Three Chart Alarm: The Fed Has Set-Up The Corporate Bond Market For A Big Fall

Tyler Durden's picture

Submitted by David Stockman via Contra Corner blog,

The three charts below [eerily similar to the ones we presented here], which appeared in the Wall Street Journal, are still another reminder that the Fed’s heedless fueling of the third financial bubble this century has done enormous damage to the internals of financial markets.  In this case, investors and savers being brutally punished by ZIRP were herded into bonds funds in a desperate scramble for yield. Accordingly, bond fund assets soared from $1.6 trillion at the time of the financial crisis to $4.1 trillion today.

Yet the market’s structural liquidity condition has gone in the opposite direction. Dealer inventories of corporate bonds have plummeted by nearly 75% from pre-crash levels, meaning that the ratio of dealer inventories to bond fund assets has virtually been vaporized. In 2008 that ratio stood at 15%, but presently it is only 1.5%.  Likewise, daily trading volumes have been cut in half since the crisis.

The implication is no mystery. When the financial markets eventually succumb to a “risk-off” selling panic, the corporate bond market will gap down violently. As one astute analyst put it:

“Everyone is hoping to be first through the exit,” said Matt King, global head of credit strategy at Citigroup in London. “By definition, that’s not possible.”

Stated differently, the Fed’s explicit campaign to force grandpa out of CDs and into corporate bond funds has caused a vast mis-pricing of liquidity. In a healthy free market, bond fund yields would carry a significant discount for illiquidity, and issuers of riskier corporate credits would face far higher yield spreads vs. the 10-year treasury benchmark.

So once again, the serial bubble machine in the Eccles Building has generated a huge unnatural market deformation that is inherently unstable and increasingly fragile. When the break comes, years worth of “extra” yield will be wiped-out in a traumatic drop in bond prices caused by a panic at the exit ramp.


As the balance of the WSJ article makes clear, the risk of log-jam at the exit gates is especially acute in the $1.6 trillion junk bond market. Prior to last week’s initial sell-off, yield spreads had been squeezed to absurdly low levels - less than 300 basis points on the Merrill index. Based on the current rate of inflation and historic 4-5% long-term losses on junk bonds, the spread should be 600 basis points or more. Indeed, during the last junk bond sell-off in 2008-2009, the yield spread over the treasury benchmark blew-out to 2000 basis points before the Fed’s artificial flood of liquidity put a stop to the carnage.



But today the junk bond market is far larger; trading liquidity is far thinner; and the Fed has already used up its trick card - that is, zero interest rates and massive monetization of the public debt. Accordingly, the carnage at the junk bond exit ramp is likely to be far more extensive this time around.  More importantly, the punters who harvested gargantuan profits by buying junk at peak yields in the spring of 2009 may find that the fire brigade in the Eccles Building is MIA when the next crash hits bottom.

By Katy Burne  at The Wall Street Journal


A shakeout in the junk-bond market is drawing only cautious interest from bargain-hunters, underscoring investor fears that many once-hot securities could prove hard to sell in an increasingly difficult trading environment.


U.S. funds investing in debt rated below investment grade lost an average 1.33% last month, according to a Barclays PLC index, their second-worst monthly performance since November 2011. In June 2013, after the Federal Reserve began hinting that it would scale back its monetary easing, they lost 2.62%.


The latest junk-bond decline intensified last week as investors continued to make heavy withdrawals of money, in part because of worry that a recharged U.S. economy could prompt the Fed to raise interest rates sooner than expected, a move that would likely pressure bond prices.


Reflecting the cautious mind set, some portfolio managers are selling riskier bonds and replacing them with safer ones because of concern about market liquidity, or the capacity to quickly buy or sell securities at or near quoted prices. Many investors say liquidity is drying up as the Fed pares its monthly stimulus and large banks trim their bond inventories.


Investors pulled more than $5 billion in July from U.S. junk-bond mutual and exchange-traded funds, according to Lipper, a fund tracker, deepening the liquidity fears and adding to concern that the recent selloff could intensify…..


The downdraft in junk debt highlights concerns that purchasers in the $1.6 trillion U.S. market, lured by higher income than on government and highly rated corporate bonds, have paid too much for the securities. Prices have rallied, sending yields to levels too low to compensate buyers for the risk of the investments, many investors say. 


Read more here...

*  *  *

As we explained in great detail here, this is already happening in the strangest of places.

