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(Un)Comfortable Myths About High Yield Debt

Tyler Durden's picture




 

Submitted by Pater Tenebrarum of Acting-Man blog,

Update on Global High Yield Debt Issuance Volumes

Here is a small addendum to our recent articles on the corporate debt bubble (“A Dangerous Boom in Unsound Corporate Debt”) and the associated derivatives-berg, which is intended to hedge both the credit and interest rate risk this credit boom has given rise to (“A Perilous Derivatives-Berg”).

We recently combed through John Hussman's weekly commentaries, one of which contained an up-to-date chart of global high yield debt issuance per quarter from Q1 2006 to Q2 2014. Both global issuance volume and the number of deals are depicted on the chart. As you can see, we have long left all previous records in the dust.

 

hi-yield

Global high yield debt issuance in USD billion per quarter, plus the number of offerings, via John Hussman.

 

 

How Compressed Risk Premiums Unwind

This low-grade debt bubble is undoubtedly going to prove to be the Achilles heel of the current inflationary boom period – even though many market participants strenuously deny it by relying on the 12 month default forecasts published by rating agencies (which show not even the smallest cloud on the horizon – in other words, it's all good). As the next chart shows, risk premiums have become extremely compressed. Mr. Hussman had something very interesting to say on that particular topic, namely:

“As we saw in multiple early selloffs and recoveries near the 2007, 2000, and 1929 bull market peaks (the only peaks that rival the present one), the “buy the dip” mentality can introduce periodic recovery attempts even in markets that are quite precarious from a full cycle perspective. Still, it's helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.

 

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss.

 

Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all.

 

Remember this because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.”

(emphasis added)

This is an important observations regarding the connection between news releases and financial markets. The news are actually rarely the cause of market movements (which more often than not makes the attempts in the financial press to “explain” day-to-day market movements incredibly comical).

Market participants only use news as triggers when it suits them, in other words, when they seem to confirm what they were going to do anyway. The important point is not whether news emerge that are seemingly associated with market moves; the important point is the degree of overvaluation and leverage.

 

Hi Yield, effective

Effective yield of the Merrill US high yield master II index – currently at 5.5%. Similar levels of return-free risk were on offer in 2005-2007 – click to enlarge.

 

 

Comforting Myths

Hence there rarely seems to be a “reason” for why market crashes happen. Market observers are e.g. debating to this day what actually “caused” the crash of 1987. It is in the nature of the beast that once liquidity evaporates sufficiently that not all bubble activities can be sustained at once any longer, bids begin to become scarce in one market segment after another. Eventually, they can disappear altogether – and sellers suddenly find they are selling into a vacuum.

Once this happens, the usual sequence of margin calls and forced selling does the rest. Risk premiums normalize abruptly, and there doesn't need to be an obvious reason for this to happen. Mr. Hussmann inter alia cites Kenneth Galbraith's description of the crash of 1929 in this context. Galbraith correctly remarked that when the crash occurred, no-one knew that a depression was lying dead ahead. The crash itself would have been in the cards regardless of what happened later. Anything could have broken the bubble, as Galbraith put it. The crash merely adjusted a situation that had become unsustainable.

After an extended credit boom, leverage can be assumed to have seeped into every nook and cranny of the markets.  In the stock market, we see it in record high margin debt and the tiny cash reserves held by mutual funds and other investors. In fixed interest rate securities, investors are encouraged by low volatility and the seeming absence of risk to lever up, as their returns on newly issued debt begin to shrink along with falling interest rates. In so doing, the risks are usually judged by looking at market history. In every bubble, a new myth emerges that seemingly justifies such investment decisions.

In the housing bubble, the myth of choice was that house prices could never fall on a nationwide basis. After all, history showed it had never happened before. It was held that eventually, problems may emerge in some regions or some sub-sectors of the credit markets, but they would remain localized and “well contained” (the favorite phrase employed by assorted officials when the bubble began to fray at the edges). In the current bubble the myth of choice is that “past crises have shown that defaults on high yield corporate debt never exceed certain manageable levels”.

Why is this a myth? After all, it is a historically correct view. It is a myth for one reason only: in all of history, there has never been a bigger bubble in junk debt than now (just as the real estate and mortgage credit bubble were unique in their extent). Therefore, economic history actually has little to say about the current situation, except for the general statement that compressed risk premiums have a tendency to one day readjust out of the blue and quite abruptly. Economic history can definitely not be used to assert that the risks are small. They are in fact huge and continue to grow.

 

Conclusion

Compressed risk premiums can never be sustained “forever”. They are so to speak sowing the seeds of their own demise. Most market participants believe they will be able to get out in time, but that is never the case – in fact, it is literally impossible for the majority to do so, because someone must buy what others sell (by definition, this means someone will be caught holding the bag when the tide goes out). In reality, it is ever only a tiny minority that manages to sell near the market peak, not least because investors have assimilated the lesson that “every dip is a buying opportunity”. This will be true until it one day isn't anymore (the search for reasons will then predictably yield the well-known phrase “no-one could have seen it coming”).

