Bill Blain: "Why We Should Be Very Nervous About Corporate Bonds"

Blain's Morning Porridge, Submitted by Bill Blain of Mint Partners

Why we should be very nervous about corporate bonds

    “Before the fiddlers have fled, before they ask us to pay for the bill and while we still have the chance.…”

This might be week the proverbial chickens have more need than ever of somewhere to recover from the last 9 years of frothy market madness. Take a look at the signs and signals – the Nikkei taking a 1000 point spanking last week, the US stock market looking wobbly on the lack of any real prospect of tax reform (my stock chartists have picked though the graphs, and see sell signals everywhere), articles saying Europe is poised on the edge of an economic boom-time (which, by the laws of financial common sense means its about the tumble back into recession…)

And then there is the UK – where sterling is in flight on rumours of a no confidence motion in Theresa May.. FFS.. Does the fact a confidence vote might be on the cards actually mean there are still people who have any confidence in her? I though we all understood how this plays out? I though we all agreed she is absolutely the worst possible leader of the conservatives and worst ever choice for prime minster, with the notable exception of any other elected conservative MPs?

Very interesting research note from a US investment banks says there is a 40% likelihood of a Labour Corbyn government by 2022. The risks of an election are elevated by the party spilt/civil war on Brexit, but also on May fundamentally misreading the leftwards shift in UK electoral attitudes – the Tories need a socially liberal leader to win an election. (I’ve got the phone number of the other Milliband brother if they are interested.)

It’s increasingly looking likely, says the bank, May may have to agree an electoral pact with the SNP to stay in power, meaning a second Scottish independence referendum and soft Brexit adding even more uncertainty for Sterling. (I disagree, I think the SNP know they won’t win a referendum now, but will “bide” their time waiting for the opportune moment, and simply demand a state of the art hospital for every Scottish village, payout for university fees, and other sweeteners to keep the unelectable May in power.)

Back in the real world, I was looking at a very interesting graph over the weekend. On one axis is the remorseless rise of the US$ corporate bond market -outstanding volume has risen from $2.5 trillion in 2001 to $5.5 trillion today. Overlaid on top was the volume of corporate securities held by the investment banks/primary dealers to promote liquidity in the corporate bond market was shown. Since the Global Financial Crisis (GFC) inventory has absolutely crashed - the amount of dealer liquidity supporting the market has tumbled from about $300 bln in 2008 to less than $30 bln today. A 90% drop! Just as well markets have been so resolutely bullish!

Consider these points carefully.

Reflect particularly on how the last 9 years of the massively benign but utterly distorted bull corporate bond market has changed fixed income fundamentals and warped how business is transacted across the credit markets. It’s difficult to conclude anything but 10-years after the GFC, fixed income markets are less robust and more likely fracture under pressure.

Everyone is aware all markets have been distorted by QE. Central banks have blitzed some $15 trillion onto their balance sheets via monetary experimentation - draining liquidity while injecting cash thus causing spreads to tighten. Interest rates have reached record lows and stayed there extending the bull rally, while defaults have been rarities..

What is more insidious is the way markets have evolved during this false phase, and the unintended consequences of QE in changing the functioning of the bond markets.

Back when I was a fixed income banker, running DCM origination at the investment bank of a global behemoth, we won corporate bond mandates on a number of key factors: how well we understood the market, how tightly we would price (my deal winning song: “Libor plus 2, Libor plus 2, you know it’s for you!”), how well we could demonstrate demand and, critically, how well we support the issuer’s market reputation by providing secondary liquidity in the bonds.

While the old days were far from perfect, contrast them with today. There is almost zero support for any bond beyond the immediate primary market. If you need to sell any bond position, you are utterly reliant on your bankers acting as a broker - seeking a bid. Banks get away with it because ... that’s what they say the regulations say.

Today’s issuer is far less concerned with the picture a deal presents. They care about getting money at close to zero rates so they can use that cheap money to fund equity buybacks. It’s been a rare issuer that’s launched bonds to actually build new plant or spend on CapEx. Leverage has risen, but who cares when money is cheap... And if inflation kicks in, what do they care – it benefits borrowers!

The second aspect of looming bond market crisis is the changed relationship with the buy-side investors. In my day we had to compete to get into the top 5 for each and every client - knowing 80% of the clients business would be done with its top relationship bankers. Today, most clients will be lucky if there are even 3 banks calling them with ideas, views and news.. And the power in the relationship has swung - rather than salesmen courting investment managers for attention, young freshly minted bankers call up expecting polite investors to fawn upon them in order to receive favourable new issue allocations.

Most business still goes to the banks on the basis they’ve persuaded clients they “know the bond best” - although increasingly Brokers like ourselves here at MINT are changing the secondary flow patterns.

There has also been massive consolidation. JP Morgan (a superb institution) dominates Fixed Income. Effectively the fewer top names comprise an oligarchy. League tables hardly matter when there are realistically only a few names in the global frame. (When I started work in the mid-1980s there could be 100 banking names on a deal tombstone!) Most fixed income entrants of the last 10-years will have absolutely no idea what a tombstone was... or what a tumbling market feels like.

