Video Update: What’s Really Going on in the Bond Market

The last two Thursdays the stock market has crashed 1.5% and its no coincidence.

It turns out, every Thursday the U.S. Treasury is selling 30-year bonds. And it doesn’t seem to be going so well.

Today Chief Analyst Adam Galas will explain what’s happening with the broken bond market and why the world of finance is freaking out.

While some are predicting a financial crisis, Adam walks through the likelihood of such an event occurring and how well your Fortress Portfolio is prepared.

Adam will also dive into one Fortress pick that has a 40% potential upside or 17% annual return over the next two years.

Click below to watch the video or scroll down to read the transcript.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome, Fortress Portfolio members, to another weekly video update. This week, we're talking about the broken bond market. And I know what you're thinking. “Bonds. Oh, my God. These are so boring.”

But as I'll show you, to understand the glories of the bond market is to understand the world of money itself, and thus the entire world.

Let me share with you what's going on in the bond market that has the world of finance in a tizzy. The last two Thursdays, the stock market crashed around 1.5% each afternoon. That’s because of the broken 30-year Treasury auction. Every Thursday, the Treasury is selling 30-year bonds.

The last two times have been a disaster. The Treasury had to sell at interest rates far higher than expected, around six basis points. But the actual bond yields soared twice as much. That’s a 3% move in bond yields in a single day.

For the boring bond market, this is crypto-like volatility. In fact, this is the highest volatility we have ever recorded, higher even than the Great Recession.

To give you an idea of just how messed up the bond market is right now… On average, the big banks – which are the ones auctioning off these bonds – must take about 12%, or one-eighth, of their bonds on their own balance sheets to clear the auction.

This time it was 24%. There just were not enough buyers.

The banks had to step in, otherwise the government would not have been able to get the money it needed. So how bad have things gotten?

Well, since 2018, just 26% of U.S. bond auctions have actually been strong. This is one of the reasons that credit rating agency Moody's is a bit worried.

It’s downgraded the U.S. to AAA negative outlook. That means there’s a 33% chance in the next two years that the U.S. will lose its final AAA credit rating.

So how bad could this be? Could this cause a financial crisis? Those are good questions.

Remember, in September 2022, the U.K. had a brand-new prime minister, Liz Truss, and there was an inflation crisis. She came in with a bold vision to cut taxes and give people money, so they could afford to buy stuff.

Well, the bond market wasn't having any of it. Fifty-year U.K. bonds lost half their value in two days. Risk-free bonds dropped 50% in value in two days. There was a pension crisis.

The Bank of England, which had been jacking up interest rates to fight inflation, had to pivot and start buying bonds in emergency moves… Otherwise the entire economy would have collapsed.

Within six weeks, the Truss government had collapsed, and she was out as prime minister. The bond market toppled the U.K. government. That's the power of the bond market.

As bad as our government is right now, it's far better than what the U.K. was dealing with in 2022.

For example, Mike Johnson, Speaker of the House, is moving the vote to keep the government open. So, it's not completely dysfunctional. The U.S. isn’t likely to have any kind of crisis like that.

But you might be wondering, “What is going on? Where are the buyers?” It’s important to remember who is the biggest single buyer of U.S. bonds in the last decade.

That would be the Federal Reserve. Forty percent of all U.S. government bonds are owned by the Federal Reserve. Since the great financial crisis, the Fed has bought $8 trillion worth of bonds.

Here’s how this works: The Fed prints the money, it buys the bonds, and then the bonds sit there on its balance sheet. When the bonds mature, the Fed takes that money and recycles it back into buying new bonds.

That money is a continuous cycle. The Fed is always buying a lot of bonds. Except this time, the Fed is doing reverse money printing, what we call quantitative tightening.

That means $90 billion a month of government bonds. As they mature, the Fed simply doesn't reinvest. The bonds roll off the balance sheet, and the money supply gets tighter. That's how the Fed is fighting inflation.

Here’s the problem with that. As you can see in the chart below, consumer expectations of long-term inflation have just soared to the highest level in 12 years.

(Source: The Daily Shot)

Remember, the Fed promises, oh so many times, “2%, 2%, 2%. We're not raising our target. It's 2%. Come hell or high water. That's what we're going to do.”

The bond market kind of believes the Fed… 2.4% for the next three years is what it’s pricing in.

But consumers aren't having any of it. They're saying 3.2%. That's a higher inflation expectation than in mid-2022 when inflation was 9.2%. Americans are very, very worried.

Who is right: the consumer or the bond market (the so-called smart money on Wall Street)?

As you can see in the chart below, based on 10 million data points, in terms of real time inflation – it's around 3%.

(Source: Truflation)

So consumers are closer to being right.

Why does this matter for Wall Street, corporate profits, and your portfolio?

Because over the last 50 years, long-term interest rates – benchmarked by the 10-year U.S. Treasury – have been 2% above the rate of inflation.

That means, if the Fed is right, long-term, 10-year yields are around 4%.

Right now, we're about 4.6%, slightly undervalued with some upside.

But if consumers are right, then it’s 5.2%. Suddenly, bond yields have to go a bit higher.

As you can see in the chart below, corporate bond yields, which are based on 10-year Treasuries plus some risk premium, have soared.

