“As an investor, you make the most money when you do things that other people aren’t willing to do,
like taking risks others shun. Attractive investment opportunities arise when you spot some security
or some part of the market being ignored and you come to the conclusion that it’s languishing cheap.
But today, I don’t think anything is being ignored. Investors are willing to do almost everything.”

– Howard Marks

I attended an advisor summit in Chicago this past week. On stage was a good friend from S&P Dow Jones Indices. He referenced an article S&P published last fall about poor quality in the popular “leveraged loan” segment of the corporate bond market. Dull, I know, but hang in with me for a short few paragraphs, I promise this week’s missive gets better.

Think of the leveraged loan market in a similar way you might have thought about the sub-prime mortgage market in 2007-2008. “No doc” mortgages provided liquidity that accelerated the boom in real estate construction, real estate prices and the economy. That is, until the system was overloaded with supply, borrowers couldn’t pay, defaults mounted and, in the end, sub-prime junk was really just junk after all. All looked swell until the gig was up.

Sub-prime was a boring topic until it became exciting for the few and painful for the many. If you watched “The Big Short” (and I hope you did), today’s piece is preview to “The Big Short, Part II.” Coming in 2022 to a theater near you. And the opportunity it will present will be epic.

Today, we’ll look at what I believe are two of the most important indicators you can follow to help you manage the risk and potentially profit from the defaults that will present in the next recession. Timing, of course, is critical and I’m trusting that what I’ve followed for nearly 27 years can help you and me identify the turning point. To which, I believe the HY price trend holds the key.

Back to my friend at the conference. So what he and his “high character” team at S&P are signaling in their article is to be aware of the poor level of protection we investors are getting in leveraged loan funds and politely saying risk is off the charts. What I’m impressed with is that S&P wrote the piece despite the fact that they and their client make money when investors buy their client’s ETF that seeks to track the S&P Dow Jones Senior Loan Index. Hat tip to S&P, to my friend, his team and their outstanding character.

First, let me give you some footing that’s important to understand. The leveraged loan market is generally where companies whose credit is so weak they can’t access the high-yield bond market to obtain financing. Read that last line again. This is the sub-prime of the corporate bond market. The popularity of leveraged loan funds and ETFs was enabled by zero interest rate policy. Seeking to improve returns on their savings, investors moved their money into riskier asset classes. That liquidity, like sub-prime in the mid-2000’s, gives borrowers to hold the upper hand. The problem is one of size, scale and poor quality. Let’s take a closer look.

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