Investors Beware

“Yes, risk-taking is inherently failure-prone. Otherwise, it would be called sure-thing-taking.” – Jim McMahon

We all know that bonds offer lower (but more reliable) returns than stocks, with better resistance to the whims of the market.

But there’s also something called high-yield bonds, also known as “junk bonds” because of their low ratings (below investment grade) and unusually high risk of default.

Lately, bargain hunters have been plowing their money into U.S. high-yield bond funds. A few weeks ago, according to Lipper Research, $1.39 billion flowed into them. This was the largest pile-in since August 2003. The fifth-highest on record.

And the U.S. market isn’t the only place money is pouring into high-yield funds. Loads of cash is flooding western Europe, too. A record amount. So far in 2010, $25.3 billion has poured into junk-bond funds there. That’s a 35% jump from the previous record set back in 2006.

The result of all this cash flowing into junk bonds signals trouble ahead.

Let me explain…

The federal interest rate is near zero. It’s been there since 2008. This policy is meant to spur growth and spending and fuel economic recovery.

It makes it easy for people to borrow money.

But it also makes it hard for investors to make money.

It induces them to take up residence in the risky neighborhoods of investing. Like junk bonds. They see high yields and reach for them.

And while investors are plowing money into junk bonds, large banks are looking to place money. Most of it is given in loans to big borrowers — loans that have the scope and scale to give banks hefty fees for commitment, underwriting, and placement. Banks also like the fat interest rate spreads typical of these “leveraged loans.”

So it’s win-win for banks and borrowers. But what about those investors?

Good Money Chasing Bad Deals

An improving marketplace goes hand-in-hand with rising asset values. And rising asset values supports a surge in junk bond deals.

Private equity shops wheel and deal to leverage the public companies they’re taking private with high-yield loans. (They use the proceeds to buy out public shareholders, as well as to pay themselves fat “management” fees. Their investors get juicy dividends too.) At the same time, they try to streamline their new portfolio companies to make them more productive and — they hope — more profitable.

In a teetering economy, though, there’s little room for that. Most companies have already squeezed out all the excess and inefficiency. Even before private equity players buy them out. Layoffs, scaled-back production, asset sales, and de-leveraging… all standard corporate fare in a recession.

Call it “Survival 101.”

But if demand doesn’t return or is not sustainable, more de-leveraging will be needed. No matter how much was already done.

A Backed-Up Backlog?

Something bad is brewing for private equity shops. And for their investors. And even for the larger universe of investors in U.S. and western European stock markets…

The private equity sector has a huge inventory of debt-laden portfolio firms. Each one is waiting to go public. But today’s initial public offering (IPO) markets are desperately thin.

So a nasty backup is forming. It looks something like traffic on the Long Island Expressway… heading out to the Hamptons… on a Friday afternoon.

This backlog of deals weighs on the rest of the market. Not only are these deals dull. The companies are sorely over-leveraged. It would take the power of a particularly exuberant market to lift any newly issued stocks. Otherwise, poor IPO debuts could kill off any enthusiasm that capital markets hope to represent as investible opportunities. And equity investors are beaten down enough as it is.

In the 2nd quarter of 2010, 90 companies filed to go public. They planned to sell a total of $23.6 billion in shares.

That is the highest number of planned IPOs on record. (At least since the last bull market that ended in 2007.)

In the same quarter, the number of IPOs cancelled was the highest since the collapse of Lehman Brothers in fall 2008. Fifty major IPOs got zapped worldwide. And markets continue to whip-saw. So it’s not likely that new share issuance will pick up anytime soon.

If anything, the traffic jam is getting longer by the minute.

That’s bad news for private equity shops. They’ve invested a total of $2 trillion in leveraged buyout (LBO) deals. That was during the easy money, credit-crazy bubble. The one that just exploded.

Note two important things. First, leveraging up continues. And second, more and more junk bonds are being issued to pay dividends to private equity masters.

DynCorp International Inc., for example, just issued $455 million worth of high-yield paper at 10.5%. It needs to finance a $1.7 billion buyout by Cerberus Capital Management. The cable TV firm Insight Communications Co. is selling $400 million worth of junk bonds to pay a $300 million dividend to its owner, the Carlyle Group. And CKE Restaurants Inc. is floating $600 million. That will help pay for its $1 billion buyout by Apollo Global Management.

Caution Is the Watchword

The low federal interest rate drove investors to seek higher yields by buying mortgage securities packed with subprime loans. It inflated the credit bubble. And the low rate is the catalyst here, too.

Investors who dare dabble in stocks right now must recognize the overhang of leveraged IPOs coming to market.

Beware the potential for another tsunami of deleveraging. It’s coming… It’s only a matter of time before healthy markets become unable to absorb the backlog of stale deals. And steer clear of leveraged, stripped-out companies fishing in the junk market for yield-hungry fools. They won’t be able to make their hefty interest payments for long.

Avoid getting stuck on the backed-up market expressways. Stay alert and watch your mirrors.

And beware. That stock market downturn you see in your mirror… may be closer than it appears.

[Ed. Note: Shah Gilani is a retired hedge fund manager and renowned financial crisis expert. In a recent expose, he warned that high-frequency traders were artificially pumping up market volume numbers. That makes stocks super-susceptible to a downdraft. And that downdraft came. Were you ready for it? Gilani was. So were subscribers to his new advisory service, the Capital Wave Forecast. The morning after it happened, his portfolio was up 186% on a short-term euro play. But that wasn’t all. It had gained more than 300% on an option play on the VIX volatility index too.

Gilani identifies the monster “capital waves” as they form. He shows how to profit from each one. And he highlights the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani’s investing strategy and the profit opportunities that result. And take a look at his recent articles. They’re available, free of charge, right here.]