(Source: YCharts)

They've roughly tripled since the pandemic lows. Back when companies were able to borrow as low as 1.4%, or adjusted for inflation, -1.5%.

Even AAA is 5.3%. The investment grade is around 6%. Junk bonds are around 7%. And the highest-risk bonds are around 15%.

But here is where it matters to your portfolio.

This is why we focus on blue chips and companies with strong balance sheets. Because the spread, the difference between junk bond yields and Treasury yields – risk-free yields – averages 10% in a recession.

That means borrowing costs for junk bonds, speculative, low-quality companies, are 13-15% in a recession.

This is why it's so important to buy quality, but especially when the economy takes a downturn. And that's exactly what's happening, as I'll explain in our next video in two weeks.

But here is a preview. You can see below, bankruptcies this year are already at pandemic levels, and we're on track to approach 2010 right after the Great Recession.

(Source: The Daily Shot)

That’s almost two bankruptcies a day, according to the S&P 500.

That brings us to our update this week on ONEOK…

If you recall, ONEOK bought Magellan, which was our recommendation back in May. It helped us lock in a 25% profit.

We sent out an alert saying sell Magellan and buy ONEOK. The reason for that was simple. In a big M&A deal like this, the company that's doing the acquisition will fall in value.

That’s because there's always a little bit of concern about how  the deal is being funded or if it’s a good deal. The company being acquired, of course, goes up.

So we had the opportunity to lock in a 25% profit and buy ONEOK on a knee-jerk selloff. And of course that paid off well. We made 15% on top of that. Plus, we locked in a 7% yield.

Let me show you why I'm still excited about ONEOK.

(Click to enlarge)

(Source: FactSet Research Terminal)

As you can see in the chart above, right now, it's trading at roughly fair value. It's done a pretty big recovery off of that initial knee-jerk reaction.

For the next two years, there’s still potential for 40% upside or 17% annual return. That's because of the tax savings from Magellan.

ONEOK is buying Magellan at nearly a 50% discount. Back in May, when interest rates were 1% lower, management said they could boost the long-term growth rate of ONEOK to 8%.

This is in the utility industry. Around 3-5% growth rates. And the company’s saying, “Oh, we can grow at 8%,” and its yield was 7%. So management says, “You buy us today, you lock in 15% in returns. And double your money every five years, for the foreseeable future.”

Absolutely incredible opportunities.

We still have 40% upside to go. That’s compared to the S&P 500 at around 11% for the next two years. That’s four times the return potential of the S&P 500.

Here’s the thing to remember about ONEOK. Even after interest rates have gone up… after management’s redone its earnings, crunched the numbers… the growth outlook is down 1% as interest rates are up 7%.

So we're still looking at around 13% long-term returns if you buy it today at fair value. That is better than the 12.5% expected from the Nasdaq long-term.

It’s a lot better than the market's 10%. And you're getting a very safe 6% yield.

How safe? Very simple. Let’s take a look at that chart again.

(Click to enlarge)

(Source: FactSet Research Terminal)

The cash flow has a 19% growth rate in 2024, and another 8% in 2025.

Based on free cash flow payout ratios, it's down. It's dropping from around 65-70% this year to 52% next year. And for context, 83% or less is safe for this industry.

So very solid payout ratio. A solid investment grade. A BBB credit rating with low cost of capital. And the company’s minting cash flow.

Last year, cash flow was $2 billion. And $4 billion is expected by 2028. That’s 14% cash flow growth per year, doubling every five years. That’s three times the growth rate of the industry.

And of course, it's paid off well for investors already.

But remember, we're talking about for the long term. We’re talking about 6-7% safe yields growing faster than the highest inflation rate in 42 years.

That is the power of the Fortress system.

We want to invest in the world's best ultra-high yield companies with strong balance sheets and capable management teams, so that they can survive and thrive and keep those dividends intact even when craziness happens.

For example, as you can see in the chart below, during the pandemic, oil didn't just get low. It went negative.

(Source: Markets Insider)

And it didn't just go -$3. It went almost -$40. And yet, ONEOK kept paying that dividend.

During the Great Recession, ONEOK kept paying that dividend. Even with four major oil crises in the last third of a century, it kept on paying that dividend. That’s 34 years without a dividend cut.

What is the risk of a dividend cut even in another Great Recession or a pandemic global downturn?

About 1.05%. For context, Goldman Sachs estimates the risk of nuclear war with Russia at about 10%.

In other words, with ONEOK, you're about 10 times more likely to be killed by Putin's nukes than to suffer a dividend cut.

That's the power of the Fortress method.

That is why we are so proud to have you as a subscriber. So that we can help you sleep well at night no matter what's going on.

We’ll watch Bloomberg, CNBC, and C-SPAN so that you don't have to. Believe us – you don't want to. It's no way to live.

We’ll tell you what's going on so you can understand the world. But most importantly, so you can understand what's going on with your companies and know your dividends are safe.

We want you to achieve your financial dreams by floating to a personal financial utopia on an ocean of safe and growing dividends.

Thank you so much for joining me. Our next video will be in two weeks because of the Thanksgiving break.

I want to remind you to please send us your questions and comments so that I can respond to them in these videos and our monthly issue. Just remember, I can't legally provide personalized investment advice.

Until next time, this is Adam Galas wishing you and your family a happy Thanksgiving and a wonderful, healthy, and relaxing holiday season.