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03-05-2014, 10:21 AM
Indications that global markets are awashed with liquidity and moving towards the penultimate stages of the current cycle. Mkt fears spiked out during the GFCs (3 sharp bear years) and now in the grinding bull stages (likely to be 7 grinding bull years) topping out in the famous crisis years that end with 7s...
PUBLISHED MAY 03, 2014
Danger lurks as investors seek yield
With money to invest but few options available, investors are turning to lower quality, rather than longer maturity bonds. By Floyd Norris
PUTTING MONEY TO WORK
Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality. There are risks to both. - PHOTO: AFP
'It is a very favourable time for bond issuers. There is just a lot of money sloshing around out there. There are simply not a lot of alternatives, and money managers are under pressure to put that money to work.'
- Martin Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors
WHEN buyers demand something, the supply will be created. Especially on Wall Street.
These days, thanks in no small part to the prolonged easing by the Federal Reserve, there is a great demand for investments that provide yield.
Apple, a rich company that borrows for two reasons - to pacify shareholders and avoid paying taxes - came to market this week with US$13 billion in new bonds. That was on the heels of a US$17 billion offering a year earlier.
It was such a smashing success that Hans Mikkelsen, a credit strategist at Bank of America Merrill Lynch, promptly proclaimed that "Apple bonds are Giffen goods". Giffen goods, named after Sir Robert Giffen, a 19th-century Scottish statistician and economist who discovered that they could exist, defy the normal law of supply and demand. Raise the price, and people will buy more.
They are extremely rare.
The classic example - and the only one I had heard of before Apple sold its new bonds - was potatoes at a time when they were the chief source of nourishment for Irish peasants. If potato prices fell, the peasants could afford more meat and would therefore eat fewer potatoes. When potato prices rose, they could no longer afford meat and would consume more potatoes.
Last week, when Apple announced its plans to sell all those new bonds, the price of its existing bonds fell a little, which is what normal supply and demand models would predict. But this week, when the bonds were actually sold, prices rose. Apple's 30-year bonds now cost more, relative to Treasury bonds, than they did before the new borrowing was announced.
"Apple," explained Mr Mikkelsen, "was able to generate increased demand for its bonds at flat to higher prices. That clearly is a testament to continued inflows to credit and the precious availability of bonds, rather than your textbook supply-demand chart."
In other words, investors are desperate for yield and will flock to it.
That is great for those companies that can issue bonds, but it took awhile for those that depend on bank loans to see a similar development. Now banks are making more loans to companies, and even mortgages are becoming easier to obtain.
"The average Fico score on new mortgages is falling, and this is consistent with the anecdotal evidence that banks are easing mortgage lending standards," said Torsten Slok, the chief international economist of Deutsche Bank Securities, pointing to data on mortgages acquired by Fannie Mae. The Fico score measures creditworthiness.
Just why mortgages took longer to ease up is the subject of more than a little speculation. Some say banks saw no reason to go after any but the safest borrowers as long as they were making a lot of refinancing loans to highly qualified borrowers. So they imposed what are known as "overlays" - requirements that were tougher than they had to be on loans that would be sold to Fannie Mae and Freddie Mac.
"Based on loans we've acquired and our conversations with lenders," said Andrew Bon Salle, an executive vice-president of Fannie Mae, "we know that many lenders have been removing overlays."
They need to do that to keep their mortgage businesses from shrinking.
Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality.
There are risks to both. The prices of long-term bonds fall sharply when interest rates go up. Lower-quality bonds are more likely to default.
These days, lower quality, rather than longer maturities, seems to be more popular. Money has poured into mutual funds that invest in bank loans - often low-quality ones. To a lesser extent, it has also gone into high-yield mutual funds that buy bonds rated below investment grade, known as junk bonds to those who are dubious of them.
"It is a very favourable time for bond issuers," said Martin Fridson, the chief investment officer of Lehmann, Livian, Fridson Advisors and a long-time analyst of the high-yield market. "There is just a lot of money sloshing around out there. There are simply not a lot of alternatives, and money managers are under pressure to put that money to work."
What that money will buy now is low yields, relative to risk. It also buys less protection than it used to in terms of covenants - terms put in bonds that are supposed to protect investors if conditions worsen. In normal times, extremely weak junk bonds at least come with relatively strong covenants. But Moody's Investors Service, which maintains a "covenant quality index", said in March that the lowest-quality new issues had fewer covenants than did slightly better-quality bonds.
That preference - for low quality rather than long duration - is easy to understand. Worries about potential Fed tightening caused long-term bond prices to fall last summer, scaring some investors. But default rates on high-yield bonds remain low.
