The credit cycle is showing signs of weakness.

music selection:  “If I Can’t Have You” — Yvonne Elliman

One of my favorite ways to invest is to buy bonds of companies that have recently been downgraded to “junk” by the major rating agencies.  These Fallen Angels are near investment grade and have a default rate a little under 2% (and you can expect to recover 40% on average in bankruptcy).  The pricing becomes stupid cheap as most bonds are held by institutions with strict requirements for their holdings.  Upon a downgrade to junk, the majority of most bonds end up being held by institutions with a legal obligation to sell.  Short term supply overwhelms demand and prices crash.

Let’s presume a bond with a 5% coupon expiring 5 years from today.  Let us assume it gets downgraded to the highest category of “high yield”.  Prices might fall to 75 cents on the dollar (or lower!) in short order.  You now earn 6-2/3rds percent on your cash outlay.  That is a pretty good yield to begin with but there is a kicker.  There is a 98% chance the bond will pay at par in five years.  That is a 33% return (0.25/0.75) over five years or enough to double your return.  Credit cycles turn fast and you can often expect to earn most of that 33% in a much shorter period of time, radically boosting yields.

The size of the opportunity in this cycle is enormous.  Never before has so much corporate debt (trillions!) been rated just one notch above junk.  When the cycle turns, (and it always turns) there is going to be far more supply than demand.  A few hedge funds are raising capital to seize on this opportunity but not enough to keep prices from falling lower than in any other liquidity crisis.  Many “money good” bonds might trade as low as 50 cents on the dollar.

There are already signs the credit cycle is turning.  S&P and Moody’s both note that there have been more downgrades and fewer upgrades in Q1 2019 compared to Q2 2018.  The yield curve has begun to invert.  Bank credit available to lend is drying up.  We may be as much as 18 months away from the next 2008 style crisis, so I’m staying invested long.  But I’m also tightening trailing stops, reducing position sizes, and being far more conservative.  I want cash on the sidelines when the market starts giving away easy money in the bond market.

You’ll note over the next 18 months or so that trading activity here at the Raptor is slower.  You will probably also notice some shifting strategy such as writing covered calls in the money instead of narrowly out, the use of spreads (especially calendar spreads), and the use of long puts on heavily indebted companies as a hedge (see SC, GM, F, HTZ, THC, ALLY, COF, T, TSLA so far).

I’ll add one note of caution.  When you see outstanding opportunities in high yield debt in the next cycle bottom, don’t put all your eggs in one basket.  A small percentage of your bonds will go to truly zero.  So long as you are properly diversified, you will more than recover with plenty of 50%+ returns.  And occasionally, you will pick up shares of a newly debt free company in reorganization that will be 5 baggers or more.  This may require “small” position sizes for beginning distressed debt investors.  Interactive Brokers has great bond pricing, an easy to use interface that allows you to trade bonds without calling a “bond desk”, and usually has a minimum lot size of 2 bonds.  Most other brokers are still in the dark ages when it comes to retail bond trading.  I receive no compensation from IB for that recommendation.  They just what I use and recommend.

Devour your prey raptors!

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