We mentioned in a recent post that we would soon return to the topic of credit spreads and exotic structured products. One reason for doing so are the many surprises investors faced in the 2008 crisis. Readers may e.g. remember auction rate securities. These bonds were often listed as “cash equivalents” on the balance sheets of assorted companies investing in them, but it turned out they were anything but. Shareholders of many small and mid-sized companies learned to their chagrin that quite a bit of this “cash” had for all practical purposes evaporated when the markets for these bonds suddenly froze.

Surprise and shock at the sudden emergence of exotic securities in unexpected places at an inconvenient moment.

We have regularly chronicled the growing insanity in bond markets over the past few years, since we feel quite certain that debt will once again prove to be the straw that breaks the bubble’s back, so to speak. The massive surge in “cov-lite” bond issuance in the corporate junk bond universe almost speaks for itself, as does the popularity of “frontier market” government bonds or bonds issued by parastatal entities in these markets (“frontier markets”).

The same applies to the resurgence in CLO issuance. Investors in these products often employ up to 10:1 leverage; reportedly banks are eagerly supplying the funds, since back-testing clearly shows that nothing bad ever happened to these carefully over-collateralized cesspools of potential deadbeat debt – and as everybody knows, that means nothing bad will ever happen. Just as there was never supposed to be a nationwide collapse in home prices, this is basically the next double plus-certain thing, which means there is little choice but to slap an AAA rating on most of these securities. Et voila, 10:1 margin is no problem; this kind of leverage was first tested by the customers of bucket shops in the roaring 20's, and for a time it was quite popular.

Besides, if one looks at credit spreads one really has to wonder what the stock market is getting so concerned about lately. Credit spreads are clearly telling us that investors in their collective wisdom expect almost no corporate defaults in the coming year, despite the fact that the corporate debtberg is of unprecedented magnitude both in absolute and relative to everything terms.

Behold the amazing resilience of the credit markets. Both euro area and US junk bond spreads remain close to all time lows, and the same is true of their effective yields (note that euro area junk spreads have recently widened a bit more because the yield spread between German sovereign bonds and US treasuries has increased – for instance, the yield on 10-year Bunds was recently at just 0.65% vs. the 2.86% yield on 10-year treasuries – interestingly, these securities were trading at the same yield as recently as late 2014). Since the “great crisis”, the mountain of corporate liabilities has grown to the sky and beyond – but so what?

Unfortunately we also have to mention the concept of reflexivity again… just throwing the three surviving bears a bone, as it were. The lack of expected defaults depends mainly on one thing: the willingness of investors to keep funding borrowers when they need to roll over maturing debt.

 As most bond investors presumably know, corporate mandarins are investing these borrowings quite wisely, by buying back the egregiously undervalued shares of their companies. The resultant decline in share floats helps to highlight what admirable earnings powerhouses many of these enterprises are. Where otherwise there may well be nothing, one now finds respectable growth in EPS. What’s not to like?

Financial Engineers Never Sleep – From Soviet Dams to Gemstones

Let us return to the more exotic corners of the debt markets, where we have recently become aware of a product that is attracting tens of billions every year from investors eager to experience a certain frisson. In this they remind us a bit of the investors who recently lent $500 million to Tajikistan so it can finally complete – no, “kick-start” – construction of a hydroelectric dam that was apparently started in 1976, in the distant, fading memory of the Brezhnev era.

Photo credit: DPA

Well, what do you know! There has obviously been quite a bit of progress since 1976, just look at this gorgeous excavation and the functional can-do air emanating from these lumps of concrete. Who wouldn’t want to shower this stunning monument to modernity in the middle of nowhere with wagon-loads of money? This endeavor brings a certain highway in Calabria to mind that has been reportedly under construction since the late 1960's (funded by the EU, which one presumes is keeping a watchful eye on proceedings there. The construction companies largely belong to a friendly neighborhood watch NGO called the ‘Ndrangetha.

