Corporate bonds are the financial IEDs (improvised explosive devices) of monetary central planning. The Fed’s sustained, heavy-handed financial repression has generated the greatest ever scramble for yield, and it is now entering its seventh year. Consequently, speculators and bond fund managers are all in the same side of the boat. And all but the most intrepid traders are scared to death to short the Fed, fearing that any day it might uncork yet another round of bond market repression.
So we have basically a highly artificial one-way market in corporate bonds—both investment grade and high yield. Very recently yields in the latter touched an all-time low of 4.87%, meaning that after inflation and taxes there is virtually no room for losses on securities that are called “junk bonds” for a reason. Likewise, the investment grade index yield is down to 2.97%, leaving almost no margin for risk relative to the allegedly risk free rate on treasuries.
What this means is that the $5 trillion corporate bond market is badly mispriced. Yet history proves time and again that sub-economic yields do not stay that way indefinitely. Eventually the normalize—either because the Fed finally cools down it printing presses or owing to an unexpected shock, such as a surge of inflation, that triggers a sell-off.
But the Fed has now taken financial repression to such an extreme that it has caused the corporate bond market to triple in size, even as Dodd-Frank has resulted in a considerable shrinkage of dealer inventories and market liquidity. Accordingly, the exits will be jammed like never before when the corporate bond self-off inexorably arrives. The speed and violence of the impending re-pricing is only hinted at by the thundering collapse of securitized mortgages that occurred in the fall of 2008.
That article below from Reuters captures bond market fragility lurking just below the surface. The smart money is already beginning to front-run the coming conflagration based on the self-evident reality that the stampede into bonds has resulted in a vast compression of spreads and drastic over-valuation of corporate debt securities on an absolute basis. Accordingly, selling pressures, which are now “contained”, will eventually intensify massively and rapidly.
Then the financial IEDs will explode. Then the bubble blind Fed will be caught flat-footed one more time. The fact is, its modus operandi is guaranteed to create financial deformations and bubbles, yet its doctrine either denies their existence or asserts an inability to prevent them. In either case, there is a mult-trillion bond market meltdown waiting to happen. The guessing game among the more astute players in the casino is only about when to more aggressively slip out of harms way.
Some of the biggest global investors have started to pull back from riskier fixed-income assets even as the Federal Reserve keeps on a green light for risk.
Loomis Sayles, GAM, and Standish are among those who say U.S. investment grade and high yield corporate bond prices have gone too far, making returns less compelling. They’re aiming to get ahead of a market reversal that could be unpleasant once the Fed starts raising interest rates, probably next year.
“Valuations are getting stretched,” said Jack Flaherty, investment manager at GAM, part of GAM Holding AG, a publicly-listed Swiss company with more than $120 billion in assets. “You’d rather be early in getting out because when it does turn, it could be more violent than expected.”
Bonds had a solid start to 2014, with the Barclays U.S. Aggregate Index returning about 3.8 percent for the first six months of the year. Interest from overseas investors and pensions has kept flows into fixed income funds strong.
GAM has pared its U.S. high-yield bond holdings, and plans to cut back more over the next few months. It’s re-allocated to emerging market local debt and convertible bonds—debt that can be converted into shares of stock.
Flaherty is concerned that after the Fed raises rates, liquidity could be a big problem because of Wall Street brokerages’ reduced presence in the corporate bond market.
In the past, big banks could be counted on to make it easier to buy and sell bonds because of their sizable inventory. But new rules have made it more costly to hold such assets.
The premium investors demand to hold U.S. high yield debt was about 353 basis points as of Monday, according to Bank of America-Merrill Lynch data. That premium is much lower than the fair value estimate of 551 basis points put out by Marty Fridson, one of Wall Street’s high yield experts who’s now chief investment officer at Lehmann, Livian, Fridson Advisors in New York.
The spread between U.S. investment grade and U.S. Treasurys was 109 basis points.
“The longer the Fed goes on, the more disruptive it would feel like when it ends,” said David Horsfall, co-deputy chief investment officer at Standish Mellon Asset Management in Boston. The firm oversees $160 billion in fixed-income assets.
“When the Fed raises rates on the short end, that would almost always cause a disruption. It has to, because rates have been so low.”
Horsfall said the firm’s U.S. investment grade holdings at one point were as much as 60 percent of its portfolio, and now has been reduced to 5 to 6 percent. For U.S. high-yield bonds, Standish held as much as 40 percent, but has cut that to 8 to 10 percent.
Standish has instead re-allocated to New Zealand and Australian bonds, as well as U.S. Treasury Inflation-Protected Securities (TIPS), which rally if inflation rises.
Prudential Fixed Income, with about $418 billion of assets under management, has also reduced its risk the past month, said Gregory Peters, managing director and senior investment officer. The firm has sold high-yield bonds that have fundamentals they’re not comfortable with, he said.
“You want to be more careful from a credit perspective,” said Peters. “The market is not going to reward bad credit stories this late in the cycle.”
Prominent investor Dan Fuss said his $24.4 billion Loomis Sayles Bond Fund is sitting on more than 25 percent of short-term U.S. and short-term Canadian government debt, cash and cash equivalents, its highest level ever, because he sees scant opportunities in the bond market.
Fuss, vice chairman and portfolio manager at Loomis Sayles, which oversaw $210 billion as of March 31, said the Loomis Sayles Bond Fund has been moving into these areas since early 2013 as bonds have become increasingly pricey.
Robust bond inflows
U.S. corporate bond inflows have been strong, boosted by the prospect of higher yields than U.S. Treasurys without the risk of equities.
So far in 2014, U.S. high-yield funds have seen a net inflow of $7.1 billion, Lipper data show, reversing outflows of $5 billion in 2013. For U.S. investment grade, inflows were $43.7 billion this year, compared with $33.8 billion a year ago.
With volatility low, a selloff seems unlikely now, said Lehmann’s Fridson. “The Fed will not raise interest rates until 2015. So until then, investors don’t have to worry about it.”
Some money managers have argued that despite the decline in spreads, there is room for further contraction. Mary Kane, portfolio manager and a partner at GW&K in Boston, believes there is a further 100-point narrowing in U.S. high-yield and 50-point contraction in U.S. investment grade.
“It’s a game of relativity. In a world of zero percent, 5 percent yield (on junk bonds) is pretty good,” said Kane, whose firm has about $20 billion in assets under supervision.
Decent returns are still possible in the corporate bond space, said GAM’s Flaherty. “And when that’s over, people say they can get out in time. But can they really get out when everybody is at the door?”