Market Update — December 18

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This week, I came upon a lot of interesting data concerning the bond market.  The summary is:

1. There is strong demand for junk bonds.

2. Distressed debt (the riskiest junk bonds) has also done incredibly well.

3. The rally is surprising, given the increase in corporate defaults.

4. The real slowdown in lending is due to the shutdown of structured products (much more than reduced bank lending).

5. The amount of government debt being issued is astounding.

6. Bill Gross is reducing his holding of Treasuries.




Now, on to the notes…




There is strong demand for junk bonds. Investors have bought $137 billion of junk issuance this year.  The record was $143.5 billion in 2006.  But, to give you a frame of reference, only $47.7 billion was sold in 2008.




Junk spreads have shrunk. Risk premiums have reached their lowest level in the past two years.  Currently junk spreads average 6.75% (above US Treasuries), but this spread was close to 20% (in the past year).  Investors have bought bonds from lower rated companies, apparently believing either:

1. the economy will recover and even the weak companies will survive

2. rates are too low on Treasuries or investment grade bonds and this is the only way to get satisfactory yield

3. the Fed won’t raise rates soon (and that will protect the economy) and banks will start lending




Pessimists think that this reflects:

1. investors disregarding risk (consistent with reduced covenants and the re-emergence of riskier structures)

2. reduced bank lending




Some of the riskiest debt has done the best and is seeing strong demand! Last month, CCC rated paper comprised 20% of all US high-yield issuance.  This is really low-rated paper.  CCC bonds made up 11% of September’s issuance and it was 4% before that.   In the past year, CCC rated bonds have returned 100%!




There is less distressed debt in the market. People define distressed debt as bonds that are selling for less than 50 cents on the dollar (signaling that the market is pricing in a high chance of default).  Distressed debt now accounts for only 1.1% ($8.9 billion) of the high yield market.  It comprised 27.5% ($202 billion) of the high yield market one year ago.   In effect, you’re seeing large money flows into the riskiest junk bonds as investors chase yields.  The reason that we see less distressed debt is not because there are fewer distressed companies.  Rather, investors have bid up the price of these bonds (so that they are no longer considered to be distressed).




It’s surprising to see junk debt do so well while we are having so many defaults. There have been 260 global corporate defaults this year — the highest since S&P started collecting this data in 1981.  America, the financial leader, had 188 of these defaults.  The previous global high was 229 (in 2001).  These 260 defaults were a combination of:

1. bankruptcy (70)

2. distressed exchanges (offers to swap old debt for new debt at a discount) (101)

3. missed interest or principal payments (89)

The global speculative default rate is 9.77%.  The high was 12.86% in 1991.




There’s too much talk about the drop in bank lending. During Q3, total loans at US banks dropped by 3% (a $210 billion decrease).  This was the largest quarterly drop since 1984.  But, if you go back to 2006, only 25% of credit came from banks.  Most loans were originated by non-bank lenders, such as auto finance companies, credit card issuers and insurance companies.  They relied on securitization.  In 2006, approximately $100 billion of loans were being securitized each month.  In 2009, there have been $5 billion of loans being securitized each month.




Investors don’t want to buy securitized loans because:




1. issuers still don’t have to retain any ownership of the securities — so the “agency problem” remains.  In other words, we don’t know that anyone has done their due diligence.




2. we don’t trust the ratings agencies — they got it wrong before and we have no evidence that they are any better equipped at analysis or dealing with business pressure.




3. investors don’t feel equipped to analyze these complex securities (and if they can’t rely on the ratings agencies, that means there’s no way to buy them)




This tells me that we need to solve this problem. I continue to maintain that the best solution is to ensure the independence of the ratings agencies by placing an entity in between the rating agency and the issuer.




Governments are issuing a tremendous amount of debt. The US, eurozone, UK and Japan have issued $3.9 trillion of debt this year.  This is up 86% from last year and 146% from 2007.  The US has assumed our rightful position of leadership — issuing $2.1 trillion of debt this year.




Here’s the problem for government bond investors:

1. if the economy continues to strengthen, investors will take risk and buy riskier bonds (possibly selling sovereign bonds)

2. if the economy weakens, these governments will issue even more debt (because tax revenue will be low and government spending will be high)




Bill Gross cut his exposure to Treasuries. Gross, the “Buffett of bonds”, had 63% of his Total Return Fund’s portfolio invested in Treasuries in October.  He reduced that to 51%.  Gross has recently said that Treasuries are overvalued relative to potential inflation.




Look at that slope! The spread between the 10 year and 2 year Treasuries has hit a new record: 2.76%.  This indicates the risk of inflation over the longer term and the desire to hold short term notes.




Speaking of sovereign debt…look at Greece. There has been tremendous fear over Greece’s debt.  Their debt to GDP level is forecast to be 135% in 2011.  The US is less than 100%.  Of course, if you added in our unfunded liabilities (promises to pay Social Security, medicare / medicaid and Veteran’s Affairs), the ratio would be in the 400 – 500% range.  But, far be it for me to be a curmudgeon.  Lets not think about it.  Lets ignore it and shake our head about how irresponsible Greece is.




Even covered bonds aren’t safe from risk! S&P threatened to downgrade all covered bonds.  Covered bonds are backed by mortgages or other bonds, but they are also backed by the issuing bank.  S&P is changing their methodology and will tighten the link between the rating of the covered bond and the rating of the issuer.




The ISDA (International Swaps and Deriviatives Association) said that credit default swaps (insurance on bonds) does not affect the bankruptcy process. There has been concern that hedged creditors (who bought swaps) behave differently than unhedged creditors.  In fact, they might have incentive to push a company into bankruptcy.  But, the ISDA says this is not the case.  Similarly, the tobacco association says that smoking is not bad for you.




The results are almost in and bonds have beaten stocks this decade. Since 2000, the S&P 500 had dropped 25% in nominal terms.  With dividends reinvested, the drop is 11%.  The total return of Treasuries was 85%.




In sum, it seems like we’re seeing increased risk tolerance, demand for junk bonds (possibly because no one will by structured products and investors need to buy something) and concern about deficits and inflation.

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