The problem is that the Fed's dominance of the market and unintended consequences of controlling the repo/shadow-banking system have left bond markets more fragile than they have ever been.

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Vampyroteuthis infernalis's picture

I have worked for companies that should have gone tits up if it wasn't for the broken bond market. Full of incompetent idiots running the show. Let the corporate bond market collapse and take those POS companies with them!

power steering's picture

They wouldn't let it go belly up in 2009, wht would they now? Jamie's bonus MUST be protected.

Vampyroteuthis infernalis's picture

Jamie will get his bonus. Someone has to be culled from the herd for this to occur. Guess who???

power steering's picture

They wouldn't let it go belly up in 2009, wht would they now? Jamie's bonus MUST be protected.

oudinot's picture

Vampy: Yes. Creative Destruction at its finest. 

Pareto's picture

Where's the pivot point Mohan?  If its really you man......welcome......back?

KnuckleDragger-X's picture

Everybody must be screwed, now stand in line and wait your turn like a good little prole.

SAT 800's picture

Agree with the article; the Junk Bond Market is a huge bubble. The basic error is fundamental and part of all human caused booms and crashes; "chasing interest rates".  Chasing interest rates is what did in Jon Corzine, twice; once at his career at Goldman Sachs, and the second time, (he's a kind of a one trick pony), at MF Global. And he's just one in an endless list.

LawsofPhysics's picture

...but don't worry, everyone in corporate management, on the board, or in leadership roles has already been warned and cashed out.

Pension funds on the other hand are still "all-in"...



fonzannoon's picture

i'd definitely separate IG corporate from HY. Some stuff is going to get blown out. In the process it will drive down the yields of other stuff.


Hippocratic Oaf's picture

HY trading way too high now. CCC snot at premiums.

Thank you FED and your buy back policies forcing investors to reach for yield and blow their shit up!

Fuck you Greenspunk, Burnyankme and Yeller

SAT 800's picture

You're welcome. This is one of the most serious of the "market distortions" caused by the central money Czars; and it will go "pop". May you live in interesting times.

SAT 800's picture

You would separate it; a rational actor would separate it; but markets aren't rational machines; and the herd mentality will sell the Corporates too. IMHO.

SAT 800's picture

Pension funds; Hah, ha, ha. ROFL. ha-ha-ha-ha. "if you like your pension, you can keep your pension"---ha-ha. Expect Change; Give up Hope.

IANAE's picture

Exit ramp? More like the Eiger Sanction...

fonzannoon's picture

Tyler please get rid of the "Yawn" guy above the guy talking about how much his sister makes. Thanks.

Yen Cross's picture

  And it's gone... Looks like you have some pull around here Fonz. :-)

fonzannoon's picture

nope....that m'fer is still there.

Yen Cross's picture

  I thought you were kidding to get get Tyler to see the spammer...You still deserve credit for the spammer.

fonzannoon's picture

hahaha I was, I am just messing around.

NoDebt's picture

I'm just glad I didn't blow MY stack about the spambots on here last night.  You should have seen Fonz last night about this stuff.  He was ON FIRE.

thamnosma's picture

Is his sister still available?  Photos?

Thomas Aquinas's picture

"It was a carefully contrived occurrence. International bankers sought to bring about a condition of despair, so that they might emerge the rulers of us all."

Louis McFadden on 1929 Stock Market Crash. Louis McFadden died of poisoning shortly thereafter.

"For a long time I felt that FDR had developed many thoughts and ideas that were his own to benefit this country, the United States. But, he didn't. Most of his thoughts, his political ammunition, as it were, were carefully manufactured for him in advanced by the Council on Foreign Relations - One World Money group. Brilliantly, with great gusto, like a fine piece of artillery, he exploded that prepared "ammunition" in the middle of an unsuspecting target, the American people, and thus paid off and returned his internationalist political support.

"The UN is but a long-range, international banking apparatus clearly set up for financial and economic profit by a small group of powerful One-World revolutionaries, hungry for profit and power.

"The depression was the calculated 'shearing' of the public by the World Money powers, triggered by the planned sudden shortage of supply of call money in the New York money market....The One World Government leaders and their ever close bankers have now acquired full control of the money and credit machinery of the U.S. via the creation of the privately owned Federal Reserve Bank."

Curtis Dall, FDR's son-in-law as quoted in his book, My Exploited Father-in-Law

daveO's picture

I guess  the title 'My Demonic Father-in-Law' was already taken.

