The market is broken. Rules of “furious madness”.
By Wolf Richter for WOLF STREET.
In these wonderful credit markets where everything is now completely derailed, the first thing that happened after the freak spectacle of CPI inflation hitting 5.0% was that junk bond yields were falling. fallen to new lows. Even the average yield on B-rated junk bonds – considered “highly speculative,” according to my corporate bond credit ratings cheat sheet – has fallen below the CPI rate. When bond yields go down, bond prices go up and everyone has a blast.
The average yield on CCC-rated and lower bonds – ranging from “extremely speculative” to “default imminent with little prospect of recovery” – fell to a new record low of 6.83% at yesterday’s close, while investors apparently don’t. You don’t mind exposing their capital to the massive credit risks offered by CCC-rated and lower junk bonds, for a “real return” (adjusted for US inflation). CPI) of just 1.83%.
These CCC-rated and lower bonds are the only category in the spectrum of U.S. corporate bonds with an average yield of above the rate of inflation.
Everything else has negative real returns, where the purchasing power of capital is destroyed by inflation, while the returns are too low to compensate for this loss of purchasing power. And there is nothing, zilch, nada, in terms of compensation for the substantial risk of default and extinction in a debt restructuring.
The average yield on B-rated bonds – “highly speculative” – fell to a record low of 4.46%, or a negative real yield of -0.53%. And the average yield on bonds rated BB – “speculative non-investment grade” – fell to a record low of 3.27%, or a negative real yield of -1.73%.
Even if CPI inflation, after perhaps 5% on average this year, comes down again next year, as the Fed continues to promise, the purchasing power of the capital invested in these bonds would be reduced by 5%. % for the year, and the yield on those bonds bought at today’s prices would be lower than that, and the investor would be in the hole in real terms. And that doesn’t even take into account the risk of default:
So, on average, these are very unappetizing substances, except perhaps for short-term leveraged speculators who bet on even lower yields, despite soaring inflation, and who could then sell off the stocks. More expensive bonds (when yields fall, bond prices go up) to the biggest fool down the road.
But long-term investors – bond funds, pension funds, or insurance companies – buy bonds to hold them, usually to maturity. And those junk bonds at these yields today, given the credit risks of the companies that issued them, are a shit deal even though CPI inflation was 2% for the remainder of their maturity.
But now inflation has been rampant. The Fed is officially surprised at how fast it has jumped, having totally underestimated it in its previous statements. And they always say it’s just temporary, it will pass next year. And if that doesn’t pass next year, and if inflation doesn’t magically return to 2%, then the Fed will act surprised again.
What is permanent is that the purchasing power of these bonds is reduced by the current rate of inflation, and that the purchasing power will never rebound. It’s just a matter of how quickly purchasing power is declining further next year, 5% or 3% or 2% or whatever.
The return on interest payments is supposed to compensate investors for this loss of purchasing power, as well as for the risk of default – where they could lose much or all of their capital. But investors are hardly compensated.
Bottom Line: In Fed-designed failing credit markets drowning in a sea of Fed-created liquidity that is now causing all kinds of problems in the banking system, the Fed is trying to control it with it through repurchase agreements day to day, as investors try to find a place to put that money, and some accept zero or negative returns in the repo market, while others vigorously seek return wherever they can find it, whatever whatever the risks.
With so much excess liquidity flowing around, what else are investors supposed to do with their liquidity – even if inflation eats it up on a daily basis? It was a rhetorical question. Everyone is trying to find a place for it, but all assets are already overvalued and yields are already repressed below the inflation rate for most bonds, in markets that have been rightly described as “mania.” raging ”.
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