Understanding bonds is not that difficult, but does need a basic discussion about how they work and how some are structured.

To start, the cost side of a bond is inverse to the yield side. This causes lower yield and higher costs as the supply/demand equation plays out. This formula works well for "A" and "Triple-B" rated bonds (safe).

The second structure that should be understood is one developed by Michael Milken in 1976-1981 called “Junk”. This structure is used to finance emerging market economies, LBOs (leveraged buyouts), MBSs (mortgage backed securities), etc. At the moment, CoCos (contingent convertible bonds) are being touted as being in jeopardy. Milken is celebrated as being the most influential individual in the modern financial environment, and if you are aware of the explosion of capital since the 1980’s (debt markets), there is no doubt the book Telecosm (Gilder) is not far off the mark.

So, “Junk” can be structured anyway the issuer sees fit (floating high yield return, conversion, cut up-tranche, etc). The yield of “typical” junk bonds are usually below 10%.

What happens if you have a borrower that is willing to pay a higher yield, say 25% ("juiced junk" as I like to refer to it)? How can it be structured “legally”?

Simple, you create what is known as a “shadow banking industry” (pooled risk capital) and match them with high risk borrowers and tranche the product to other counterparty risk takers (what Lehman Brothers did, RIP). I have heard of tranches (five million dollars) going for as high as 38% yield and selling for .75 on the dollar!

Understanding the shadow banking industry is not easy, as there are few, if any, texts, schools or blogs that teach this. It is purely the concoction of financial engineers that have reason to hide their structures (Feds, IRS, etc). Its size is staggering.Two-to-three times the 20 trillion dollar US gov debt. I have even heard 80 trillion by a Bernanke cohort!

The first upload shows the complexity of shadow banking, and how credit intermediation (loan-sharking) is achieved (okay, this is complex).

{{ right }}

{{ end }}

Looking at the largest-known market “and” the longest bull market in history (when the US treasury market prices rose for 35 years), one can see this phenomenon unfolding. However it is reaching a precarious point of unbalance (if Treasuries are safe-paper AAA rated, then as risk goes up they become more desirable and expensive).

Remembering that yields fall as demand for the product increases (in this case, 10-yr Treasuries), the following chart shows how yields fell from 15.84% in 1981 to the current yield of 1.75%. This means that the cost rose from about $25 for a 10-yr note to $130 today) and indicates how risk is rising through the decades.

A healthy, normalized yield would be in the 3% area (according to the Fed). In 2008, the "dislocation" at 3% started. In 2010-2011, a re-test failed miserably. 2013 saw a return of optimism and once again the 3% level was rejected. Currently, the bond market is signaling a liquidity problem is near and is “never” wrong.

Understanding bonds to assess risk is a cornerstone of being a wise trader/investor. 

Now I'll take a look at size, the bond markets relationship to stocks (also known as the business cycle), and how debt expansion/contraction is tied to economic cycles (projections).

I'll also look at the broader economics, and most importantly how to trade/invest with the market at your back, not your face.

All money managers must have a “macro” economic view of the coming investing environment for at least six-nine months.

All capitalism starts with the premise “I lend you money and I trust you will pay me back”. What happens when this equation no longer works? Just a thought.

The actual size of the bond market in the U.S. is unknown. However, a rough estimate would be 85-100 trillion dollars, give or take. The public bond market is 38-40 trillion, with the potential for shadow banking to increase that to 50-60 trillion if you include leverage. The stock market, in comparison, is a mere 21-25 trillion. This is one reason stock traders/investors need to have an eye on the bond market “size”.

The relationship of stocks/bonds is fairly straightforward. Both markets try to attract capital to their respective markets in the futures pits. Companies try to maximize margins, earnings and dividends, and bonds offer a coupon with the full faith of those that borrowed, whoever they are.

The first thing that should be understood is this: “The accumulation of debt, and then the repayment of debt, drives every economic cycle that there is”. Don’t ever forget that, because the inverse is also true. “Every recession that there ever was started with the slowing of debt issuance”.

Right now, we see a contraction of debt in the energy sector (perhaps other sectors as well) and as a consequence we are also seeing capital flowing into the (riskiest) bonds (and banks). This is the first signal of a pending recession, and can be referred to as  “debt contraction”. This is as simplistic a way I can think of to explain this complex shifting of capital/sentiment. Economists use either way too many backward-looking figures to make their models dependable, or forward-looking ones for trader/investors.

The PBS documentary “Trader” (1987) shows how individuals push 100’s of millions of dollars into and out of the futures markets (stocks/bonds) on a daily basis and, interestingly enough, how they manipulate positions to disguise their true intentions. It’s also a great overview of “macro” viewpoints and how hedge funds specifically “must” get this correct, or fail trying.

How do you apply this in as simplistic a way as possible? We'll use the chart of iShares iBoxx $ High Yield Corporate Bond (Ticker: HYG) as an illustration.

The chart of HYG (riskier bonds) have been dislocating since late 2014 (major reason the stock market couldn’t go up in 2015).

Starting late 2015, the 84.00 long-term support level started to break. The current level is around or below levels not seen since 2010 and 2011 (not good). That 78-79 area is key to risk normalization- you can see how hard they bounced in 2010 and 2011. If HYG starts moving toward 71.50 and break 75.00 decisively then the stock market is in for a very rough ride.

When debt dislocates, you can be assured that the Fed will get involved. Why? Well, they know a debt un-wind is akin to another 1929 thing, and banks close their doors as all lending stops.

While I do expect the 58.00 area to be reached eventually, it is a bit premature to target those levels at this time.

One other point about the HYG chart- you can use the chart to determine “when” to get back into the stock market at a perceived bottom.

In March of 2009, HYG engulfed the previous week's candle, running from 61.50 to over 67.00 in a single week. That move told investors to buy stocks, and the stock market responded.

Now that the stock/bond markets are in sync, you can use bond charts in conjunction with stock index charts.

The Elliott form on TLT (10-yr Treasuries) is incomplete. A wave 4 corrective, which will see the stock market respond higher, (which is happening now)  will be followed by a wave 5 higher on TLT, which will see stocks go down. (This inverse relationship happens whenever the markets are in sync).

How I watch for a wave 4 completion is; The RSI should print around a 45 number from the previous overbought RSI of the wave 3. As TLT goes up, S&P goes down and visa-versa. (Portfolio guys need exposure, but can adjust weightings from stocks to bonds). In this case, they are selling stocks and buying Treasuries, or selling bonds and buying stocks.

Everyone wants to prognosticate the end of the world scenario for the stock market, but my take is it can only happen if bond lenders “demand” higher rates, which would put Treasury yields not only above 3%, but as high as 8%-10% plus.

This will create a forced change in the financial system (fiscal and monetary) and deflation of assets will be immense, putting the S&P well below 2009 levels.

I only saw "bond vigilantes" once in the 25-plus years I’ve been at this. It was in 1993-1994, and I had just started trading (1991-1992 ). The dislocation in markets was dramatic. Stocks cratered, bond prices fell, interest rates rose, borrowing became more expensive. The bond traders/market went against fiscal/monetary policy. When the top of the S&P happens, the bond market will warn “all” who are listening just when to leave stocks.

This is the reason I watch the bond market. Trade safe.