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At least in the US, a series of attention-getting stories, Sandy, then the elections, then the immediate roll right into fiscal cliff gamesmanship, followed by the Patreaus/Allen scandal, have made finance news seem comparatively dull, even though the stock market is in a swoon thanks to the engineered fiscal cliff nailbiter And Europe keeps looking more and more jaundiced by the day.
The Economist has taken note of the fact that the normally staid corporate bond market is looking a bit frothy (hat tip Richard Smith):
By the end of October global corporate-bond issuance for the year stood at $3.3 trillion, close to the record set in 2009. The pace has not slackened: Abbott Laboratories this week raised $14.7 billion, the biggest deal of the year, at maturities ranging from three to 30 years and with yields as low as 1.2%. The ease with which large companies can raise money is in sharp contrast to the plight of smaller businesses, which are still finding it hard to get finance from the banks….
According to EPFR Global, a data provider, bond funds have attracted a cumulative $395 billion since the start of this year, and almost $1.1 trillion since the beginning of 2008. In contrast, equity funds and money-market funds have seen net redemptions of $467 billion and $793 billion respectively since the start of 2008.
The culprit is the notorious search for yield. Investors are holding their noses and taking risks they might ordinarily shun, since sitting in cash is too frustrating. And so far, the pile into corporate bonds has looked like a winning game: the article reports that returns for US corporate investment grade bonds have been a juicy 9.4% so far this year.
The problem with bonds is that despite the nice pop this year, risks are generally biased towards the downside in the form of credit risk and interest rate risk. While risk spreads are lower than they’ve been over the last five years, they are still better than in 2005 and 2006 (not that that is necessarily a great endorsement). Interest rate risk would seem to be the much greater hazard, but investors are confident that the powers that be will sit pat on rates till 2015, and will signal well in advance any intention of tightening. The reason for that practice was when Greenspan created a crash that produced more losses that 1987’s Black Monday, when he increased the Fed funds rate by 25 basis points in 1994 without any warning. Investors were so certain that yields were going to instead stay flat or fall that the rate increase triggered all sorts of derivatives losses, even among savvy players. That led to lots of headlines and hearings, but in the end, the industry beat back reform proposals.
Everyone seems so confident that any risks here can be foreseen and managed that it seems almost certain that too many investors will take the plunge and too many will get out too late. And the implicit bet is that ex some fiscal cliff perturbations, we’ll have clear, if slow, economic sailing through at least 2015. We’ll see how this comparatively cheery bet works out.
Update: Walter Kurtz points out that corporate bond spreads have widened a bit in the last month, but he calls this taking some chips off the table in light of the fiscal cliff negotiations. This does not seem to be a rethinking of the fundamentals as much as professional fund managers avoiding reporting undue volatility, something pension fund consultants dislike.
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Once again we see that the only parties benefiting from the Fed’s zirp/q.e. policy are primary users of money which includes banks and corporations(but not most individuals). And in the case of corporations by and large the largest reason for the borrowin is to reduce interest expense, engage in financial engineering or purchase other companies. In the case of companies, nothing terrribly wrong here, but not things that create jobs and not a net positive when one considers the lost interest income by the lenders which include pensions, individuals and such. Of course the big concern is that when rates are zero are uses of this borrowed money good ones or is capital being mis-allocated?
If you look at the CCC-rated total returns (High-Yield are generally B’s) the difference is even more dramatic.
http://research.stlouisfed.org/fred2/graph/?id=BAMLHYH0A3CMTRIV,
For any individual investors buying a high-yield debt, just know what you’re buying and why….and know that bear markets in high-yield debt can last even longer than bear markets in ordinary stocks. (doubt a lot of people remember the 80’s high-yield bubble bursting).
If you don’t know what rating, duration are…..teach yourself those concepts or find someone who knows.
Tell that advice to all the pension fund managers that get sold return over risk management.
The system is not broke, its fixed.
Pension managers don’t have a choice.
Let’s say you’re managing a public employee pension, with a target return of 8%. Do you reach for yield via (i) junk bonds, (ii) real estate and (iii) private equity (not VC, but LBO).
Or do you go to your mayor/governor and tell them that they must prepare current public employees for a significantly smaller retirement package.
Wouldn’t it be better for pension funds to be allowed to write student loans and mortgages guaranteed by the government? That sounds like a much more virtuous circle, no?
Oh Susan, how will the cartel maintain its monopoly on credit creation if we start letting the plebes in?
Why help out public sector employees (which today inordinately benefit from defined benefit plans with high return targets) with the federal government guarantee?
If you want the federal government to assist public pensions funds, let’s have the federal government provide significantly enhanced (at least 35% higher) social security benefits for private-sector employees.