FDR was a bankster.

Dr. Engali's picture

Let's revisit this article when the ten year is under 2%. Still... that MyRa with it's 2.5% yield is looking mighty attractive to grandma and grandpa.

IANAE's picture

...seems much more documented prognosticating this time around than prior bubbles, will be interesting to see which, if any, turn out - ex post - to be accurate.

Buckaroo Banzai's picture

Indeed. The idea that corporate bondholders will be streaming for the exits presumes that they will have someplace better to go, barring mass corporate insolvency of course. As long as Treasury yields keep heading south, this story looks like a nothingburger.

thamnosma's picture

Did the Obammies actually implement that MyRa monster?  I haven't heard or read a thing about it since Zero announced it months ago.

Dr. Engali's picture

It will roll out later this year, which just happens to be impeccable timing.  

ebworthen's picture

I wish the FED would cover my ass on a five year bender in Vegas.

Buckaroo Banzai's picture

If only your bender could absorb tens of billions of dollars. Then you might have a shot!

Cthonic's picture

article's or images broken, (or don't like inline linking... )

yogibear's picture

The Fed has caused such a mis-pricing that it will be ugly when they lose control.

jiggerjuice's picture

So say I'm a corporate monkey working my monkey job, and I have 401k in my 3 functional choices, though there are subgroups within them: stocks, bonds, or money market fund. Money market will drop to zero when the cash claims roll in, not protected by FDIC so obviously that's the first thing that will go to zero. Stocks will drop some 30-50%. Bonds too? Where do I stick my money... I just want to preserve the match on my contributions, at this point I don't care about appreciation. What do I do people? 

Cheduba's picture

Simple - don't contribute, cash out, take the hit, and use the proceeds to buy PMs to protect against inflation.

A retirement account that is confiscated by a broke government is absolutely worthless to you.

Professorlocknload's picture

Maybe collect some barbaric relics?

youngman's picture

Well I am riding the PM market all the way much for that investment advice or theory...I thought for sure gold would be $5,000 and ounce by now withall the money printing...I guess you can add trillions of pieces of paper..but that does not affect the real money at all....wierd..not broke yet..but I did not get the market recovery of the last 5 years....lost that and more

Grande Tetons's picture

Common sense died years ago.  I think foul play was involved. 

QE49er's picture

Digging through my storage shed, I came across a box of VHS tapes.  One of the videos was about the coming crash & bankruptcy of the US, it was made in 1995.

thamnosma's picture

Yeah, apparently the Big Kahuna may never occur.  However, there can be no doubt whatsoever of the changing position of the US dollar nor about the failing quality of life of the American middle class.  That much is clear as a bell.   The world is very different place than in 1995.

ddsoffice's picture

The Housing Report in my inbox this morning corroborates everything:

The Unvarnished Truth About Rising REO Volume The Unvarnished Truth About Rising REO Volume by Lynn Effinger AUG 4, 2014 3:54pm ET Print Email Reprints Comment Twitter LinkedIn Facebook Google+

Signs are definitely pointing to a rise in REO activity across the country in specific markets, particularly in Massachusetts, New York, Florida, Ohio, Illinois, Tennessee and elsewhere. With respect to this development I offer the following comments by Amy Dix, a veteran REO specialist who is broker and co-owner of The House Store, a successful Knoxville, Tenn.-based real estate company. She reports to me that REO assignments in her office are on the rise.

"We have received one or two assignments each day over the past couple of weeks," said Dix. "Some are coming from asset management companies that we hadn’t received assignments from in quite a while."

While in Florida for an industry seminar recently I had the opportunity to visit with over 30 members of the National REO Brokers Association, who were among over 400 real estate professionals at the session. Most of the NRBA members also reported increased listing activity on REO.

The asset management division of the organization that held the seminar (which preferred not to be named in this article) has over 7,000 REO in their portfolio.

They expect that number to more than double through portfolio acquisitions and organic growth from their lending side. This is, perhaps, only anecdotal evidence of a worsening housing market and general economy, but it is clear to me that the downturn that I and other industry observers are predicting may be closer than anyone thought.

In an article written by Lucia Mutikani put out by Reuters on Aug. 1, "U.S. job growth cools, unemployment rate rises," the author points out that "…job growth slowed in July and the unemployment rate unexpectedly rose, pointing to slack in the labor market that could give the Federal Reserve room to keep interest rates low for a while." For those who are happy to see interest rates potentially remain quite low this news might appear positive.

