Weekend Edition: Get Ready for the Greatest Financial Mania the World Has Ever Seen, Part 2

Editor’s note: Today, we're sharing Part 2 of a special essay from longtime friend and founder of Stansberry Research, Porter Stansberry. In case you missed Part 1, you can read it here.

The full essay was originally published on September 9, 2016, in The Stansberry Digest.
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Today, around the world, something around $15 trillion in fixed income is trading at a price that guarantees investors will lose money if they buy the bond and hold it until maturity.

I want to make sure you understand what’s happening because the bond market and bonds are a mystery to a lot of individual investors.

A bond can trade at a negative yield to maturity (guaranteeing a future loss) while still paying a current coupon. How can that happen? It happens when investors bid the current price of a bond so far above par that the remaining coupons to be paid won’t cover the loss when the bond matures.

So, for example, you might see a bond trading at $130 when it only has $29 worth of interest left to be paid before it matures at $100. An investor buying a bond like this has to believe he’ll be able to sell it at an even higher price, to an even bigger fool… or else he’s guaranteed to lose money.

Of course, all investors believe that they will be nimble enough to sell before that happens. And all investors believe that governments will continue to buy these bonds… or maybe even stocks… and do whatever it takes to keep the bubble growing.

This situation is the definition of an investment mania. Everyone knows that, someday, these bonds will reach maturity. And, at some point before they do, just as surely as the sun rises, these bonds are going to cause huge losses. And yet, despite these obvious facts… investors have begun to price even “junk” bonds – that is, noninvestment-grade debt – at prices that guarantee investors will take losses.

Just like Templeton back in 2000, I know for certain that this mania is running out of steam.

How can I know for sure?

There are three big “tells”:

First, total U.S. corporate debt is now 45% of GDP. That’s where the two previous credit cycles peaked (’02 and ’08). It’s simply not possible that the amount of credit outstanding to corporations can grow much from here because, even at very low rates of interest, there are not enough willing borrowers. Think about yourself. Does it really matter if someone offers you a 2% rate on a credit card? Are you going to go into debt for any reason? Nope.

Second, and far more important when it comes to timing, the number of banks in the U.S. that are tightening lending standards is rising and has just passed a critical threshold (10%). Banks tend to tighten lending standards at the same time, at the end of a credit cycle and beginning of a default cycle.

Third, we know for sure that a new default cycle has begun because not only are banks tightening, but credit downgrades (by the ratings agencies) have bottomed (in 2014) and continue to grow substantially. Likewise, outright default rates have bottomed and continue to grow rapidly. Morgan Stanley’s top high-yield bond analyst (Meghan Robson) believes the default rate in high-yield bonds will hit 14% by the end of 2017 (it was basically zero in 2014). She also says the total default rate will peak at 25% annually within five years.

The “fuel” that’s behind this mania and the reason it continues to grow (for now) is the fact that most professional investors, aka “Wall Street,” believe that without higher interest rates, there simply won’t be a trigger for a panic. But these guys are forgetting something that’s very, very important…

There are two ways to trigger a panic in the bond markets, not just one.

Yes, the first trigger is higher interest rates. (If new bonds are being issued that pay higher rates of interest, it makes the older bonds – which pay lower coupons – worth less in comparison.)

But the second trigger for panic, the one they’re forgetting, is simply rising defaults. Cheaper credit, by itself, won’t fix a failing business. Cheaper credit, by itself, can’t fix falling profit margins where there’s tremendous overcapacity, as there is in energy, manufacturing, retail, real estate, etc. In these sectors, defaults can and surely will cause massive losses for bond investors.

This panic will begin in the next 12 months. And because the numbers are so large and global, the coming bear market in junk bonds will influence fixed-income markets and equity markets around the world.

Since 2012, junk-bond issuance has totaled $1.4 trillion in the U.S. alone. That’s as much capital in four years as was issued in the decade between 2002 and 2012.

And for the first time ever, global junk-bond issuance has equaled America’s. It is this cheap and seemingly endless supply of capital that has lowered profit margins, which is why corporate earnings continue to decrease (four quarters in a row…) and industrial production is falling. It explains the glut in energy and materials, too.

I’ve been warning about this coming massive bear market in corporate debt. I’ve called it “the greatest legal transfer of wealth in history.”

This is a period when wise investors (like Templeton) will take massive amounts of wealth from fools. To help position our subscribers on the right side of this trend, I’ve invested a lot of time and money in building a huge analytical engine to study every corporate bond that trades in the U.S. We examine around 40,000 individual bonds every month. We build our own credit ratings for every issuer and we compare our estimate of creditworthiness to the ratings agencies. We look at discrepancies between our view, the ratings agencies’ views, and the market’s pricing. In short, we’re using computers and databases to find the “needle in the haystack.”

This analysis has, so far, led to 11 recommendations in our Stansberry’s Credit Opportunities service.

Three of those recommendations never traded below our buy-up-to prices. Even so, the eight recommendations that have traded inside our buy-up-to windows (so far) have led to annualized returns of nearly 50% – with zero losses. The yield of this recommended portfolio is 7.5%.

Huge amounts of capital have flooded into the junk bond markets this year, making it virtually impossible to buy bonds at a proper discount. But we know… our real opportunity is coming.

But what about regular investors? What about folks without the capital or the sophistication or the patience to deal in the bond market, where getting a position filled can take months and dozens of phone calls? And… why only trade this mania from the long side? Why bother with finding the needles in the haystack? Why not simply do what Templeton did and sell short the bonds you know will fail?

That’s a great question. And I’ve spent a year thinking about the right and safe way to make gains that are big enough to cover the risks involved. The answer isn’t trying to short individual bonds. Or even bond exchange-traded funds. The right way is a wholly different kind of strategy.

It’s something you’ve never seen me recommend before.

It’s a strategy that, like Templeton’s, will take a year or more to reach a substantial profit. It’s a strategy, like Templeton’s, that is extremely contrarian. It’s a strategy that I plan to invest several million dollars into personally… and that I believe will make me between 10 and 100 times my investment. It’s a strategy that will take discipline and patience – so most investors won’t follow it.

And that’s the primary reason I believe it will work. I’ll tell you all about it next week…

Good investing,

Porter Stansberry

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