Dear Natalie: After learning more about the risk in bonds, I decided to trim back on a few. I was showing a gain for my bonds when I initiated the sell order. However, when the sell went through, it was for a loss. What happened?
Signed: How Does a Gain Become a Loss in the Same Trading Day?
There was a liquidity squeeze behind the scenes in March. As the Federal Reserve Board explained in their Financial Stability Report of today, “The ability of creditworthy households, businesses, and state and local governments to borrow, even at elevated rates, was threatened.” With economic activity closing down due to the pandemic, and so much leverage in the bond market, investors feared that corporations, states and local governments would all need to borrow in order to shore up budgetary gaps. When a new bond is issued in a crisis, typically the rate will have to be higher. That means that existing bonds can become illiquid, or worse, require a haircut, where you receive only a portion of your original investment back.
The Federal Reserve Board noted in today’s report that: “Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains reemerge.” In other words, the economic challenges are probably not over. In fact, many economists believe that the worst of the financial fallout of the crisis is still on the horizon. If the worst is still to come, then, even though getting liquid might have cost you a little, waiting could cost you much more. Below is a more detailed explanation of what is happening in the bond market in particular, and in the economy at large.
Illinois was just downgraded to the lowest rung of speculative, just above default. When you hear Congressmen talk about letting states go bankrupt, Illinois could be the state they are referring to. However, Illinois is not the only state that is facing budgetary challenges. Five states, 10%, were just one or two rungs above junk status before the coronavirus recession hit. (Email info@NataliePace.com for details.) With the loss of tax revenue nationwide, all states face a liquidity challenge. Even states with AAA status (32%) will need to borrow money to meet current demands, after months of very low tax revenue, which is now exacerbated by 18% unemployment.
In the corporate bond market, 11.4% of the S&P500 are currently at speculative status, including some recent downgrades, such as the Ford Motor Company. 227 companies (45.4%) are at the lowest rung of investment grade – just above junk bond status. That leaves only 216 companies (43.2%) that are rated A and above, or unrated. Again, with the stresses in the financial system, most companies are going to need to borrow money to make it through the hard times. For many existing bondholders, that creates credit risk and potential illiquidity. We’ve seen Berkshire Hathaway and Apple issue more debt. Disney has suspended its dividend and share buybacks, as have the airlines and auto manufacturers.
In short, for bonds, keep the terms short and the creditworthiness high. Underweight bond funds and money market funds. (Click for additional blogs and details.)
Credit and Term Risk
Most municipalities, and many corporations, like to borrow long-term – for 30 and even 40 years. So, if you have bonds on the “safe” side of your portfolio, you may have long-term bonds in there. Or you may have a bond fund. These are vulnerable to both capital loss and liquidity. As I mentioned, if the state or company has to borrow more money, which they will, new investors will want to be paid for taking on the additional risk. That means the new bond will have to offer a higher interest rate, and potentially a shorter term, as well. This is true even when the Fed Fund rate is at zero. They have to do this due to the heightened credit risk.
The bond covenants may put the new issuance in front of you, in the case of a restructuring. In this scenario, existing bondholders find that their bonds are worth a lot less on the secondary market if they want or need to sell (you experienced this), and may become illiquid (you can’t sell, even at fire sale prices).
In the case of Greece, when the country was bailed out by the European Union, the existing bondholders received only about a third of their principal back. Those were the terms of the bailout. That put MF Global out of business. (Google MF Global to read up more on this.)
This is what happened to you. You wanted to sell your bonds, but there weren’t any interested buyers in the room. Eventually, your broker was able to execute the trade, but at a lower price. The alternative would have been holding onto these bonds. If the crisis deepens, then the liquidity could dry up further, and you would have had to lower your rates even more to bait a buyer.
Ford bondholders recently experienced this first hand. Investors were willing to loan money to Ford for 30-year or even 40-year terms for a yield of 5-6%. When Ford was downgraded to speculative status, junk, on September 9, 2019, existing bondholders were put into a perilous position. They could sell at a steep loss, or hold until term and pray that Ford doesn’t have to restructure in the meantime. The pandemic heightens the risk, and lowers the price that they can exit their positions for.
What Lies Ahead?
Economists warn that the current recession will not be a V-shaped rebound. The U.S. economy shrank by -4.8% in the first quarter of 2020, and that was with only 15 days in lockdown. The current (2nd) quarter includes at least two months of Stay at Home or Safer at Home Orders. The 2nd quarter is predicted to contract another -12% sequentially, which could be as high as -40% year over year. Sadly, that is a contraction for the history books that rivals the Great Depression.
The Financial Stability Report does a good job of presenting the Framework of the current pickle we’re in, writing:
Elevated valuation pressures tend to be associated with excessive borrowing by businesses and households because both borrowers and lenders are more willing to accept higher degrees of risk and leverage when asset prices are appreciating rapidly. The associated debt and leverage, in turn, make the risk of outsized declines in asset prices more likely and more damaging. Similarly, the risk of a run on a financial institution and the consequent fire sales of assets are greatly amplified when significant leverage is involved.
There was too much debt and borrowing from Peter to pay Paul, in every corner of the developed world, before this pandemic hit. Corporations, nations, states, cities and citizens were all borrowing to make ends meet. (Corporations were also borrowing to pay dividends and buy back their own stock. Click to read more on Financial Engineering.) Good husbandry advocates that you fix the roof while the sun is still shining, and save for a rainy day. No one did that. Here we are. Liquidity will be your friend if “outsized declines in asset prices” materialize.
If you are interested in learning what's safe in a world where stocks, bonds and money market funds are all subject to capital loss, consider joining me for my next Financial Empowerment Retreat, June 13-15, 2020. Get additional information by clicking on the banner ad below.
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Please note: Natalie Pace does not act or operate like a broker. She reports on financial news, and is one of the most trusted sources of financial literacy, education and forensic analysis in the world. Natalie Pace educates and informs individual investors to give investors a competitive edge in their personal decision-making. Any publicly traded companies or funds mentioned by Natalie Pace are not intended to be buy or sell recommendations.
ALWAYS do your research and consult an experienced, reputable financial professional before buying or selling any security, and consider your long-term goals and strategies. Investors should NOT be all in on any asset class or individual stocks. Your retirement plan should reflect a diversified strategy, which has been designed with the assistance of a financial professional who is familiar with your goals, risk tolerance, tax needs and more. The "trading" portion of your portfolio should be a very small part of your investment strategy, and the amount of money you invest into individual companies should never be greater than your experience, wisdom, knowledge and patience.
Information has been obtained from sources believed to be reliable however NataliePace.com does not warrant its completeness or accuracy. Opinions constitute our judgment as of the date of this publication and are subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors.
Natalie Pace is the co-creator of the Earth Gratitude Project and the author of The Gratitude Game, The ABCs of Money and Put Your Money Where Your Heart Is. She blogs on Huffington Post and Medium, and is a frequent guest contributor to national news shows and magazines. She has been ranked the No. 1 stock picker, above over 830 A-list pundits, by an independent tracking agency, and has been saving homes and nest eggs since 1999.