Hey There Income Hunters,
Exchange Traded Funds (ETFs) were an amazing creation when first brought forward nearly 30 years ago. And total assets under management today are approaching $6 trillion.
ETFs can be many things. Some are low-cost and provide diversification, tax efficiency and flexibility. However, one feature that is vastly misunderstood is liquidity.
No doubt day-to-day there is tremendous liquidity in the popular ETFs. The ETF is liquid and even the options on the ETF can be deeply liquid.
It gets a bit murky when the specifications of the ETF give the managers a lot of wiggle room, though — particularly when different credit ratings and flexibility in the duration for securities that can be held are in play.
So, as competition has entered the market, portfolio managers have pushed the envelope to cram riskier assets into ETs in order to increase returns.
This is where the story gets a bit scary. When the financial market bubble eventually bursts, the fire sale of assets will begin and liquidating all those illiquid assets held in the ETF will be near impossible.
Sadly, investors will lose much more than they ever intended
However, smart #IncomeHunters can be on the right side of the trade and make a fortune.
Today, I will share some secrets about an ETF I think will explode to the downside when the market turns to sellers — thanks to what’s under the hood.
Check it out …
Corporate Debt ETFs Are Like Bugs in Search of a Windshield
Passive investments like ETFs have inflated stock and bond prices just as collateral debt obligations (CDOs) inflated subprime mortgages more than 10-years ago.
When these massive inflows reverse — and they will — it will get very ugly.
It’s the Big Short all over again, except this time it’s investment grade corporate debt ETFs.
Check out the growth in corporate debt since 2011 …
So, basically the economy was hardly growing, yet corporations almost doubled the amount of debt.
And now the majority of that risky debt is sitting in a few ETFs. Here is the most vulnerable of the lot …
iShares Investment Grade Corporate Bond ETF (Ticker: LQD)
What makes this so eerily similar to the underlying mortgages that were sold to investors during the crisis is the fact that today’s “investment grade” corporate bond universe contains upwards of 50% of riskier companies …
How about this stat:
There are 2,427 individual corporate bonds held in LQD.
How about trying to sell Anheuser-Busch (Ticker: BUD), which is BBB credit, into a falling market?
Here is the thing, when the market is for sale because of a credit stress, some BBBs will be downgraded to BB, which means they fall out of investment grade.
When that happens, any money fund that holds that security must liquidate it. So after a few downgrades, the value of the ETF collapses because the portfolio managers keep dropping their bids.
Check out the price action in LQD during the financial crisis …
I am showing this so you have something to compare the magnitude of the crisis brewing in this market today …
Now let’s compare the financial crisis to the Covid crisis LQD trade:
Can you believe the increase in volume? How about the fact that LQD is $30 higher in price while the amount of debt outstanding has doubled?
Did I hear somebody say bubble?
Now take a look at the yield spread the BBB corporate bonds are to the similar maturity US Treasury Bonds, which are considered riskless …
Absolutely insane that BBB paper is valued this close to what are called riskless Treasuries.
With inflation soaring, bonds are mispriced and certainly corporate bonds are horribly mispriced.
I have been making triple digit returns setting up put spreads on the iShares 20+ maturity Treasury Bond ETF (Ticker: TLT) and now I am buying put spreads on LQD.
Yesterday I purchased Nov. 19 133/131 put spreads for .78. If LQD closes below 131 at the Nov. 19 expiry, my return would be 156%,
That is the power of options, and I feel great about this one.
Bring It Home
Pretty bad close yesterday in the S&P 500.
The pressure on the market is coming from the bond market. Interest rates around the world are rising because inflation is out of control.
I am cautiously optimistic that the reopening trade could accelerate economic growth. This would boost stocks, but they may grind lower for a couple of more weeks while we wait for Congress to raise the debt ceiling and pass the spending and infrastructure bills.
Bonds, however, are a different story. Inflation is the death of bonds and until the Fed decides to buy bonds and control interest rates, they will rise for a while longer.
Have a happy Friday and as always …
Live and Trade With Passion My Friends,