade status. Here is a section from a piece by Glenn Yago for the Library of Economics and Liberty:
The market for new-issue junk bonds dramatically reopened for business in 1977 when Bear Stearns and Company underwrote the first new-issue junk bond in decades. Soon thereafter, Drexel Burnham brought the debt of seven below-investment-grade companies to market. By 1983 more than one-third of all corporate bond issues were noninvestment grade. Today, the junk-bond market, by most definitions, exceeds half a trillion dollars.
This explosive growth had several causes. High-yield bonds were extremely attractive for borrowers, as they had lower interest rates and greater liquidity than private placements, and they imposed fewer restrictions on the actions of the borrowers (restrictive covenants) than either loans or private placements. The value of high-yield bonds to investors, moreover, was strengthened by the research of W. Braddock Hickman, Thomas R. Atkinson, Orin K. Burrell, and others, who discovered that below-investment-grade debt earned a higher risk-adjusted rate of return than investment-grade bonds. In other words, the interest rate that premium junk bonds offered more than compensated investors for the added risk of default. Michael Milken trumpeted these insights to both his investor customers and entrepreneurs seeking growth capital, with stunning success. The companies Milken financed with these bonds created millions of new jobs between the 1970s and 1990s.
Jeff Gundlach then went through a thought experiment “what if the historical default rate that we think of as normal i.e. around 4% is reflective of the fact that our only experience has been of a secular bull market. What happens if in a secular bear market the average default rate is higher? He also pointed out that high yield bonds almost never mature, they mostly are either called back, refinanced, upgraded or default.
He also highlighted that as 30-year Treasury yields hit a new all-time low in February flows into long-dated bonds hit a record highs. From a chartist’s perspective this type of volume at a major peak is about as contrarian a signal as one might wish for. Yields found support above the low in March and rallied last week to break the progression of lower rally highs that has been in evidence since late 2013 and to confirm the failed downside break.
The long-term progression of lower rally highs is currently at 4% and it is looking increasingly likely that level will be tested at some point over the next year.
As anyone with even the least bit of knowledge of trends will admit, 2-year yields continue to move progressively higher regardless of the fact short-term interest rates have not risen just yet.
Mr Gundlach was positive on gold and remarked on the metal’s relative performance compared to the CRB. Bullion is currently bouncing from the lower side of a two-year range and a clear downward dynamic would be required to question current scope for continued higher to lateral ranging.