A Vast Pool of Greater Fools
One of the undeclared (or only occasionally admitted) goals of the enormous monetary pumping by central banks in recent years was to drive investors toward buying riskier assets. After all, if one gets virtually no interest on savings deposits and so-called “high quality debt” – which these days comprises mainly the debt of de facto bankrupt governments – is trading at yields to maturity somewhere between absurdly low and negative, what is one going to do with the flood of money pouring forth from the central planners?
A picture from the future: Risk is rediscovered at the worst possible moment.
Photo via instagram, author unknown
Junk bonds have benefited enormously from this backdrop. As is always the case at the height of a bubble, they look extremely “safe” based on the default assumptions published by the credit rating agencies. The main reason for this appearance of safety is the fact that demand is so strong that even the silliest stuff has no trouble finding a fresh batch of greater fools willing to throw money at it. In other words, it is very easy to refinance maturing debt. In this respect, junk bonds are an excellent mirror of bubble conditions: Just as most of the profits reported by companies during a credit-driven bubble are really capital consumption in disguise, the assumed safety of junk debt masks growing underlying risks. A small preview of what happens when these risks materialize is currently enjoyed by investors in energy-related junk debt – incidentally one of the sectors with the greatest amount of debt issuance in recent years. This has affected the overall performance of junk bonds rather noticeably:
The unadjusted price of junk bond ETF JNK (the adjusted version adds interest payments to the price performance chart. The adjusted version mirrors the ETF’s total return and looks a lot better of course, but the chart is also not as informative) – click to enlarge.
Creditor Protections Disappear Into Bubble Black Hole
However, the misadventures of the energy sector have apparently failed to thin the pool of greater fools out. Anything still seems possible, no risk is deemed too large. Thus Bloomberg reports that creditor protections have just hit the “lowest quality on record”. Has anyone noticed how common terms and phrases like “record”, “unprecedented”, “highest/largest in history”, etc. have become in connection with financial markets? These are linguistic bubble markers; even if one were completely unaware of the backdrop, the prevalence of such terminology would have to be seen as a sign that something rather momentous is underway. Bloomberg writes:
“Investor protections in new U.S. junk bonds fell to the weakest level in at least four years as risky borrowers are able to dictate terms to yield-starved investors, according to Moody’s Investors Service.
The rating company’s gauge of the strength of investor safeguards registered its worst reading in February for newly issued speculative-grade bonds in data going back to January 2011, analysts Alexander Dill and Evan Friedman wrote in a report today. Moody’s covenant-quality gauge, in which 5 indicates the weakest protections and 1 the strongest, measured 4.51 for bonds issued in February, up from 4.41 in January and surpassing the previous record of 4.43 in September 2014. Covenants are protections written into bond documents that can restrict an issuer’s ability to borrow more.
The weakening protections come as easy monetary policies by global central banks have driven borrowing costs to all-time lows. Companies with speculative-grade ratings have sold $60.8 billion of dollar-denominated bonds this year, up 18 percent from this time last year. Investors are drawn to the higher yields offered by junk-rated bonds while companies are eager to sell new debt amid expectations that the Federal Reserve may raise interest rates this year for the first time since 2006.
“Investors are freely and liberally trading a lot of covenant protection for the opportunity to be in the high-yield space,” Friedman said in a telephone interview. “Investors are not getting enough covenant protection in their documents to provide meaningful protection if there is a downturn.”
Of the 26 high-yield issues in February, 46.2 percent are so-called covenant-lite bonds that receive the weakest possible quality score, according to Moody’s. That’s significantly higher than the 27 percent reading in January and the historical average of 21 percent, Moody’s said.
Companies in the oil and gas sector sold just 12 percent of junk-rated bonds issued in February, below the 21-percent long-term average, Moody’s said. Issuance by energy companies has slowed as investors demand higher yields and stronger protections to own these bonds after the price of oil fell by more than half from its peak 2014 price in July. The average covenant quality score for the three bonds issued in the sector in February was 4.04, “significantly stronger” than the broader market’s average, according to the Moody’s report.
In other words, the bubble in dodgy corporate debt still shows no sign of letting up. We have discussed the dangers of this development in some detail previously (See: “A Dangerous Boom in Unsound Corporate Debt” and “Comfortable Myths About High Yield Debt”). Although these missives were written last year, they still provide a fairly useful summary of the situation. The only thing that is different between then and now is that a portion of the debt bubble has in the meantime blown up, while bubble conditions overall have become even more extreme.
As can be seen above, not only are creditor protections on the endangered species list, but issuance volume continues to soar into the blue yonder. We find it absolutely stunning that energy-related junk bonds covenants are still above 4 on the 5-point scale (with “5” designating the worst possible protections) and that this score is actually “significantly stronger than the market average”.
A quick glance at the chart of crude oil suggests that the carnage in energy-related junk bonds is probably not over just yet. And yet, newly issued bonds in the sector are still getting away with a covenant score above 4 – click to enlarge.
Credit, as the saying goes, is “suspicion asleep”. We would amend that slightly so as to better describe the current situation. At the moment suspicion is either in a coma or it is dead. At any rate, we can no longer detect a heartbeat or a breath. We have little doubt though that the day of resurrection will come, a miracle that will undoubtedly catch many speculators with their pants way down.
Charts by: StockCharts.com