Yet the banks are increasingly profitable in the fixed income space. Corporate bond market making has collapsed for a number of reasons. The most obvious is regulation - the powers making sure banks can’t be overextended with risky inventory by piling up capital charges and reigning back “risk activities”.  That was great news for investment banks. By dropping market making, their daily VAR (Value at risk) has declined by around 90%. Nothing unusual about banks profiting from regulation at the expense of their customers.

So, what we have is more concentrated market, with diminished liquidity, limited expertise, and a disturbing non-alignment of interest between the buy and sell side. Does that bode well for long term stability?

Nope.

Comments

pods ninja247 Mon, 11/13/2017 - 12:50 Permalink

Sure they will. Government ones at least. Just as soon as they make you buy into them after your 401k becomes a 201k again.The groundwork has been layed already with MyRA.  Now we just have to wait till the system seizes up again and then people will be "protected" by putting all their eggs in the USA basket.I just can't hardly wait!pods

In reply to by ninja247

pods Mon, 11/13/2017 - 12:48 Permalink

I'm more worried about the whole damn ponzi going tits up.  Then have my kids look up at me and ask why I brought them up into this kind of world.Kinda fucking blows when you see things slowly going to shit, and know that that is the BEST possible outcome of all.pods

taketheredpill Mon, 11/13/2017 - 12:58 Permalink

Why when (if?) HY breaks it will be worse than 2008, when HY lost - 26% (and - 40% relative to Govies)     1)      Much less investor protection since 60% of debt issued is now “Cov-Lite.  In 2007 the previous peak was 25%.       2)      A lot of the borrowed funds have gone to Share buybacks rather than Capex.  Since there will be less hard assets left over when Bond holders end up owning the firm,  the recovery rates will fall.      3)      In 2008 you could look at previous 5 years of growth and assume the US economy will recover to a 4% GDP growth rate, and factor that into how much you’re willing to pay for the firm (based on asset value and expected profitability). Today, who is predicting growth to reach 4%?      4)      Regulatory changes design to make US banks safer have restricted how much corporate bond inventory they can hold on their books.  There is no more “buyer of last resort”.  With “stink bids” gone much higher risk of market going “no bid”.       5)      In 2007 High Yield Bond ETFs were created.  They currently hold many Billions because they are very liquid so you can always sell them in a hurry.  Unfortunately the underlying asset-class is very illiquid.  This disconnect has raised alarm bells at the Fed and Bank of England because of fears that “phantom liquidity” (liquidity that is there when you don’t need it and gone when you do) could increase volatility in a sector sell-off.On the other hand, why take a chance on losing your job. BTFD. 

Harry Lightning Mon, 11/13/2017 - 13:34 Permalink

The real question that needs to be answered before we can make any predictions about the fate of the corporate bond market in the Sttates is whether the US Fed ever will follow the lead of the ECB and start buying in corporate bonds during a crisis. If they do not, then spreads would widen if credit quality drops or rates start moving up across the spectrum. In 2008 the Fed bought in Mortgage Bonds, which made some sense so as to stop the bleeding in the passthrough market for the remaining quality paper. But they did not buy in junk. Credit spreads of all maturities went through the roof...recall how high the TED SPread rose to, it made me cringe that the CME had stopped trading a Treasury Bill Futures market to arb agaianst the Eurodollar futures. Will the Fed cave and buy corporates if the next crisis comes from credit quality implosion of corporates with large outstanding corporate bond issuance ? Until the Fed says otherwise, a good credit spread trade makes a lot of sense. Buy the single name credit default swaps against a log poition in US Treasuries and th cash register will start ringing soon. The strategy should work well against the most levered companies with the best chance to see credit quality sink. Companies that stand to see revenues contract if the economy faulters, contract to the point that their converage ratio will force a default. Ordinarily credit spreads widen in a recession, this time they will really widen since the corporate yoelds went to such ridiculously low levels with all the QE around the world. How much does Amazon's inventory financing affect company profits if short term interest rates are another 150 basis points higher ? Where would the money come from to pay interest on outstanding debt if they already are getting squeezed on interest payments on borrowed money ? Maybe Amazon would not be affected for they might not have any outstanding debt. But I think JC Penney probably has a lot of outstanding debt, along with car companies and all the other companies that have been around for a while and have big inventory to finance and have difficulty selling their products when the economyh slows. Those are the perfect candidates for a credit widening trade

Atomizer Mon, 11/13/2017 - 13:49 Permalink

Why you should be concerned, a dyke on CNBC said it best. This bitch is tied up with municipal bonds. 

Financial guru Suze Orman says to say no to bondfunds and yes to individual bonds. ... The impact may be felt more keenly by holders of bond mutual funds and exchange-traded funds than by investors who have bought individual bonds. Owners of individual bonds can wait and collect their full principal upon maturity.