October 13, 2016
October 13, 2016
“Only when the tide goes out do you discover who’s been swimming naked.”
In the face of unusually low rates of inflation and economic growth, central banks across the developed world have lowered interest rates to percentages near or below zero and purchased trillions of dollars of financial assets to motivate risk-taking, stimulate economic activity, and create jobs. Their actions have had the intended effects of elevating the price of all financial assets – e.g. stocks, bonds, and real estate – while lowering the cost to borrow money. In layman’s terms, people are wealthier and money is cheap. Central bankers hope the combination will compel more risk taking and less saving.
Central banks are now the 800 pound gorillas in markets for investment grade bonds, or so-called “safe assets.” Most of the trillions of newly minted dollars, euros, and yen have been used to acquire U.S. Treasuries, sovereign debt in the Eurozone, and Japanese Government Bonds (JGBs), respectively – essentially sucking up a substantial portion of those bond markets. This has driven interest rates across the universe of bonds lower, left investors yearning for anything with yield, and sent some investors flocking to more exotic areas of the ever-expanding market for bond securities.
One such area is high-yield debt (in investment lingo, “junk bonds”). Instead of loaning money to the U.S. government or large, profitable companies such as Apple or Walt Disney for a low single-digit rate of interest, an investor can lend to companies that are small, highly leveraged, or struggling financially and earn a mid-to -high single-digit interest rate, depending on the issuer and terms of the loan. For example, Sprint, which hasn’t turned a profit since 2006, is one of the largest issuers of junk bonds. Sprint’s bonds that mature in 2025 currently offer a yield of 8.5%.
A disturbing development in the junk bond market over the recent past has been a tendency for companies to issue bonds with very limited protections to bond investors. These so-called “covenant-lite” bonds have watered-down financial covenants, which are promises from the borrowing company to adhere to certain financial measurements. In a typical loan arrangement, the bondholder can demand their money back if certain financial covenants are breached; so in the absence of such protections, a bondholder is far more exposed to losses, most likely when the next recession hits and the tide recedes.
Other, newer markets for bonds include contingent convertible bonds (CoCos) and structured notes. CoCos are issued by banks and offer higher yields than typical bank debt. However, if the issuing bank runs into serious financial trouble, investors in the bank’s CoCos will be forced to absorb some of the bank’s losses. Structured notes, also commonly issued by banks, offer attractive yields that are paid so long as certain conditions are met such as stock indices remaining above certain levels.
In functioning capital markets, risk and return are inextricably connected. There’s no free lunch. The higher yield on higher risk bond alternatives is great until it isn’t. For thoughtfully balanced investors, the Achilles heel of junk bonds, CoCos, structured notes, and other exotic loan arrangements is that they tend to behave much like stocks, especially when markets are under stress and stocks are falling. In 2008, the Barclays U.S. High Yield Loan index fell ~29% and the Barclays U.S. Corporate High Yield index fell ~26%. By comparison, the Barclays Capital Aggregate Bond Index (“Barcap”), an index of high quality bonds, was up over 5% that year. In short, high risk bonds performed poorly when investors needed them the most.
The positive correlation between high-risk bonds and stocks works just fine for investors in good times. The fatal flaw with this approach, of course, is that skies aren’t always blue and the stock market doesn’t move up in a straight line. In a bad economy, shaky companies go bankrupt and bondholders & stockholders suffer alike. Our investment strategy is therefore fundamentally structured around pairing asset classes with low or negative correlations, not positive, because different patterns of return lower overall portfolio volatility and provide the mechanism to rebalance (sell high, buy low). This process is fundamental to earning attractive risk-adjusted returns over time.
Ultimately, in the context of a well-diversified investment portfolio, we think stocks are a better place to take on additional risk if and when more risk is appropriate. Exotic bonds offer higher yields in the short run, but we believe discipline will be rewarded come the next bout of significant market turbulence or a steep rise in interest rates. The juicy yields boasted by junk bonds and other exotic structures may prove to be analogous to mirages across a barren desert.