A disaster waiting to explode

Low interest rates, zero interest rates, or negative interest rates, these are the situation facing millions of people around world whose incomes are dependent on interest rates. It is probably not an overstatement that the world is currently in its madness in the sense that virtually every country is expanding its debt load to make interest as low as possible. As such retirees have no choice but to look for high yields to generate their incomes. So in this zero or negative interest world, where can they go? High yield bonds or junk bonds! One example is the incredible premium people are paying for Pimco High Income Fund (PHK). This is a close-end fund (CEF) that seeks high current income with capital appreciation through investment in corporate debt obligations and income producing securities. In other words, it is a junk bond fund. Given the nature of CEFs, the number of their issued shares are fixed and as such they are traded daily as a stock purely based on the demand and supply, which could lead them to be overpriced, i.e. prices higher than the its net asset value (NAV), or discounted (prices lower than NAV). Here is the key for CEFs: they tend to return to its NAV over time. If you pay too much, you are more likely to lose money just as general stocks. So what’s the situation for PHK? Well, its NAV is below $7 at the moment but its share price is around $10 (see the chart below). In other words, people who are chasing for its high yield (about 12%) are willing to pay almost 40% more than its real value. If PHK simply returns to its NAV, the shareholders’ value can easily be haircut by 30-40%. The thing is, bonds are very sensitive to the long term government bond rates, especially for junk bonds. If there is any expectation that the long term rates are moving higher, the junk bonds can easily crash. I think the bond market is sending a warning signal that we may start to see higher long term bond rates. In the past 2 weeks or so, the 10 year Treasure yield is breaking out to the upside to 1.7% at the moment. If this trend indeed continues, it will be a disaster for junk bond investors. PHK will surely be among the first ones to explode! If you hold PHK, better to get out immediately before too late. As a trader, I will consider to buy TBT, a leveraged inverse ETF against long term bonds (e.g. TLT). TLT may be a bit oversold and is due to rebound in the short term but any bounce is likely an opportunity for buying TBT to bet for the next leg down for TLT.