Almost needless to say, this particular bond issue was wildly oversubscribed, allowing it to be priced a full 90 bps below initial guidance. Transparency International lists the wonderful country of Tajikistan as “one of the most corrupt in the world”, which we assume is either based on the lies of envious competitors in the neighborhood, or yet another overly hasty assessment courtesy of the Donald. Besides, the wily Tajiks have an ironclad business plan for the dam: it will sell electricity to nearby Afghanistan. What, we ask, could possibly go wrong?

The above information was first reported in the WSJ, in an article that also included the tidbit of information following below. As it turns out, Tajikistan is not the only gem in the rough (so to speak), investors are throwing money at. The story was picked up by Elliott Wave International which mentioned it in its monthly financial forecast, where it came to our attention.

Investors desperately want something to buy, preferably something that sports a yield. With the ECB and its trusty printing press submerging large parts of sovereign yield curves in the euro area below the previously dreaded “zero bound”, the hunt for yield with a plus sign in front of it has evidently morphed into a clown-show of truly grotesque proportions.

It is perhaps not too big a surprise that a type of exotic product that tended to appear on the scene in size near the end of the previous two booms has made a roaring comeback. This future financial coffin nail is referred to as the “bling bond” these days. While the term encompasses a wide variety of asset-backed bonds using non-traditional types of collateral, the name is actually derived from the fact that said collateral inter alia includes diamonds. It seems diamonds are no longer merely a girl’s best friends, they are now the best buddies of fixed-income investors too.

Go get ’em while they’re hot! Esoteric ABS – the best thing since sliced bread sees record issuance as the greedy maws of “investors” open wide to be stuffed with anything sporting a yield. There is a particularly funny background story associated with the diamond-backed portion of these innovative future sources of deep regret.

Here we will consult the WSJ, which provides some color on bling bonds. The specific type of bond their name is derived from apparently popped up for the first time in 2007. Its career was a brief one, but the timing was certainly interesting; we wonder if it might be a useful signal of the proverbial bell-ringing kind (in which case these ABS should perhaps be renamed “ring bonds” or “clang bonds”):

Mortgage-backed bonds were the most infamous ABS, but investment banks innovated far stranger types, including airplane-backed bonds, bonds backed by royalties owed to David Bowie and, in 2007, a $100 million bond backed by the inventory of Antwerp, Belgium-based diamond dealer Diarough.

Like many pre-crisis ABS, repayment of the diamond bonds was predicated on refinancing, and after the securitization market dried up, Diarough restructured the debt instead. The gem merchant cut the interest it paid bondholders and extended the due date of the bonds, according to a report by Moody’s Investors Service. By 2017, the esoteric ABS market was showing signs of life again, and Diarough returned with a $150 million deal in August. Bond funds, flush with cash from yield-hungry investors, flocked to the new bonds, warranting an increase to $155 million.”

“Predicated on refinancing” – you don’t say. Lather, rinse, repeat – evidently, it has taken precisely 10 years and several trillion dollars of freshly printed fiat money to induce total investor amnesia. The WSJ informs us in an aside that “Gert Ovart, a finance manager at Diarough, declined to comment”. It seems possible that this P.T. Barnum of Antwerp was a tad worried he might break into an uncontrollable laughing fit during the interview.

Most of the world’s rough diamonds are indeed sold at auctions in Antwerp. To the left are diamonds of different qualities from the Renard mine in Canada. The diamonds to the right are from South Africa, but we are not sure from which de Beers-controlled hole in the ground they emerged; we do know where they were 

last though, and it wasn’t kimberlite. South African police reportedly found them at the airport, inside a Lebanese smuggler. They thereupon proceeded to “mine” them with the aid of laxatives. Possession of uncut diamonds without a license can be punished with prison sentences of up to 10 years in South Africa. As penalties related to license-deficiencies go, this is probably a record.

Exquisite Lunacy

We want to leave you with an overview of both the credit exposure that has been amassed during the post-GFC echo bubble, as well as the sheer lunacy the central planners have managed to induce. One of the charts below shows that yields on Portuguese sovereign bonds have recently declined below those on US treasuries. Yes, this is crazy – but that was in late January. In late February, this remarkable event was topped by something that not too long ago seemed completely impossible: yields on Greek two-year notes fell below those on 2 year US treasury notes.

