Is The Fed Trying To Arrange A Bailout Of Junk Bond Funds? – Dave Kranzler

TND Guest Contributor:  Dave Kranzler

Warning #3:   If you are hesitant to sell your bond funds, use any bounce in the junk bond market to get out of all fixed income funds.  Someone asked me the other day about Treasury funds.   Go read the fine print in the prospectus.  You can find it online.  If the fund permits the use of derivatives, get out of it.  100’s of thousands of investment advisors and retail investors loaded up on Pimco’s Total Rate of Return fund having no idea that it is riddled with derivatives.   If you own Black Rock funds, don’t wait for a bounce.  Just get out.  Black Rock is the financial market version of Fukushima.

I heard a rumor today that the Fed is trying to solicit “fire sale” liquidity bids from private equity funds for big chunks of the bonds held by high yield mutual funds and ETFs.  I want to emphasize that this is an unsubstantiated rumor but it comes from a good source.

At this stage in the game, I believe the Fed will do anything possible to keep the system from collapsing.  On the assumption that the rumor is valid – which I would suggest has a 95% level of probability – I would also expect to see the Fed, in conjunction with the Treasury, offer private equity firms zero-percent credit lines in order incentivize and facilitate an attempted bailout of the junk market by private equity funds.  After all, this would be a no-risk opportunity for the managers of these funds to throw their growing cash piles at something besides Silicon Valley unicorns in order to put the cash to work and skim fees off the invested capital.

Of course at the end of the day, if this scenario plays out, it will be just another attempt to kick the proverbial can down the road and forestall the inevitable collapse of the financial system.  Unfortunately the fundamentals which support the idea that there’s any intrinsic value in the majority of the junk paper that has been issued over the past five years continue to deteriorate.

The primary reason for the Fed to prop up the junk bond market is to prevent the stock market from collapsing.  The graph on the right shows what’s at stake (click to enlarge).   At some point the performance of the S&P 500 and the high yield bond market will be forced by the market to re-correlate.  I highly doubt that high yield bonds will converge up to the stock market.

The graph below on the left shows that leveraged loans, which sit on top of junk bonds in the capital structure, are chasing junk bonds in a race to the bottom now.  Theoretically, to the extent the the top of the capital structure – leveraged loans – are valued at less than 100 cents on the dollar, everything below them is worth zero.  In a strict application of bankruptcy law, liquidation payouts go from top to bottom.  However, for practical purposes, bankruptcy workouts typically sprinkle some of the agreed restructuring value to the debt tranches below the senior secured level.  If for nothing else than to prevent lawyers from cannibalizing any remaining value with fees.

As you can probably guess, if senior secured debt and junk bonds are worth substantially below par, the equity is worth zero.   THAT is why the stock market eventually follows the junk bond market lower.  THAT is the dynamic that the Fed will attempt to prevent using any possible means at its disposal – legal and illegal.

History tells us this will eventually fail.   The degree to which the end result is catastrophic is always directly proportional to the amount of effort that went in to the attempt to prevent the inevitable.

You can make money off of this inevitability by shorting the stock market.  As this unfolds, there is a lot of money to be made shorting all of the hideously overvalued stocks.   My new subscription service will be rolling out two ideas per week that will help you find ways to exploit the gross price distortions and sector bubbles that have developed after 6 years of extremely reckless monetary policy by the Federal Reserve and U.S. Treasury.    You can subscribe by clicking here:   SHORT SELLER’S JOURNAL.

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About Dave Kranzler:

 I spent many years working in various analytic jobs and trading on Wall Street. For nine of those years, I traded junk bonds for Bankers Trust. I have an MBA from the University of Chicago, with a concentration in accounting and finance. My goal is to help people understand and analyze what is really going on in our financial system and economy. You can follow my work and contact me via my website Investment Research Dynamics.  Occasionally, I publish on Seeking Alpha too. As a co-founder and principal of Golden Returns Capital, LLC Mr. Kranzler co-manages the Precious Metals Opportunity Fund, a metals and mining stock investment fund.

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