September 2018 – Monthly Commentary
The Federal Reserve releases the value and composition of their Open Market holdings every Wednesday afternoon. These are the securities the Fed bought when, in their judgement, the economy demanded artificially low interest rates. On Wednesday September 5, the value of the Open Market holdings fell below $4 trillion dollars for the first time since peaking at $4.24 Trillion in April 2017. That represents a reduction of approximately 5% and a milestone in monetary policy, though the Fed is unlikely to champion it as such. Namely, because there are plenty of critics that argue the size of their emergency monetary policy should have never reached that size. The program to reduce the reinvestment of maturing securities has now been in effect for a year and, as of October, the amount of maturing debt not reinvested has reached the Fed’s stated goal $50 Billion a month. That’s up from $10 billion a month when the program began last October. At the commencement of the program investors feared the absence of Fed buying would pressure interest rates higher, especially when the amount reached full effect. To date, it could be argued that the impact has been muted as rates have only risen marginally. However, with the ten year note above 3% and the economy continuing to run hot, one wonders if the reduced demand will finally push interest rates materially higher. An important consideration is the growth in the budget deficit. Over the last twelve months the United States has run a budget deficit of $1.2 trillion dollars. That’s roughly an additional $100 billion a month, when combined with the Fed’s $50 billion roll-off, adds to the supply of treasuries that needs to be absorbed by the market. Also of consideration, the Fed has never defined exactly what they would deem a normalized balance sheet. At the start of the crisis, the assumption was that it would fall back to the pre-crisis level, but it’s now assumed that the steady state amount will be more like $2.5 to $3 Trillion.
Two months ago, we wrote about the global emerging market bond rout and the illogic of the lopsided risk/reward tradeoff of the sector, especially when global interest rates are at very low levels. Since then we’ve heard conflicting arguments of “it was only a matter of time before the emerging markets corrected” (the Halyard opinion) versus the opinion that the recent correction is a “buying opportunity.” What’s certain is emerging market bonds share a similar risk/reward profile to high yield debt and investors have largely ignored that similarity. To the contrary, the high yield bond market has rallied with the Bloomberg Barclays U.S. Corporate High Yield Index generating a total return though September of 2.56%, despite rising interest rates. That has driven the yield spread to 310 basis points, the lowest level since prior to the crisis. The price action has been achieved despite a deterioration of aggregate credit quality.
Even more perplexing is the price rally in high yield bank debt. The sector proved disastrous to investors during the crisis. Prior to October 2008 bank debt was thought to be the safest form of high yield debt. The securities were marketed as being higher in the capital structure than high yield bonds, thereby insulating it from first losses, and touted as having never fallen below a price of 90 cents on the dollar. That is, until investors dumped the paper en masse and no buyers surfaced to take the other side of the liquidation. When the dust cleared, many individual loans traded as low as 60 cents on the dollar. Fast forward to 2018 and much of the same nonsense that was occurring prior to the crisis is happening again. New issue bank debt will set a record this year and the vast majority of that debt is structured as covenant lite loans, securities that don’t require the borrowers to maintain certain financial standards to avoid having the debt called. S&P estimates that 78% of loans currently outstanding are covenant-lite deals. Demand for the debt is being driven by Collateralized Loan Obligations (CLO’S). You’ll probably recall CLO’s from the financial crisis. They’re similar to an ETF in that many small loans are bought and packaged into a CLO wrapper and marketed as being less risky than individual holding’s. The pitch is the same as it was in the years before 2008. It may not be the same situation as that which faced emerging markets over the last two months, but it’s eerily similar. While there is no immediately recognizable catalyst that would cause a panic in the sector, the debt is priced for perfection.
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