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  • Martin Sosnoff

Junk Bond Spreads Widening Spell Trouble For Stock Valuation

I’ve started to shed paper gains on my junk bond holdings. This is so even though I keep duration at 5 years and don’t go below BB credit ratings. I’ve sold down to my sleeping level.

When friends try to tap me for loan participation in their deals, I tell them the rate of return on my capital runs into the teens and I don’t participate in unsecured credit. Try to tap me for capital and friendships normally end.

The high-yield bond market is defined as any loan below investment grade. If you lend your brother-in-law $10,000 unsecured, that’s a high-yield loan. J.P. Morgan employed low-grade paper at the start of the 20th century to buy U.S. Steel from Andrew Carnegie. The yield was 5%. This became a high-grade credit that did sink back into near insolvency, summer of 1982.

As late as 1988, Bethlehem Steel was in arrears on its preferred stock dividend. In the financial meltdown of 2008 – ‘09 I bought Bank of America’s preferred at 5 bucks while Warren Buffett was dealing on a debt and warrants structure to keep them alive. (He made billions). Bank of America soldiers on.

Alfred Sloan didn’t get it right when he said “The men who manage money manage all.” This snappy pronouncement did not hold up forever. The securitization of shabby mortgages during 2008 – ‘09 practically destroyed our financial system.

It took Bob Rubin, then Secretary of the Treasury, to come through with massive injections of capital to save our banks and major Wall Street houses. Merrill Lynch was merged into Bank of America, worth $4 a share, while Lehman Brothers was not chosen to be saved.

During the financial meltdown, the market sold down to book value and yielded 5%. Comparably, in March 2021, the S&P 500 Index sold down to book value and also yielded 5%. Currently, highly regarded corporate debt yields 5%, too. The onset of Covid-19 spread sheer pessimism in our financial markets. Everyone feared recession was around the corner. The S&P 500 has doubled since the March, ’21 low.

My contrary play, currently, in the high-yield market is looking premature. I’ve given back some paper profits as 10-year Treasury yields have elevated. Mine is a spread game professionals play. Historically the spread between 10-year Treasuries and junk has to be at least 300 basis points to get you involved.

Currently, junk paper is sloughing off. The market is saying the Fed is way behind in dealing with inflation. Quarter-point bumps, even half-point increases in Fed Funds probably fall short in dealing with the inflation risk for the country, nearing 7%.

Pundits still stick to rosy projections: The market is worth 20 times forward 12 months earnings power, they say. Inflation soon relapses to 4% while GDP continues its momentum of 4% to 5%. But, this is just verbiage. Meanwhile, spreads between junk and 10-year Treasuries widen. This is the real world players deal with day in, day out.

Bob Rubin’s career on Wall Street spanned decades running the Goldman Sachs arbitrage business under Gus Levy, who chaired Goldman as well.

Remember Sidney Homer who wrote the classic book on interest rates going back to biblical times? Sidney, a Solomon Brothers senior partner, displayed in his office a dozen or more charts on interest rate spreads and referred to them religiously. Meantime, his partner Henry Kaufman’s annual study on the supply and demand for funds was a must read for everyone involved in securities markets. It was as good as any forecast on interest rates, specifically for the next 12 months.

If I’m right that rates press through to a much higher level than the consensus, prime growth stocks like Apple, even Microsoft with good numbers mark time at best. Basic industrials, particularly commodity plays in copper, steel and aluminum, are vulnerable after huge and largely unforeseen price gains. Industrials can mark time in a declining GDP setting. Because I see a steeper yield curve, I’ll hang in with the financials.

I love Jim Tobin’s Q Ratio because it treats with bedrock assets relative to stock market valuation. At present, stocks sell at 2 times asset value, a dangerous level of valuation which has proved so for over a century. Can you imagine, stocks got as low as 30% of book value in the Great Depression? Most cycles, stocks barely made it above book.

Most high-yield bonds masquerade as bonds but actually are equities. If the credit improves, a bond can get called away from you. If it doesn’t float, the bond collapses and you see a corporate reorganization. Your bond paper is then exchanged for equity, maybe near zilch. These days, banks like JPMorgan Chase can carry 20% of their loan portfolio in commercial and industrial paper that is highly leveraged, comparable with junk bonds. Some institutional loan players love this paper because it’s tied to LIBOR, protecting you from losses in a rising yield scenario. If recession hits, you don’t belong in this loan sector because of default risk.

Headline writers got it wrong when they labeled Michael Milken the “Junk Bond King.” In a good year, Mike took home $600 million from underwriting corporate honchos like Rupert Murdoch, Carl Icahn and Larry Tisch. At first, traditional underwriters like Goldman Sachs, Lehman and Merrill Lynch turned up their noses, but they learned fast how to play in this game and coin money.

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