Mr Fridson says that he thinks that investors are not being paid nearly enough for the risks they are taking and that high-yield bonds are overvalued. But he concedes that has been true for some time, and it is far from clear what will cause that to change.
Late last year, Mr Fridson caused a bit of a stir when he said "the next upsurge in the default rate" was likely to begin in 2016 and last for four years. "During that period," he wrote in a commentary for S&P Capital IQ LCD, "we project that on a global basis, approximately 700 bond issuers and 1,150 debt issuers in total will default. The face amount of bonds and loans going into default should approximate US$1.5 trillion, with the US accounting for US$1 trillion of the total."
He noted that "the projected number of defaulting debt issuers is triple the number that defaulted in the short but severe upsurge of 2008-09 and nearly double the number that defaulted in the five-year upsurge that began in 1999". A currently hot category of fixed-income mutual funds features funds called "unconstrained" or "strategic" by their sponsors. They can use derivatives to eliminate any risk from rising interest rates. Eric Jacobson, a mutual fund analyst at Morningstar, says that some now even have "negative duration", a concept that is hard to fathom. The funds also have the freedom to move in and out of different kinds of bonds, which is supposed to produce superior performance - and will do so if the managers do turn out to be able to call market turns in advance.
Good luck.
Eventually, I suspect that some of those who have poured money into such funds will be surprised to learn that they have purchased lower-quality bonds, something that will be very painful if Mr Fridson turns out to be right.
All this easy credit may not do as much as it could for the economy. Loans that finance corporate acquisitions, or dividends to private equity funds, won't do anything for employment, or at least a lot less than loans that pay for the purchase of new plants and equipment.
As for Apple, the yields on this year's bonds are a little higher than the ones on last year's. The new 30-year bond has a coupon of 4.45 per cent, compared with 3.85 per cent. The 10-year bond rate has climbed to 3.45 per cent from 2.4 per cent. If you bought either bond a year ago, and sold it this week, you would have a net loss.
There is a sense in which Ireland, home of the Giffen goods potatoes, has also produced the newest Giffen goods. Thanks in part to a sweet deal with Ireland, Apple has been able to accumulate a huge cash hoard without paying much in the way of US income taxes, but it would have to pay a lot of taxes if it used that cash to pay dividends and buy back stock. So it borrows money instead.
If all this ends badly, as Mr Fridson expects, there will be a lot of blame heaped on the Fed for keeping interest rates so low for so long, thus encouraging the speculation. At least some of the criticism might be better directed at the Congress. Had it been willing to provide more fiscal stimulus, the Fed might not have been forced to follow the course it has. NYT
PUBLISHED MAY 03, 2014
Danger lurks as investors seek yield
With money to invest but few options available, investors are turning to lower quality, rather than longer maturity bonds. By Floyd Norris
PUTTING MONEY TO WORK
Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality. There are risks to both. - PHOTO: AFP
'It is a very favourable time for bond issuers. There is just a lot of money sloshing around out there. There are simply not a lot of alternatives, and money managers are under pressure to put that money to work.'
- Martin Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors
WHEN buyers demand something, the supply will be created. Especially on Wall Street.
These days, thanks in no small part to the prolonged easing by the Federal Reserve, there is a great demand for investments that provide yield.
Apple, a rich company that borrows for two reasons - to pacify shareholders and avoid paying taxes - came to market this week with US$13 billion in new bonds. That was on the heels of a US$17 billion offering a year earlier.
It was such a smashing success that Hans Mikkelsen, a credit strategist at Bank of America Merrill Lynch, promptly proclaimed that "Apple bonds are Giffen goods". Giffen goods, named after Sir Robert Giffen, a 19th-century Scottish statistician and economist who discovered that they could exist, defy the normal law of supply and demand. Raise the price, and people will buy more.
They are extremely rare.
The classic example - and the only one I had heard of before Apple sold its new bonds - was potatoes at a time when they were the chief source of nourishment for Irish peasants. If potato prices fell, the peasants could afford more meat and would therefore eat fewer potatoes. When potato prices rose, they could no longer afford meat and would consume more potatoes.
Last week, when Apple announced its plans to sell all those new bonds, the price of its existing bonds fell a little, which is what normal supply and demand models would predict. But this week, when the bonds were actually sold, prices rose. Apple's 30-year bonds now cost more, relative to Treasury bonds, than they did before the new borrowing was announced.
"Apple," explained Mr Mikkelsen, "was able to generate increased demand for its bonds at flat to higher prices. That clearly is a testament to continued inflows to credit and the precious availability of bonds, rather than your textbook supply-demand chart."
In other words, investors are desperate for yield and will flock to it.
That is great for those companies that can issue bonds, but it took awhile for those that depend on bank loans to see a similar development. Now banks are making more loans to companies, and even mortgages are becoming easier to obtain.