 

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Tue, 08/26/2014 - 10:53 | 5144835 Vampyroteuthis ...
Vampyroteuthis infernalis's picture

Those spikes look like icebergs the USS Fed is going to slam into.

Tue, 08/26/2014 - 11:07 | 5144890 Headbanger
Headbanger's picture

Keep an eye on the USD Index (DXY) for it breaking below the support trend line starting  six trading days ago:

http://www.marketwatch.com/investing/index/DXY/charts?symb=DXY&countryco...

 

Tue, 08/26/2014 - 10:56 | 5144861 Dr. Engali
Dr. Engali's picture

Let's revisit this article when the ten year is at 1%. 

Tue, 08/26/2014 - 11:01 | 5144873 The Merovingian
The Merovingian's picture

Why stop at 1%?  With the 2yr German Bund going negative ... UST yields have a lot of room to drop from where I'm sitting.

Tue, 08/26/2014 - 10:59 | 5144869 The Merovingian
The Merovingian's picture

But the TeeVee talking heads said the trend is my friend ...

  /sarc

Tue, 08/26/2014 - 16:01 | 5146325 JRobby
JRobby's picture

Firehose the TeeVee heads live on Friday at 10 AM.

Kick off the HOLIDAY right

Tue, 08/26/2014 - 11:08 | 5144886 Quinvarius
Quinvarius's picture

If the Fed was smart, they would stop pumping these bubbles up and start managing the decline.  Someday they will be forced out of the markets and they need the markets to be in a self sustaining place when that happens. 

Tue, 08/26/2014 - 11:16 | 5144923 Mrmojorisin515
Mrmojorisin515's picture

self sustaining?  Like the SP500 at 666? Or the dow at 6,000 -7,000?  Those were self sustaining number, maybe should have been even lower.  They use the markets to contain the inflation they create with the money printing.  Really a market should only drift sideways, with companies paying dividends on profits.  Look at the history of the market before the money printing took hold, you'll only see one other time when it rocketed upwards.

Tue, 08/26/2014 - 11:20 | 5144934 Mrmojorisin515
Mrmojorisin515's picture

which still misses the point.  Money is only a derivative of energy, peak conventional oil was reached around 2005.  Shale oil and gas has kept the country on life support.  When that bubble bursts, look out below  

Tue, 08/26/2014 - 11:07 | 5144893 clade7
clade7's picture

I'm sure my bank classifies me as "High yield debt" since I pay on time....if my wife dies before me though, then all bets are off...some poor investor will loose his ass if he's counting on 'Ol Clade to give a high yeild return..looks good on paper probably...

Tue, 08/26/2014 - 11:45 | 5145048 Grinder74
Grinder74's picture

loose =/= lose.  Although if you're teh ghey, then your ass is definitely loose.

Tue, 08/26/2014 - 11:20 | 5144936 Yancey Ward
Yancey Ward's picture

The Fed will simply buy corporate debt with QE Whatever.

Tue, 08/26/2014 - 11:27 | 5144958 Robert_manboobs...
Robert_manboobs_ Paulsen's picture

Market Risk Premium = RM-rf

We are really not that far out of bounds given the lowness of the "risk free" government bond.  For the last decade and a half high yields have typically yielded between 8-9%.  Most high yields are 5-7 year terms. Historically government bonds have paid around 3-4 % for that time frame in recent years.

Meaning your coupon was between 5-6% Risk, and 3-4% risk free.

It is more compressed today than normal, at a 1.6% risk free and a 4-6% average risk premium.  the compression is at most 100 basis points, and given the markets hunger for any kind of payment, this will continue as long as the risk free rate remains so close to zero.  The chart above does point out the danger in new issues of these bonds, as not having to pay for the risk free portion of the debt may encourage more bad actors to enter the field.  but that just means due diligence is more important than ever on individual issues.

Of course if you permabears/gold bugs/bitcoiniacs  are right and the US loses world reserve currency status, you could easily lose 100% of your investment in this space, but thats true of almost every space.

Tue, 08/26/2014 - 11:42 | 5145027 free_lunch
free_lunch's picture

One can do a million calculations with a million checks on the result.

Then one can store the result in a database on a server, then an 8 year old with access to the server can replace the value in this database field by selecting the field and type in any desired value..

That's the weak spot of anything based on software, in the end the results are stored in a database, bank-accounts, stock-value, on-line poker, voting results..

So how safe is all this data really?

Tue, 08/26/2014 - 16:03 | 5146333 JRobby
JRobby's picture

Erase all of it

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