Tuesday, October 27, 2015

Which Bond Bubble Worries Her Most?

Jeff Cox of CNBC reports, Junk bond market betting big against Fed rate hike:
Traders have been using junk to bet against the possibility that the Federal Reserve will raise interest rates anytime soon.

Exchange-traded funds that track high-yield bond indexes have been the beneficiaries of a cash surge in recent weeks as market participants figure the central bank probably won't raise rates in 2015, and it could be well into 2016 before anything happens.

In just the past week alone, three bond-related ETFs pulled in $2.4 billion. Two are focused on high-yield, or junk, bonds, according to ETF.com, despite repeated warnings on Wall Street that the segment of the market is headed for the rocks.

The iShares iBoxx $ Investment Grade Corporate Bond, the iShares iBoxx $ High Yield Corporate Bond and the SPDR Barclays High Yield Bond have been hugely popular.

During October, the group has pulled in $6.6 billion, with the two junk funds attracting about $4.3 billion of the total.

By contrast, in August, when the market was still anticipating that the Fed might raise its key interest rate in September, the two high-yield funds lost a net $344 million.

Since then, a sputtering economy and lackluster inflation have changed Wall Street's perception of when the central bank's Federal Open Market Committee will enact its first hike since taking its funds rate to zero in late 2008. Traders now put just a 7 percent chance of a rate move at Wednesday's FOMC meeting and a 36 percent probability for the final one of the year in December, according to the CME's tracking tool. Current expectations are for a March 2016 hike, with a 59 percent chance.

The Fed's rate posture is critical to the bond market because yields and prices move in opposite directions. A Fed hike would be expected to trigger responses across credit markets, driving rates higher and eating into bondholder principle.

Moreover, corporate America has been dependent on low rates to finance the trillions of debt issuance it has taken on during the era of zero interest rate policy, or ZIRP. The $8.1 trillion in net outstanding debt has grown by 8.4 percent in 2015.

The quality of that debt has eroded as well, making high yield particularly sensitive to rate increases and the possibility for an elevated level of defaults.

Ratings agency Moody's reported Monday that the rolls of "potential fallen angels," or issuers with investment-grade debt currently in danger of becoming junk, swelled by 17 in the third quarter, while no companies fell into the opposite category, called "potential rising stars." It's just one measure by which bond quality has declined, another being the continuing erosion in covenants, or the conditions companies must meet to their bondholders.

Still, ETF buyers are willing to take a shot at the market, believing that in addition to the Fed staying dovish with rates the default level will remain low.

In addition to junk funds, the ETF market in general has been flocking to fixed income. The Vanguard Intermediate-Term Bond fund also was in the top 10 over the past week in terms of flows, taking in $484.5 million, while the iShares Core U.S. Aggregate Bond ETF pulled in $416.8 million, according to ETF.com and FactSet.
In my last comment I went over Mercer's global ranking of top retirement systems and referred to the latest Absolute Return Letter, The Real Burden of Low Interest Rates, where Niels Jensen explains why low rates are here too stay making it more difficult for all pensions to generate the returns they need to cover their liabilities.

Today I'm going to discuss one of my favorite subjects, the (not so) scary U.S. bond market that all these gurus have been warning us about. This includes hedge fund titans Paul Singer and Carl Icahn, as well as the maestro Alan Greenspan who also sounded the alarm on bonds.

My regular readers already know my stance on all these "dire warnings" on the "bond bubble." I ignore them for the simple reason that I don't see an end to the deflation supercycle and think the era of low growth, low inflation/ or deflation and low returns is here to stay for a very long time.

And while Bridgewater's Ray Dalio is worried about the next downturn (he should be more concerned about his funds' lackluster performance), central banks are very busy saving the world, coming up with new tricks like negative interest rates and even buying municipal bonds to mitigate the ravages of deflation and spur growth (wait till the Bank of Canada starts buying provincial bonds).

In other words, there won't be any bursting of any U.S. bond bubble. The Fed has a serious deflation problem to contend with, especially after China's Big Bang, and it knows it would be making a monumental mistake if it raises rates anytime soon. This shift in focus from domestic to international  concerns represents a sea change at the Fed, one that we better all get used to.

Are there unintended consequences to maintaining rates so low for so long? Of course, central banks are fueling a property bubble all around the world as rates remain at historic low levels. They are also exacerbating inequality as low rates favor financial speculation, rewarding overpaid hedge fund managers but punishing savers. Record low rates also force pensions to take on more risk to make their return target by investing in hedge funds and private equity funds, providing elite managers with a perpetual source of funds and making them obscenely wealthy in the process.