Clockwise from the top left corner: 1. assets in US bond mutual funds and ETFs (given that banks are no longer prop trading and acting as market makers for corporate bonds, this is a ticking time bomb); 2. Emerging market corporate bond issuance – last year issuance in the EM junk bond segment exploded to $115 billion – roughly similar to total EM corporate bond issuance in 2004; 3. Portuguese 10-year yields break below US treasury note yields; 4. CLO issuance volume goes bananas again in 2017, but remains slightly below the 2014 record high (the last year of “QE3”).

And no, we didn’t make up that story about Greece. At one point in 2011, two year notes of the Greek government traded at a yield-to-maturity of 300% (not a typo). As recently as two years ago, these notes still yielded a respectable 10%. Now the other extreme has been reached, which feels as though we have arrived at peak smoke-and-mirrors.

People are fearlessly piling into Greek government debt these days…

Lastly, here is a curious recent development that has caught our eye. Despite the seemingly intact euphoria in the riskiest corners of the credit markets, the charts of junk bond ETFs such as JNK and its close relative HYG look a bit iffy of late; they may well be in the process of rolling over into a downtrend. Note that this is the “price only” chart, not the total return chart that is sometimes used for these instruments.

HYG, daily: although junk bonds have outperformed treasuries rather noticeably, HYG had begun to diverge from the stock market last August.

When stocks sold off in early February, it went along for the ride. Note that HYG and JNK both also sold off sharply during the late 2014 to early 2016 troubles in the energy patch. Contrary to the wider junk bond universe, their prices never recovered to anywhere near the peak levels they inhabited prior to the upheaval in the highly indebted energy sector, but they did trend higher with the stock market from early 2016 until mid-2017 (in total return terms new highs were of course reached and the decline was mitigated). We are focusing on this specific time period since the major low made in early 2016. There were sharp corrections before, but in the most recent phase since the mid-2017 top, we see a series of lower highs and lower lows, which represents a change in character.

Conclusion

It is actually hard to fault investors for buying these bonds, or borrowers for exploiting the strong demand; after all, what is an institutional investor tasked with buying fixed-income securities supposed to do? Navigating these treacherous waters seems quite a challenge, and big risks lurk everywhere.

Moreover, financial repression type regulations have created a class of buyers for debt with negative yields to maturity as well. Note that negative yields have long ceased to be solely a secondary market phenomenon; nowadays even the ESM (European rescue mechanism/SPV) borrows at negative yields when issuing new debt with maturities of five years or less – buyers are locking in a certain loss if they hold such paper to maturity. And yet, demand remains brisk so far.

Obviously, the central planners are to blame for this situation. Whether they admit it or not, they have created a vicious cycle. It should be obvious that such extensive manipulation of interest rates and securities prices will have a profound effect on the quality of investment decisions, many of which are bound to make zero to very little sense.

While a market economy will always create wealth, incessant capital misallocation tends to adds up over time (it is no coincidence that real economic growth has slowed noticeably decade after decade in the post-WW2 era). Much of the economic activity that is once again greeted as proof of interventionist success is really little more than capital consumption in disguise – yet another giant Potemkin village has been erected.

Superficially, things still appear fine – as long as no recession is imminent and official readings of “inflation” remain tame, one would not expect confidence to be shaken. At the same time, the situation has begun to feel a lot more uneasy after the recent strong increase in sovereign bond yields, the rapid flattening of the yield curve and the sudden return of stock market volatility.

In our next post we will look at the migration of risk. A side effect of QE was that the proportion of covered money substitutes in the banking system has vastly increased. As a result, large banks don’t have to fear that they will be quickly derailed by electronic quasi-bank runs and evaporating interbank lending when push comes to shove a la 2008/2009 (i.e., when the “plonk” moment arrives). But systemic risk has not disappeared, it has merely changed hands. Stay tuned.

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