Bear Market Signal #4

Bear Market Signal #4:

This "Overhang" May Lead to the Collapse of Record Levels of Corporate Debt

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We noted yesterday the astonishing level of debt that folks owe on credit cards, mortgages, and student loans. These debts have climbed to levels not seen since the 2008 financial crisis, and few even notice... much less care.

After all, many mainstream financial pundits think there's nothing to worry about until a recession hits.

But that's the wrong indicator to focus on... In fact, it's completely backward.

The next stock market drop is likely to happen before the next recession. And most investors will have little time to react.

That's why you must prepare your portfolio now, before the market correction, crash, or collapse. And it's why we're detailing the 10 Bear Market Signals that you should be watching.

Over the past two days, we've detailed government and consumer debt — two of the three main legs of the "credit market." The credit market is where all types of debt are bought and sold. Because the credit market isn't as exciting as the stock market, investors often ignore it altogether.

But this is exactly where the last financial crisis began... One type of consumer debt (subprime mortgages) started going bad, causing massive selling of the troubled loans.

It's critical to understand what's happening in credit. The credit market drives our entire economy. It's highly cyclical. When interest rates are low and credit is cheap, we experience "booms." When rates rise and credit tightens, we experience "busts."

And the next place we're watching for our Bear Market Signal No. 4 is the corporate credit market. Stansberry Research senior analyst Mike DiBiase reports:

Since the last financial crisis, credit has been cheap and easy to access. And during the current credit cycle, the biggest excesses have occurred in corporate debt.

When this corner of the credit market starts to turn — as more and more high-yield ("junk") corporate debt goes bad — it will kick off the next crisis.

Since the last financial crisis, companies have gorged themselves on cheap credit. Yield-starved investors have gobbled up this debt in record numbers... U.S. corporate debt has ballooned to $9 trillion today, roughly double the amount from 2007. In the chart below, you can see that corporate debt is at all-time highs — both nominally (in red) and as a percentage of GDP (black line)...

U.S. Corporate Debt

But it's not just the sheer size of corporate debt that's troubling... It's also the quality. The largest portion of this debt today — a record $3 trillion worth — is rated as the lowest level of investment-grade debt, one level above junk status.

That's also known as "BBB" debt. It's still investment-grade... but barely. The chart below shows the credit ratings of investment-grade debt outstanding since 1989.

U.S. Investment Grade Credit

You can see the huge ballooning of the lowest-quality investment-grade debt.

And in March, the Bank for International Settlements (BIS) made a startling admission...

In its latest Quarterly Review, the so-called "central bank to the world's central banks" warned that all is not well with BBB debt. It warned that this debt could trigger massive losses in the retirement accounts of millions of Americans. From the report...

Rating-based investment mandates require portfolio managers to hold assets above a minimum credit quality. Such mandates often apply to corporate bond mutual funds, and allow investors to easily choose the desired risk exposure, often focusing on the investment grade segment.

Since the [2008 financial crisis], investment grade corporate bond mutual funds have steadily increased the share of BBB bonds in their portfolios. In 2018, this share stood at about 45% in both the United States and Europe, up from roughly 20% in 2010.

As interest rates remained unusually low post-[financial crisis], portfolio managers were enticed by the significant yield offered by BBB-rated bonds, which was substantially higher than for better-rated bonds.

In other words, 10 years of insane easy-money policies have wreaked havoc in this area of the market, too...

In search of yield, fund managers have been pushed to load up these traditionally conservative bond funds with more of the riskiest investment-grade debt than ever before. As a result, investors in these "safe" funds are unknowingly at risk of massive losses when the credit cycle inevitably rolls over...

As Mike wrote last year:

Many institutional investors — like pension funds, insurance companies, and endowments — have policies that prevent them from investing in anything other than investment-grade debt. So if any BBB-rated bonds in their portfolios are downgraded to junk status, these institutions will have no choice but to unload the bonds immediately...

As this new wave of junk debt floods the market, bond prices across the board will plunge... Investors simply aren't going to devote that much of their capital to these riskier bonds.

For unprepared investors, it's becoming clear... We're marching closer to a tragic ending.

Meanwhile, companies are even more leveraged today than they were before the last financial crisis. And a stunning $3.5 trillion in debt is coming due over the next three years.

Never before has so much debt come due in such a short period of time while credit conditions are tightening significantly.

Something has to give.

It's clear that we're nearing the end of the current cycle. When the current credit bubble pops, enormous amounts of capital will be lost, wiping out unprepared investors.

By paying attention to one key warning sign, you'll be able to spot the danger before most people...

We believe the bubble will pop when the majority of banks are tightening credit. That's when they will be demanding higher interest payments and greater credit protections (or worse, cutting off credit completely to some companies).

The banks hold all the cards. They are the linchpins that have kept the credit bubble alive.

Most companies can't afford to pay off their debt when it comes due. Instead, they rely on banks to refinance it. For most of this cycle, banks have been loosening credit and refinancing the debt — even as corporate debt has ballooned and credit quality has weakened. The banks have been kicking the can down the road.

Many companies that can barely afford their interest payments have been on "life support."

But this game can't go on forever...

Interest rates are rising at the same time massive amounts of debt are coming due. Eventually, banks will refuse to take on the added risk. Suddenly, many companies won't be able to refinance their debt, forcing them into bankruptcy.

The default rate will rise sharply, causing investors to dump their bonds. And since the high-yield bond market is far less liquid than the stock market, many bond prices will quickly fall off a cliff.

And shareholders at many of these firms are likely to be wiped out.

Our next Bear Market Signal has only happened three other times in history... all of which were followed by a major bear market or recession. Click the "Bear Market Signal #5" button below to learn more.

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Jim Rogers

Jim Rogers

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Porter Stansberry

Porter Stansberry

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Austin Root

Austin Root

Austin Root is editor and portfolio manager for the Stansberry Portfolio Solutions products and American Moonshots. He is also director of corporate development at Stansberry Research and a senior analyst for Stansberry's Investment Advisory.