Zero interest rate policies (ZIRP) also fuel inequality via the buyback bubble. As rates remain at historic lows, companies are incentivized to borrow big and plow that money right back into a share repurchase program, allowing them to literally manipulate earnings-per-share so their CEOs and top brass can keep inflating their bloated compensation without having to hire new workers or invest in capital, equipment and research and development.

No wonder dividends and stock buybacks are on track to hit a new high this year and could top $1 trillion for the first time, according to Michael Thompson, managing director of S&P Capital IQ Global Markets Intelligence:
Companies have been increasing their buybacks and dividends to please investors for years. Total payouts from S&P 500 companies surged 84% in the past decade to $934 billion in 2014, from $507 billion in 2005, according to a report by S&P Capital IQ.

While getting cash is great for investors, there's two sides to the thank-you's that companies are giving out.

On one hand, they can be a healthy sign that reflects a company's confidence in its future and willingness to share the cash its business is generating. But increasingly they're seen as a gimmick to distract investors from problems like struggling sales growth and lack of ideas in how to invest its cash.
This is a structural problem that is worth paying closer attention to because as companies plow cash into share repurchase programs, rewarding investors and mostly their top brass, they're not doing their part to invest in human and physical capital.

All this fuels inequality and rising inequality concerns me from a social and economic point because it exacerbates long-term structural unemployment and is very deflationary.

[Note: Those of you who want to delve deeply into the issue of inequality should pick up Thomas Piketty's The Economics of Inequality, Tony Atkinson's Inequality: What Can Be Done?,  Joseph Stiglitz's The Great Divide and Robert Reich's Saving Capitalism: For the Many, Not the Few.

I would also recommend Piketty's Capital in the Twenty-First Century but it's way too long and technical even if it's a masterpiece on the subject of inequality. I found Atkinson's book to be a particularly excellent read as he offers policymakers ideas on tackling rising inequality not simply by taxing the rich but also through tackling poverty.]

But while rising inequality concerns me and academic economists, it doesn't concern the Fed and other central banks which are there to respond to the needs of the financial and corporate elites. And to be fair to the Fed, even if it did raise rates, it would end up crushing the over-indebted masses which are struggling to pay off their credit card bills and the mortgage on their overvalued homes. 


Lastly, while all the focus is on the U.S. bond bubble, Bloomberg's Lianting Tu recently reported, If You Thought China's Equity Bubble Was Scary, Check Out Bonds:
As a rout in Chinese stocks this year erased $5 trillion of value, investors fled for safety in the nation’s red-hot corporate bond market. They may have just moved from one bubble to another.

So says Commerzbank AG, which puts the chance of a crash by year-end at 20 percent, up from almost zero in June. Industrial Securities Co. and Huachuang Securities Co. are warning of an unsustainable rally after bond prices climbed to six-year highs and issuance jumped to a record. The boom contrasts with caution elsewhere. A selloff in global corporate notes has pushed yields to a 21-month high, and credit-derivatives traders are demanding near the most in two years to insure against losses on Chinese government securities.

While an imminent collapse isn’t yet the base-case scenario for most forecasters, China’s 42.2 trillion yuan ($6.7 trillion) bond market is flashing the same danger signs that triggered a tumble in stocks four months ago: stretched valuations, a surge in investor leverage and shrinking corporate profits. A reversal would add to challenges facing China’s ruling Communist Party, which has struggled to contain volatility in financial markets amid the deepest economic slowdown since 1990.

“The Chinese government is caught between a rock and hard place," said Zhou Hao, a senior economist in Singapore at Commerzbank, Germany’s second-largest lender. "If it doesn’t intervene, the bond market will actually become a bubble. And if it does, the market could crash the way the equity market did due to fast de-leveraging.”


The slide in stocks is one reason why corporate bonds have done so well, prompting a 91 percent jump in issuance last quarter. Many investors who sold shares during the Shanghai Composite Index’s 38.4 percent drop from its June high have plowed the proceeds into debt, viewing the market as a haven given its history of almost negligible defaults. Five interest-rate cuts since November have also fueled gains as the People’s Bank of China seeks to revive growth with lower borrowing costs.

Yields on top-rated corporate notes due in five years have declined 79 basis points, or 0.79 percentage point, this year to 4.01 percent. The yield premium over similar-maturity government securities has dropped to 97 basis points, near the lowest since 2009.

