Editor's note: The market has had a great year so far. But according to our founder Porter Stansberry, there's still reason to be cautious of the big picture. In this excerpt – adapted from a December 2022 issue of The Big Secret on Wall Street, published by his firm, Porter & Co. – Porter highlights a red flag he's seeing in one corner of the market... and discusses why your portfolio could be at risk.
The Federal Reserve – and central banks around the world – dropped rates to zero for most of the past decade...
Of course, this policy had many side effects for the market. Primarily, it pushed investors everywhere to reach for yields. Retirees were hit especially hard by this move...
The Fed removed the ability to earn safe yields from the traditional retirement income vehicle – U.S. Treasuries.
Countless retirees and other yield-starved investors had to find an alternative source of yield... So they turned to corporate debt.
As I'll cover today, that's how the Fed's policies drove the rise of a dangerous investment vehicle. It has become a ticking time bomb... But no one wants to talk about it.
The days of zero-percent interest are over. And if you have money stashed in a retirement fund, it's time to pay attention...
Through 2020, the volume of corporate bonds held in mutual funds more than tripled since the Fed dropped rates to zero during the financial crisis. Take a look...
Likewise, the reach for yield fueled an explosion in assets among corporate-bond exchange-traded funds ("ETFs").
Regulators clamped down on reckless real estate lending in the wake of 2008. So the credit that had been created over the past decade found a new home in corporate bonds. And instead of going through the banks, this credit was funneled through alternative avenues... like mutual funds and ETFs.
Most mutual funds and ETFs that own corporate bonds are passively managed. That means there's no human investment manager calling the shots.
Instead, the buy and sell decisions are on autopilot. They're dictated by a series of rules. One rule is that if a bond loses its investment-grade rating, it must be sold – no questions asked.
What could trigger such a downgrade? Any number of things. A recession might cause a decline in earnings, for example. Rising interest rates can be another trigger.
In each case, a company's debt burden and interest expense relative to earnings would deteriorate... exceeding the threshold for an investment-grade rating.
The ultimate disaster scenario would be a one-two punch: a sharp recession caused by higher interest rates. And that's precisely the scenario I see coming for the economy...
The massive growth in investment-grade bonds sitting at the lowest rung of the ratings ladder – now a record 60% of the investment-grade universe – could trigger an avalanche of downgrades into non-investment-grade status.
And that means one thing – fire sales.
We could see billions of dollars in sell orders come from every passively managed mutual fund and ETF that owns investment-grade corporate bonds.
Now, a fire sale in the highly liquid stock market is one thing... But it's a different story in the corporate-bond market. The average corporate bond trades far less frequently than stocks – depending on the issue, a few times a day to only every few days. (Less-liquid bonds can trade "by appointment," which is rare and only if a broker happens to have both a willing seller and willing buyer.)
The problem is, holding these bonds in mutual funds and ETFs creates the illusion of liquidity. That's because mutual funds and ETFs are set up to allow for unlimited volumes of daily trading.
But the underlying instruments in these funds – corporate bonds – don't have sufficient liquidity to process large sell orders.
This mismatch is a ticking time bomb. If investors ever lose faith in their bond holdings and rush for the exits... or if a rash of downgrades forces the funds to dump their bonds... that bomb will explode.
The former Bank of England Governor Mark Carney once explained this fatal flaw...
These funds are built on a lie, which is that you can have daily liquidity, and that for assets that fundamentally aren't liquid.
We got a taste of what the coming fire sale in corporate bonds will look like back in March 2020. The iShares iBoxx Investment Grade Corporate Bond Fund (LQD) – a benchmark for high-grade corporate bonds – collapsed by 22% in nine trading days. Check it out...
The situation was so dire that for the first time ever, the Fed stepped in to buy corporate bonds. But this only inflated the bubble further... After the Fed's intervention, U.S. corporations sold a record $300 billion in debt in April 2020.
With inflation running out of control, this kind of intervention is now off the table... It won't happen a second time.
And it's one of the reasons why the coming fire sale will make March 2020 look like a picnic.
Regards,
Porter Stansberry
Editor's note: Porter accurately predicted the 1998 emerging market crisis, the 2008 financial crisis, and the 2023 banking collapse. Now, he's stepping forward with an urgent warning that goes against everything you've likely heard from the financial media.
He details how one shocking event could split the market in two... But if you know how to take advantage of it, this could be the greatest wealth-building opportunity of your lifetime. Click here to learn the details.
Further Reading
"If it looks too good to be true, it likely is," Porter writes. Many investors succumb to the "fear of missing out." But that's a mistake. Here are five red flags you should look for before you blindly follow the hype... Learn more here.
It takes discipline and research to build a successful portfolio. But it doesn't have to be a difficult process. If you follow this simple "cheat sheet," you'll learn how to find the winners and avoid the losers in the market... Read more here.
