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Sunday, September 14, 2014

Wall Street At Work Aggravating Risk—-Would You Like Some Leverage On Them Junk Bonds!

Once upon a time junk bonds yielded 12-15% on a regular basis and not without reason. After accounting for average losses of about 5% on a long term basis—plus inflation, taxes, illiquidity and real returns—-double-digit yields made good sense financially.

After more than a decade of financial repression by the Fed and other major central banks, however, junk bond yields have fallen to the 5-6% range. Such rock-bottom yields, of course, are completely uneconomic and barely cover the risk of loss—-let alone inflation, taxes and the rest.  So you would think that bond fund managers would go on strike, forcing yields back into at least a minimum zone of rationality.

Needless to say, you would be wrong. As highlighted in the Bloomberg piece below, fund managers are still insisting on a 10%+ return, but not by buying fewer over-valued junk bonds. No, they are just buying them on leverage in order to goose the yield on their own capital at risk.

Some Wall Street genius at Citigroup has even calculated that leveraging junk bonds at 2.3X is a better trade than leveraging US Treasuries at 8.1X. Is this fool serious? Has he not noticed the massive inflow of yield-starved investors into bond funds during the last half decade—-at a time when Wall Street dealers have drastically reduced their own trading inventories owing to Dodd-Frank regulation; and, also, due to the possibility that they may have actually learned something about the danger of leveraged inventory during the September 2008 meltdown.

In any event, the premium for illiquidity should be going up on account of reduced dealer capacity and a massive growth of bond mutual funds—-which, by the way, amount to demand deposits on the funding side and roach motels on the asset side; that is, the bonds go in during the boom but have no way to get out during a bust when investors dump their holdings en mass.

Unfortunately,  the Fed’s massive bid in the bond market—-that’s what $3.5 trillion of government and GSE debt purchases since 2008 amounts to—-has prevented price discovery from reflecting this new reality.

Likewise, the risk of loss has also been obscured by 5 years of can-kicking in the junk bond market.  All the huge maturities which should have been paid-off in recent years from the massive issuance in the years before the financial crisis have simply been refinanced in a giant maneuver of “extend and pretend”.  So what looks like reduced loss rates on outstanding bonds is actually just the result of a giant Wall Street snow-plow which has pushed the day of reckoning out past 2015.

It goes without saying that the central banks have not eliminated the business cycle—-their pretensions to the contrary notwithstanding. Indeed, we are already in month 62 of this so-called recovery cycle—compared to an average expansion of about 55 months in the 10 cycles since 1948.
So when the next economic contraction finally hits and there is an investor run on the junk bond funds, look out below.

The evaporation of liquidity will result in soaring yields as desperate fund managers scramble to generate cash and are forced to sell into a bidless market. And then the gamblers who followed Citi’s advice and leveraged up their holdings by 2-3X will face margin calls and be forced to join the selling stampede, too.

Finally, there will be a day of reckoning for the “extend and pretend” snow-plow as maturity dates are reached. In the context of a battered new issues market, the legions of LBO debt zombies will not have the option to refinance at ridiculously sub-economic yields. Then the loss rates which have been artificially suppressed during the Fed’s long bubble cycle will come screaming back into the market, adding kerosene to the fire.

Maybe the resulting crop of ex-bond fund managers will then have the time and insight to explain, even if belatedly, to our clueless monetary politburo that, yes, there was a financial bubble after all.

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