How to Hedge Credit Risk

It should be no surprise to Berman’s Call viewers that I think the sheer amount of debt in the world is problematic. History teaches us that the bigger the percentage of debt compared to the size of the economy measured by gross domestic product (GDP), the slower economic growth will be in the future. Almost half of investment grade corporate bonds are rated BBB, one notch above junk status. In 2009, that number was less than 33 per cent.

The quality of corporate balance sheets have been eroding for years in the era of cheap debt. In the next recession, we are going to see lots of investment pain in the corporate bond sector. Have a look at what happened with high quality corporate bonds in 2008 to 2009. This is when only one-third of the index was BBB-rated. Today, the credit risks are far greater.

In the high yield space, many investors have been attracted to the sector because of the higher yield. Currently, HYG, the largest high yield ETF with almost U$16 billion in assets, has a yield a bit higher than five per cent.

The quality of bonds in that index is below investment grade. In other words, these are the companies that might default during the next economic downturn. Typically, it’s about 10 to 15 per cent or so of the universe.

BBB 0.01%
BB 48.36%
B 37.77%
CCC 11.01%
CC 0.78%
NR 2.07%

I don’t often recommend inverse exposure ETFs, but for those more aggressive investors out there, SJB is an inverse exposure to high yield bonds. It’s not ideal to hold for long periods of time because it costs about five per cent per year (the yield) to hold. But if/when prices of high-yield bonds sell off as the market sniffs a recession, this ETF should do very well.

I believe the next recession will be a huge problem for companies with weak balance sheets (lots of leverage).

Watch Larry discuss this topic in a video segment on BNN Bloomberg

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