By contrast, the yield on corporate notes globally has increased 26 basis points to 2.92 percent. Credit-default swaps on China’s sovereign debt jumped to a more than two-year high of 133 basis points in September and were last at 113 basis points.

Risks Rise

A reversal in the bond market would do more damage to China’s economy than the drop in shares and exacerbate capital flight from the biggest emerging market, according to a worst-case scenario projected by Banco Bilbao Vizcaya Argentaria SA. The Spanish lender more than doubled its first-quarter profit by selling holdings in a Chinese bank.

“The equity rout merely reflects worries about China’s economy, while a bond market crash would mean the worries have become a reality as corporate debts go unpaid," said Xia Le, the chief economist for Asia at Banco Bilbao. "A Chinese credit collapse would also likely spark a more significant selloff in emerging-market assets.”

For all the concerns about a bond rout, default levels in China have so far been remarkably low, thanks in part to government-orchestrated bailouts for troubled firms. Just four companies have defaulted on onshore bonds, including Shanghai Chaori Solar Energy Science & Technology Co., which became the first to renege on its debt in 2014.

Government Firepower

China has the wherewithal to stave off a crisis in its credit markets, according to Ken Hu, chief investment officer for Asia-Pacific fixed income at Invesco Ltd. "Unlike most other emerging-market countries, China has high domestic saving rates, little government debt, healthy fiscal balances, strong trade and current account surpluses, and most of its corporate debts are domestic," he said.

Policy makers went to unprecedented lengths to combat the tumble in share prices, including compelling state-owned firms to buy equities and preventing major stockholders from selling. The Shanghai Composite rose 1.27 percent on Friday, its second straight day of advance after a week-long national holiday.

A recovery in the equity market could be the trigger for a selloff in bonds as money managers liquidate their holdings to catch the rally in stocks, according to Thomas Kwan, the Hong Kong-based chief investment officer at Harvest Global Investments Ltd., whose Chinese unit offers funds through the Qualified Domestic Institutional Investor program.

Warning Signs

The risk of a downward spiral in debt prices has increased after investors took on leverage to amplify their returns, according to Ping An Securities Co. The monthly volume of bond repurchase agreements -- a form of borrowing used by investors to increase their buying power -- has jumped 83 percent from January to 39 trillion yuan in September, according to data from the Chinamoney website.

About 16 percent of companies on the Shanghai stock exchange lost money in the past 12 months, double the proportion last year, and the number of firms with debt levels twice their equity has doubled to 347 since 2007. Profits at Chinese industrial companies sank 8.8 percent in August from a year earlier, the biggest decline since the government began releasing monthly data in 2011.

Baoding Tianwei Yingli New Energy Resources Co., a maker of solar components, could become the latest Chinese company to default on local-currency notes after its parent said it’s unlikely to meet a deadline next week on a 1 billion yuan bond.

“Global investors are looking for signs of a collapse in China, which itself could increase the chances of a crash,” Commerzbank’s Zhou said. “This game can’t go on forever."
Indeed, investors betting big on a global recovery have not been rewarded and continue getting hammered as energy and commodity prices head lower as everyone nervously awaits news out of China.

This is why I even though I agree with those who say the possibility of rate hike this year shouldn't be ignored, I wouldn't bet on it and would only worry about it next year once we see clear signs that a global recovery is well underway. And if for any reason a global recovery doesn't materialize, I would expect the Fed to start talking about more QE or even negative rates if deflation fears spread to America.

All this to say that even though the Fed is cognizant of all these supposed bond bubbles, it won't be a factor to worry about in the next few months. The October surprise I discussed earlier this month remains my base case scenario for the near term.

Below, CNBC Finance Editor Jeff Cox breaks down what investors should expect from the Fed in the coming weeks and months. I agree with him that the "ghost of 1937" weighs heavily in the Fed's decision and that bank stocks matter a lot more than economic data.

But with deflation fears reigning, I don't see any huge run-up in financial shares (XLF). And while China may be dumping Treasuries, U.S. banks are scooping them up as the ultimate carry trade continues unabated. Fun times and as long as the music doesn't stop, neither the Fed nor you should worry about any bond bubble anywhere in the world.

Update: The Federal Reserve kept interest rates close to zero for yet another meeting but said it would focus on its “next meeting” in mid-December on whether to raise interest rates. Like I said above, I wouldn't ignore the possibility of rate hike this year but I wouldn't bet on it.

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