The Macro Market Wrap Up With The Mad Genius, Vol. 38

In continuation of my forecast for this year, the next topic I’d like to talk about is bonds. In particular there are 3 categories of bonds I’d like to address today, which are corporate investment grade bonds, non-investment grade, junk or high yield bonds, and treasury bonds.

Before I get started I just want to clarify that there are three terms to understand with treasuries, which are bonds issued by the US government. There are treasury bills, treasury notes, and treasury bonds. Most of the time when you hear treasury bonds, it is just a general term for all treasuries, but the technical definition is any treasury that is due to be paid in full, including principle and interest, in more than 10 years. A treasury note is anything due to be paid in full, including principle and interest, in 365 days or more, but not more than 10 years. And a treasury bill, also called a t-bill, is 52 weeks (364 days) or less. The easy way to remember that is a bill is due now, a note is a reminder to pay soon, and bond is super long term, like a bond between parent and child.

Anyhow, if my forecast for interest rates and asset sales at the Fed plays out as I suspect it will, what we’ll see is continued strength in the price of bonds for now, but as soon as the Fed begins back tracking, initially there will be a flight into bonds from virtually all other tradable assets. That’s because US treasuries are perceived as a safe haven asset.

Once people realize what is going on, that the economy is headed sharply and quickly into recession, and the Fed begins to move on reversing policy, the next realization will be that treasuries are not the safe have they were once thought to be. The rest of the world will be dumping treasuries. Slowly at first, but they’ll pick up the pace soon enough. And when there is a supply glut without the demand to soak that up, the price falls and the interest rate will rise, regardless of what the Fed will try to do to prop up the treasury market.

What this means is that there will be initial strength in the price of treasuries, and then protracted weakness in the price of treasuries. And the only treasuries that will be worth holding will be those coming mature in 3 months or less. The longer the maturity date beyond 3 months, the more volatility you will see.

As far as investment grade corporates, the economy is moving quickly to recession. Not just in America but also around the world. So investment grade companies will see falling revenue as well as falling net earnings, regardless of where in the world they have diversified their business model to. This will cause investment grade bonds to be downgraded by two or more notches, meaning that anything currently below AAA will go to non-investment grade, which I’ll get to in a moment.

The key takeaway on investment grade bonds is that as they are downgraded to junk territory, institutions will be legally obligate to sell, either because they are insurance companies that must hold a certain percentage of assets in investment grade bonds, or because the corporate charter (think mutual funds) won’t all junk in their portfolio. With a flood of supply coming to the market, the price of these bonds will fall, and the yield will rise.

As far as junk bonds go, any company that has a junk rating means the likelihood of bankruptcy is pretty serious. We’ll probably see at least 25% of junk bonds fail, meaning that if you own them you’ll either lose everything or take a #2 all the way around on your barber’s clipper. Junk bonds at BB have a 25% chance to file bankruptcy, and lower ratings equal higher chances of failure. Many of these companies can only stay in business now if they can refinance their current debt into new debt with a higher interest rate, decreasing the probability of getting paid back. So how will they fare if the economy retracts?

The key takeaways for all bonds is that for now you still have a chance to get out of dodge. Prices may remain temporarily strong, but that strength will quickly fade as the economy slows. The lower the grade on the bond, the more likely are further downgrades and default. And treasuries will not remain the safe haven once thought, leaving the only safe place in bonds now at the three month maturity or shorter.

Thanks for reading Volume 38 of The Macro Market Wrap Up With The Mad Genius. If you have any comments or questions please leave them below and I’ll be sure to respond pretty quickly. Until next time remember that there is always a bull market somewhere in the world, and on the opposite side of every crisis, lies opportunity.

#economics #investing #bonds #defaults #downgrades #forecast2019