General Motors Company (GM), Berkshire Hathaway Inc. (BRK.A), Apple Inc. (AAPL): The Bond Market Has Only One Way To Go

On May 7, the yield on the Barclays U.S. Corporate High Yield Index fell to a record low of 4.97%. It was the first day in the history of the U.S. junk bond market, where less creditworthy companies borrow, that the index yield fell to less than 5%. The next day, yields fell again to 4.96%. That means that investors were willing to risk 100% of their invested capital in return for a couple of lowly percentage points above 10 year U.S treasuries.

On various occasions in the past, I have written that it is impossible to justify the high price of junk bonds and their correspondingly low yields. You must remember that the default rate on these bonds will soar, sooner or later. In March 2009, for comparison, the default rate on this category of debt hit 14.9%. And of course, default rates rise when more bonds are issued. Issuance hit an all-time record in 2012.

Not the only sign

Believe it or not, that’s not even the worst sign that the debt market is headed for an enormous crash. Not only are investors no longer being compensated adequately for the risk of default, issuers of these debts have also succeeded in placing clauses in the contracts that allow them to repay investors with additional debt securities rather than cash. So-called pay-in-kind (PIK) toggle notes allow corporate borrowers the option of issuing still more debt rather than paying bondholders interest in cash.

Needless to say, a borrower who requires the option to repay you with still more debt isn’t likely to repay you. These investments are sure to end badly, too.

A few live examples

This past month, General Motors Company (NYSE:GM) issued new debt paying a yield of only 3.75%. General Motors Company (NYSE:GM) is sitting on roughly $100 billion in pension obligations. It went bankrupt less than five years ago. And it operates in a sector that’s still suffering from massive overcapacity. For investors to sacrifice their capital for five years and be rewarded with 3.75% is nothing short of ridiculous. That’s a sure sign of a top in the corporate bond market. And General Motors Company (NYSE:GM) wasn’t doing it alone.

In May, Berkshire Hathaway Inc. (NYSE:BRK.A), whose cash hoard reached a record $49.1 billion in its first quarter, sold $500 million of 1.3%, five-year debt with a 57 basis-point spread and an equal portion of 4.3%, 30-year bonds with a relative yield of 135 basis points. Remember, Berkshire Hathaway Inc. (NYSE:BRK.A) doesn’t need all that cash – it took it simply because it could. And when Buffett is selling bonds, instead of buying them, everyone should stop and listen. Technically speaking, you could say that Buffett and Berkshire Hathaway Inc. (NYSE:BRK.A) are short the bond market.