"The average Fico score on new mortgages is falling, and this is consistent with the anecdotal evidence that banks are easing mortgage lending standards," said Torsten Slok, the chief international economist of Deutsche Bank Securities, pointing to data on mortgages acquired by Fannie Mae. The Fico score measures creditworthiness.
Just why mortgages took longer to ease up is the subject of more than a little speculation. Some say banks saw no reason to go after any but the safest borrowers as long as they were making a lot of refinancing loans to highly qualified borrowers. So they imposed what are known as "overlays" - requirements that were tougher than they had to be on loans that would be sold to Fannie Mae and Freddie Mac.
"Based on loans we've acquired and our conversations with lenders," said Andrew Bon Salle, an executive vice-president of Fannie Mae, "we know that many lenders have been removing overlays."
They need to do that to keep their mortgage businesses from shrinking.
Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality.
There are risks to both. The prices of long-term bonds fall sharply when interest rates go up. Lower-quality bonds are more likely to default.
These days, lower quality, rather than longer maturities, seems to be more popular. Money has poured into mutual funds that invest in bank loans - often low-quality ones. To a lesser extent, it has also gone into high-yield mutual funds that buy bonds rated below investment grade, known as junk bonds to those who are dubious of them.
"It is a very favourable time for bond issuers," said Martin Fridson, the chief investment officer of Lehmann, Livian, Fridson Advisors and a long-time analyst of the high-yield market. "There is just a lot of money sloshing around out there. There are simply not a lot of alternatives, and money managers are under pressure to put that money to work."
What that money will buy now is low yields, relative to risk. It also buys less protection than it used to in terms of covenants - terms put in bonds that are supposed to protect investors if conditions worsen. In normal times, extremely weak junk bonds at least come with relatively strong covenants. But Moody's Investors Service, which maintains a "covenant quality index", said in March that the lowest-quality new issues had fewer covenants than did slightly better-quality bonds.
That preference - for low quality rather than long duration - is easy to understand. Worries about potential Fed tightening caused long-term bond prices to fall last summer, scaring some investors. But default rates on high-yield bonds remain low.
Mr Fridson says that he thinks that investors are not being paid nearly enough for the risks they are taking and that high-yield bonds are overvalued. But he concedes that has been true for some time, and it is far from clear what will cause that to change.
Late last year, Mr Fridson caused a bit of a stir when he said "the next upsurge in the default rate" was likely to begin in 2016 and last for four years. "During that period," he wrote in a commentary for S&P Capital IQ LCD, "we project that on a global basis, approximately 700 bond issuers and 1,150 debt issuers in total will default. The face amount of bonds and loans going into default should approximate US$1.5 trillion, with the US accounting for US$1 trillion of the total."
He noted that "the projected number of defaulting debt issuers is triple the number that defaulted in the short but severe upsurge of 2008-09 and nearly double the number that defaulted in the five-year upsurge that began in 1999". A currently hot category of fixed-income mutual funds features funds called "unconstrained" or "strategic" by their sponsors. They can use derivatives to eliminate any risk from rising interest rates. Eric Jacobson, a mutual fund analyst at Morningstar, says that some now even have "negative duration", a concept that is hard to fathom. The funds also have the freedom to move in and out of different kinds of bonds, which is supposed to produce superior performance - and will do so if the managers do turn out to be able to call market turns in advance.
Good luck.
Eventually, I suspect that some of those who have poured money into such funds will be surprised to learn that they have purchased lower-quality bonds, something that will be very painful if Mr Fridson turns out to be right.
All this easy credit may not do as much as it could for the economy. Loans that finance corporate acquisitions, or dividends to private equity funds, won't do anything for employment, or at least a lot less than loans that pay for the purchase of new plants and equipment.
As for Apple, the yields on this year's bonds are a little higher than the ones on last year's. The new 30-year bond has a coupon of 4.45 per cent, compared with 3.85 per cent. The 10-year bond rate has climbed to 3.45 per cent from 2.4 per cent. If you bought either bond a year ago, and sold it this week, you would have a net loss.
There is a sense in which Ireland, home of the Giffen goods potatoes, has also produced the newest Giffen goods. Thanks in part to a sweet deal with Ireland, Apple has been able to accumulate a huge cash hoard without paying much in the way of US income taxes, but it would have to pay a lot of taxes if it used that cash to pay dividends and buy back stock. So it borrows money instead.
If all this ends badly, as Mr Fridson expects, there will be a lot of blame heaped on the Fed for keeping interest rates so low for so long, thus encouraging the speculation. At least some of the criticism might be better directed at the Congress. Had it been willing to provide more fiscal stimulus, the Fed might not have been forced to follow the course it has. NYT