However, for those of us who are eager to see signs that the economy in general and housing market in particular improve significantly, and truly recovering, not merely being reported as such, this is more bad news.

Additionally, the article indicated that the ranks of the long-term unemployed swelled and "…the length of time Americans are spending unemployed rose after reaching its lowest point in more than five years in June." This will not help the housing market nor the economy to improve much at all.

This comes on the heels of other news from Reuters on July 30 regarding economic growth in the second quarter of this year.

While on the surface of it the economic news from Reuters, as reported by Fox Business, "U.S. Economy Grows at 4% Pace in 2Q," also seemed positive, when one considers the fact that early reports like this one have been revised downward time and time again, the picture darkens. In the Fox piece they quote the Commerce Department as indicating on July 30 that, "Gross domestic product expanded at a 4% annual rate as activity picked up broadly after shrinking at a revised 2.1% pace in the first quarter."

There are far too many indicators being reported today to ignore the signs that the number of foreclosures and the associated REO are going to rise.

Many individuals and families who received loan modifications and other loan workouts are falling back into default, the backlog of foreclosures in judicial foreclosure states are beginning to make it to the system, adding more REO to the mix, Home Equity Lines of Credit are recasting, as are mortgages that were modified through the Treasury Department's HAMP program, which means higher mortgage payments while home prices are beginning to decline in many markets, FHA loans have become the "new" subprime loans, and the government is pushing lenders to make loans to low-income families.

The unvarnished truth is that REO are making another comeback. Actually, they never "really" went away.

Lynn Effinger is a veteran of more than three decades in the housing and mortgage servicing industries. He currently serves as executive vice president of ZVN Properties Inc.

Freddie Sells $659M of Debt in First Soured-Mortgage Deal Bloomberg News AUG 4, 2014 11:53am ET

Print Email Reprints Comment Twitter LinkedIn Facebook Google+

Freddie Mac, the government-backed mortgage giant, sold $659 million of "deeply" delinquent home loans in its first offering of such debt.

Twenty-two potential buyers participated in the auction, which was conducted by affiliates of Bank of America Corp., the McLean, Va.-based company said. It didn't disclose the price, and won't be naming the buyer, according to Tom Fitzgerald, a spokesman.

The company, which "selected the winning bidder on the basis of economics," will "continue to look for opportunities to reduce exposure to less-liquid assets in its investment portfolio," it said in the statement.

Freddie Mac and rival Fannie Mae have been stuck with a bevy of soured mortgages, bought out of bonds they guaranteed, after a surge in defaults amid the U.S. housing crisis. The companies, which were seized by the government in 2008, previously sought to recoup value themselves by modifying the loans or selling homes after foreclosures.

The loan sale comes as investment firms such as Lone Star Funds, One William Street Capital Management LP and Ellington Management Group LLC seek to gobble up bad home loans as the housing market recovers, pushing up prices.

"We’re not going to do transactions that are wealth transfers to private investors," Freddie Mac Chief Executive Officer Donald Layton said on a conference call with reporters in May.

The company, which owns or backs $1.9 trillion of housing debt, held $169.1 billion of loans on June 30, according to monthly disclosures. It's also begun repackaging reperforming and modified mortgages into new bonds that it guarantees.

ddsoffice's picture

And this:

Double-Whammy Coming When HELOCs, Loan Mods Reset in 2015 by JUL 15, 2014 5:53pm ET Print Email Reprints Comment (1) Twitter LinkedIn Facebook Google+ Related  Enlarge This Image

Interest rate resets on many home loan modifications and home equity lines of credit seem to be on a collision course that may create a hardship for many borrowers who didn't expect to be so vulnerable.

HELOC originations peaked in 2005 and most of those second liens are due to reset in 2015. The peak year for first-lien modifications was in 2010 and most of those proprietary and government-sponsored modifications are also due to reset in 2015.

A simultaneous hike in the monthly payments of both first and second liens is "sort of a double whammy," says Aaron Horvath, a senior vice president at Springboard Nonprofit Consumer Credit Management in Riverside, Calif.

Homeowners will have to tighten their budgets to afford the higher payments, which is where housing counseling can play an important role, says Horvath. But for some borrowers who have been barely able to make reduced mortgage payments, the resets "could be the straw that breaks the camel's back," he says.

