History does not repeat – but it does rhyme

Diana Gordon says the best time to buy junk bonds is when there is blood in the streets; the oil price collapse has over 40% of high yield energy companies trading at big discounts

14th Dec 15, 5:32pm by Diana Gordon

By Diana Gordon*

Having spent most of my career as a high yield – a.k.a junk bond - portfolio manager, I found myself really grateful that I could step aside from that market when I came to New Zealand three years ago.

The global high yield market had doubled over the past 5 years, pushing past US$2 tln and yields had dropped to shocking lows. An unintended consequence of ultra-low interest rates and money-printing saw yield-hungry - even yield-desperate - investors become tourists in riskier asset classes like junk.

Do you like risk piled on risk? Then why not purchase a bond of an emerging market high yield company? Or that favourite Japanese retail investor trade of buying high yield in Brazilian Reals (a.k.a the double-decker)? None of these were going to end well. But when? The answer appears to be right now.

At time of writing, the JNK US High Yield ETF is down 7.9% YTD. Some 20% of companies are trading at distressed levels (as at Nov 30^th) and defaults are beginning to pick up.

One concentrated high octane fund run by smart investors has put up the gates to prevent a run on redemptions. That's pretty big news in a market that relies on the genteel fiction that there is always liquidity in freely tradable junk bonds. Liquidity was very poor during the global financial crisis (GFC) but somehow mutual fund managers were able to get through without having to put up the gates.

Connecting the dots to the telecom bubble

This all takes me back to 1999 when the junk bond market was booming. Enter stage left the telecom media & technology (TMT) sector, desperate for capital readily provided by the burgeoning high yield market.

The internet was the new, new thing. TMT companies began to trade on price to PP&E (or capital put in the ground) ratios or price-to-eyeballs. Nobody cared about the pesky cash flows you would need to pay your creditors. Surely that didn't matter, as all the companies would be bought up by the sleepy incumbent telecom companies? Or they could just raise equity in the exploding NASDAQ? Right? Um.

Turned out fibre in the ground was a commodity and the incumbents could build it themselves. Eyeballs went elsewhere. The NASDAQ collapsed, bond prices collapsed, often to zero, with an aggregate loss of US$190 bln in the high yield bond market alone.

The high yield market can be capricious, sometimes shutting down altogether. In times of crisis, a company that has constant need for capital is going to get burned.

Back to the future - now it’s energy and commodities

Fast forward 15 years to the shale gas revolution:

A hugely growing high yield market in a desperate search for yield? Check.
A good story about intrepid new technology that provides clean energy coupled with energy independence from the Middle East? Check.
A strong stable commodity price rewarding early adopters? Check.
A highly capital-intensive industry that requires constant access to a sometimes-inconstant market ultimately dependent on a commodity price? Sounds familiar.

High yield energy companies grew from low single digits to 15%+ of the market through 2014. Following the recent oil price collapse, over 40% of high yield energy companies are now trading less than 80c on the dollar, with the same story playing out somewhat in the minerals and mining sector. Venerable and once well-regarded investment firms have been caught with their pants down overweight the wrong sectors.

GFC version 2.0?

The junk market right now feels to me a lot more like the bursting of the telecom bubble of the early 2000s rather than the more systemic meltdown of 2008 when high yield was down about 30%. I don't think this will stop the Fed from its gradual hiking policy. It knows that it has messed up by pushing interest rates down too low, with unintended consequences.

There are plenty of good companies that have nothing to do with oil and gas or materials whose bonds are being sold to meet redemptions.

Many of those companies that had stared into the abyss in the GFC (with the abyss cheerily waving back) have got religion about shoring up their liquidity. So even though revenue growth has been rather anemic over the past 8 years, most companies have been pumping out lots of free cash flow. Even the most pedestrian of bond issuers has been able to refinance their debt at very low coupons.

Opportunity or threat?

There are a number of funds in New Zealand that invest in high yield, more as a minor adjunct to their fixed income allocation through direct investment, or go-anywhere funds. The industry has mostly dodged the bullet this time around, partly due to being burnt by the junky New Zealand finance companies.

So is there an opportunity for New Zealand investors in high yield debt? Buying high yield bond funds still retains an element of buying a sandwich thinly filled with the proverbial brown stuff of oil and gas and materials companies. But of course that can present opportunities to pick up non-oil and gas and materials bonds cheaply when the funds have to meet redemptions.

The best time to invest in junk is usually just before defaults peak when there is blood truly on the streets. High yield is certainly looking more attractive but we aren't there - yet.

This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed, or relied on, as a recommendation to invest or refrain from investing in a particular financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any investment decisions.

Diana Gordon is the Fixed Interest Portfolio manager on the Investment Strategy team at GMI/Kiwi Wealth in Wellington.

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8 Comments

by Roger Witherspoon | 14th Dec 15, 6:21pm 1450070488

Cool. Does the panic spread to all corporate debt worldwide (ie in NZ too)? Does it spread to all non government debt? Does it spread to all debt as margined junk owners are forced to sell the good stuff too?

by Stephen Hulme | 14th Dec 15, 6:28pm 1450070909

An unintended consequence of ultra-low interest rates and money-printing saw yield-hungry - even yield-desperate - investors become tourists in riskier asset classes like junk.

I very much doubt it.

The symptoms you describe were totally expected if not demanded by the ex-university tenured academic residents of the Marriner S. Eccles Federal Reserve Board Building.

..Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy. Following this logic, Tobin suggested that purchases of longer-term securities by the Federal Reserve during the Great Depression could have helped the U.S. economy recover despite the fact that short-term rates were close to zero, and Friedman argued for large-scale purchases of long-term bonds by the Bank of Japan to help overcome Japan's deflationary trap. Read more

by Stephen Hulme | 14th Dec 15, 6:47pm 1450072068

High yield is certainly looking more attractive but we aren't there - yet.

Imitations are a wonderful thing.

Total Non-Financial Debt expanded at a 2.0% rate during Q3, the slowest debt expansion since Q2 2011. Q3 debt growth slowed sharply from Q2’s 4.6% and compares to Q3 2014’s 4.5%. Importantly, the Credit slowdown was broad-based. Household debt growth slowed to 1.5% from Q2’s 4.2%, to the weakest expansion since Q4 2013. Home Mortgage growth slowed from Q3’s 2.4% to 1.6%, while Consumer Credit slowed from 8.5% to 7.2%. Federal government debt growth slowed from 2.4% to Q3’s 0.2%.

Yet the most remarkable Credit slowdown unfolded during Q3 in Corporate borrowings. Corporate debt growth slowed to a 4.3% pace, about half Q2’s 8.8% (strongest since Q3 2013’s 10.1%). In dollar terms, Total Business Borrowings slowed to a seasonally-adjusted and annualized rate (SAAR) of $586bn, down from Q2’s $1.025 TN.

Total Non-Financial Debt growth slowed markedly to SAAR $871bn, the weakest Credit expansion since Q4 2009 (SAAR $686bn) and down from Q2’s SAAR $1.989 TN and Q3 2014’s $1.907 TN. It’s worth noting that the rate of Credit expansion during the quarter was less than half the $2.0 TN bogey that I have posited is required to sustain the Bubble and unsound economic expansion. Read more

by Roelof | 14th Dec 15, 7:30pm 1450074629

Great article.... Throw on top of that the credit spread widening cycle/phase we are about to go thru..??..

Peter Warburton of economic perspective and author of the cult classic...'Debt and Delusion" says:

"Our contention, supported by independent empirical work, is that the US Federal Reserve’s unconventional monetary policy and increasingly elaborate ‘forward guidance’ are intimately connected to the compression of US corporate credit spreads. Beyond the impact of essentially zero short-term interest rates, these other policy interventions have distorted the pricing of credit risk, especially for the least deserving issuers of debt.

The unwinding of spread compression is at an early stage, and may not mature in crisis for another year or two, but the message is that the next US downturn will be deeper and longer as a consequence of the extent of policy interference in private credit markets.
The verdict on central banks’ large-scale asset purchases and pre-commitment strategies is likely to become harsher as time goes by.
However, spread widening is significant for its empirical connection to subsequent adverse economic performance. The commencement of a tightening cycle, however mild, is likely to unleash a wave of bond and leveraged loan defaults which will aggravate the next economic downturn. The arrival of credit market discipline will punish investors in corporate bond funds, who are among the principal beneficiaries of this moral hazard trade. While a serious US economic downturn is probably a prospect for 2017-18, rather than 2016, the implication of our investigation is that unconventional monetary policy has pre-disposed the US economy to larger output and employment losses when that time comes.

by Simon | 15th Dec 15, 8:22am 1450120970

my study of the great depression is not very thorough, but I believe it was commodities that fell first then. Farmers could make any $ and it rippled through the world. Can oil ,iron ore, other commodities this time repeat this?

by steven | 15th Dec 15, 8:45am 1450122326

Looking at the state of some of the oil producing nations, yes. What will really kill our economy will be when the 1929 crash is repeated however, that will wipe out Trillions in share values, so no pensions as an example, that will hurt. Then the OBR events from crashing property prices will take out much other savings that will hurt even more.

by Stephen Hulme | 15th Dec 15, 9:15am 1450124125

my study of the great depression is not very thorough, but I believe it was commodities that fell first then.

Hmmmm.

The price of Australia’s top export has been almost slashed in half this year. That makes it all the more surprising economists increasingly see iron ore propping up growth as they assemble their 2016 forecasts.

The reason: Australian producers are making up for the price destruction by doubling down on volume, in the process worsening a global supply glut. There’s even a new entrant to the market -- Gina Rinehart, Australia’s richest person, last week oversaw her company’s first shipment of iron ore to South Korea.

The surging exports are also papering over a massive drag on the economy from collapsing mining investment and could account for most of next year’s growth, according to Citigroup Inc. and Goldman Sachs Group Inc. Still, the fall in commodity prices will hurt fiscal revenue, making it more difficult for the government to pare back a deficit and reach its goal for a surplus by the end of the decade. Read more

If someone pulled the global over production pin Fed officials could stop scratching their collective heads in respect of missing inflation.

Federal Reserve officials this week are expected to raise interest rates for the first time in nine years on the expectation that employment and inflation will hit targets reflecting a healthy U.S. economy.

But Fed officials face a troubling question: Jobs are on track, but inflation isn’t behaving as predicted and they don’t know why. Unemployment has fallen to 5%, a figure close to estimates of full employment, while inflation remains stuck at less than 1%, well below the Fed’s 2% target.

Central bank officials predict inflation will approach their target in 2016. The trouble is they have made the same prediction for the past four years. If the Fed is again fooled, it may find it raised rates too soon, risking recession. Read more

Redefining inflation to affect a redistribution of wealth was never a premise likely to deliver wide spread rewards.

by steven | 15th Dec 15, 8:46am 1450122400

Assumes exponential growth on a finite planet, good luck with your junk.