This Time It's Different!

That is what the world's yield chasers must be thinking – egged on by quantitative easing programs enacted by the Federal Reserve and the BoJ, and the lowest administered interest rates the world has ever seen, the hunt for yield has become downright bizarre.

In action that surely leaves all old market hands slack-jawed, the Barclay's US High Yield index yesterday fell below 5% for the first time ever. BAML's High Yield Master Index II meanwhile remains only a smidgen above 5%. There was a time when a 10 year US treasury note yield at 5% was considered low. The action in junk bonds tells us that according to the collective wisdom of market participants, nothing can possibly go wrong (and we thought that was what they had already concluded in 2006/7).



Hi Yield Master Index II

The BofA Merrill Lynch High Yield Master Index II yield – just a smidgen above 5%. We have arrived in financial Nirvana.



The FT's Alphablog says it doesn't want to question the markets, but with an added 'WTH?'.


“Suggested names so far for these newly rehabilitated instruments include ex-junk, recycled and … errr… bonds.

We’d also note that, over in the equity market, never-sell-Shell is yielding 5 per cent, Vodafone 5.05 per cent, and Glaxo 4.6 per cent. Now we don’t want to question the market, but: what the hell?”


Indeed, it seems actually a very good time to 'question the markets'. After all, what has made these extraordinarily low junk bond yields possible is a distortion of market prices via central bank policy. Indeed, this is the goal of the policy. Most economists blithely accept this price fixing operation of the cost of money by central economic planning agencies as 'normal', but it is no more desirable or normal than if a committee were setting any other prices in the economy. In fact, it is far more harmful.

Meanwhile, Fitch recently noted that although high yield default rates remain historically very low, they have begun to tick up in April. From Fitch's “High Yield Default Insight” report dated March 2013:


“March Lull: The U.S. high yield par default rate remains below average and is expected to stay low, barring a shock to modest economic growth this year. The rate slipped to 1.6% in March, down from 1.9% at the end of 2012. However, activity has been brisk in April, and Fitch projects that the rate will move back up to 2.0% in the second quarter. Default patterns tend to be choppy in a benign rate environment. Eight issuers defaulted on $3.4 billion in bonds in the first three months of this year compared with 12 issuers and $5.2 billion in first-quarter 2012.

April Bounce: April has thus far added seven issuers and $2.8 billion to the year’s tally (versus two and $0.5 billion last year). April defaults are noted at the bottom of page 5. The defaults all involve ‘CCC’ or lower rated issuers.

EFH Filing: Public sources state that Energy Future Holdings (EFH) is considering a prepackaged bankruptcy. Such an event would propel the default rate to an estimated 3.5%. While EFH’s troubles are well documented, the rate would nonetheless hit a three year high. Shifting perceptions around default conditions could affect risk receptivity in an otherwise booming high yield market.”


(emphasis added)

Naturally, at the height of a boom – even if it is only an echo boom – default rates tend to be very low. This is not necessarily a sign of a healthy market. Rather, it is a sign that credit is freely available to all comers, who therefore have little problem to continually refinance their debts, even if their fundamental strength seems dubious. The 'wise men' in the investment committees of pension funds and various other institutional investment organizations just buy once they have identified an asset class that seems to offer a sliver of additional return.

This is also why CDOs and other structured products boomed during the housing bubble: the class of so-called 'professional' investors didn't care about the fundamental distortions of the marketplace; a little bit more yield was all they cared about. They were picking up pebbles in front of a bulldozer. But surely, this time the outcome will be different!


The Hunt For Yield – A Side Effect of the 'Bubble in Safety'

We previously wrote about the perceived 'bubble in safety', noting that the assets listed in the critical assessment published by Seth Masters could not simply be lumped together, as they are both logically and historically distinct. Their recent correlation (such as the correlation between gold and treasury bonds over recent years) may well have been driven in part by similar motives, but these are assets that can be completely inversely correlated under different historical and fundamental circumstances.

However, there is undoubtedly a connection between the 'safety bubble' (which does express itself both in bond and stock markets) and the 'hunt for yield'. As we pointed out, this is inter alia evidenced by bond funds beginning to stray into investment in equities. It is clear what these funds are buying in the equities universe: allegedly 'recession-proof', high dividend yield stocks. In the process, they have made rather low yields out of what used to be fairly high yields (in housing vernacular one would say 'the cap rate isn't justifying the investment anymore'):




The normally staid utilities ETF XLU has gone 'parabolic' in typical bubble-fashion. In the process, its once upon a time high yield has become a so-so yield.



Below is a chart of the dividend yield of Duke Energy over a number of years (h/t, Sovereign Investor), which shows that it is now at a level where trouble usually soon erupts:



duke energy dividend yield

Duke Energy's share price and dividend yield, via 'Sovereign Investor'. Back at a level where trouble is usually not too far away anymore.



Conclusion: An Even Bigger Crisis Than 2008 May Lie Ahead

The 'hunt for yield' has become almost pathological. Investors treat 'junk' bonds (the name is not a coincidence) as though they deserved almost no risk premium anymore. It is amazing to see how little memory investors apparently possess, or how eager they are to simply ignore experience, even recent experience, in favor of placing bets that are ultimately almost certain to once again produce staggering losses (although not necessarily in the near to medium term).

The contrarian conclusion from this ties in with something we have mentioned several times already. One only needs to consider what the underlying main thesis of these investment processes is. It consists of unbounded faith that central banks will protect these speculations forever and ever.

In fact, it can be reduced further, to simply representing 'unconditional faith in central banks'. Therefore the proper contrarian conclusion must be that the next crisis will entail a crumbling of this faith. We can infer from this that the next financial crisis will be of an even greater amplitude than the last one in 2008. The reason is that in 2008, as well as in the two major iterations of the euro area debt crisis, central banks proved to be the last bastion able to restore the severely damaged confidence of investors. If this bulwark of investor faith crumbles to dust, there will be no stopping the next panic until prices have reached their natural clearing levels. In view of the fact that the biggest credit bubble in all of history has been created over the past four decades, this should be a truly cathartic event.



Charts by: StockCharts, Sovereign Investor, St. Louis Fed




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One Response to “Yield Chasers United Sets New Records As Well”

  • SavvyGuy:

    Like a watched pot that never boils, 30-yr Treasury bond yields quietly matched their 2008 lows last summer and are now carving out a yield-bullish (price-bearish) inverse head-and-shoulders bottom in yields.

    Another bubble that nobody talks about is the short average weighted maturity of all Treasury debt…a little more than 5 years. This looks good because it keeps interest payments low, but necessitates large roll-overs quite often, exposing it to future interest rate risk. My point here is that once long T-bond yields start to rise, the Treasury may want to lock in long yields before they rise further, and issuing more long bonds is the only way to extend the average weighted maturity of all Treasury debt.

    So it seems all the players are leaning towards one side of the bond market boat, and it promises to be quite a spectacle when it flips!

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