The Treasury Department launched its Home Affordable Modification Program in 2009 and modification activity peaked in 2010, when servicers completed 512,700 workouts. At the time, the prevailing mortgage rate was 5%, but servicers reduced the borrowers' rates to 2% to make payments more affordable. The terms of HAMP mods include rate resets after five years, in 100 basis point annual increments — meaning that by 2015, those HAMP mods from 2010 could experience the first of three annual 100-basis point resets to bring the interest rate up to 5%.

With a 100-basis point step up in the rate, the median monthly payment increase is about $95 each year, with the majority of HAMP borrowers experiencing two to three rate increases, according to Treasury estimates.

"This step-up concept works well when borrowers are experiencing income growth," Horvath says. "But many borrowers have not experienced wage increases and some are still underwater on their mortgages."

Meanwhile, a HELOC rate reset could add another $100 to $300 to a borrower's monthly mortgage obligations.

The Hope Now Alliance of mortgage servicers completed 1.2 million proprietary mods in 2010. Most of these proprietary modifications have HAMP-like features with a five-year reset and 100-bp step up in annual rates, according to Hope Now executive director Eric Selk. "As investors and lenders did more modifications, the features of later vintage modifications changed over time," he says.

A spokesman for Wells Fargo, the industry's largest servicer, says the bank is "currently reaching out to customers five months prior to the effective date of their interest rate change and then send a reminder communication two and one half months before the change becomes effective" under HAMP.

Under Consumer Financial Protection Bureau rules, servicers must notify borrowers of a reset 120 days in advance. This notice must include contact information for borrowers to contact housing counselors for advice and assistance.

"There are going to be millions of people dealing with these resets" over the next few years, Horvath says. "The good news is that the servicers' infrastructure is in place. The housing counselors are staffed up. All that stuff is in place. It will not be quite the chaos that we dealt with in 2009." Springboard has provided one-on-one counseling to over 300,000 homeowners across the country. 

In May, Hope Now servicers completed 11,770 new HAMP mods and 24,900 new proprietary mods. The Treasury Department recently extended the HAMP program through year-end 2016.

Many HAMP borrowers facing rate increases may qualify for alternative modifications, including a HAMP Tier 2 which offers borrowers a fixed rate based on the current mortgage rate and a new 40-year term. The current mortgage rate on a HAMP Tier 2 mod is 4.25%

Treasury officials wanted to keep this option open for the borrowers facing resets, which is one reason the department extended the HAMP program through 2016. 

Comments (1) It is great that the Treasury Department is doing this for the person who needs help but what is really happening is they are still bailing out the banks at the cost of the tax payer.
Tell Joe we love paying his mortgage so that irresponsible lenders can stay in business and get 0 percent money from the federal reserve bank and the taxpayer can eat it with high inflation and 0% on savings. Posted by Jonathan A | Wednesday, July 16 2014 at 12:05PM ET


antidisestablishmentarianismishness's picture

Nimrods have been predicting Armageddon since time began.  Teen goths and brain deads always bet on it happening in the near future.  Then they go broke.  It's like clockwork.

kurt's picture

VHS tape loops in a mobius strip formation packed in the walls like insulation can block Electromagnetic Radiation. Take out the phillips screws, separate the sides, unravel the wheels, cut into strips, carefully glue the tape sections, be sure to flip one side 90 degrees. Now remove your drywall, fill the cavities between the studs with the mobius stips, hold them in place with aluminum window screening material, this gives additional protection from beam energy. Put up your drywall or hire a professional but he must be sworn to secrecy on a bible. If you are handy, you can turn the old plastic VHS cases into transistor radios or craft boxes.

scraping_by's picture

So, how much time would you really need to liquidate and go home before the cliff's edge? Say, if someone had inside information on the cash spigot being turned off, how mad would the scramble really be?

I suppose if you're depending on other traders, rather a lot. If you're depending on the CB cabal or the captured herd at Treasury, not so much. Both are available to run a pre-crash TARP, and they likely have plans for it.

Tell me again about capital formation for economic needs...

oudinot's picture

Oil Market down?????

Surprising in this geopolitcal messy world we are in.  And we all think the Am. dollar is on its path  to worthlessness  but gold prive supressed, silver is in neutral , the dollar is strong, 10 year is below 2.50? QE to be gone.WTF.