C&B Notes

Foul Smelling Potpourri

Investors have pursued a potpourri of securities in an effort to realize yield in a zero interest rate policy world, and issuers have been more than happy to oblige with structures that have been more and more complex and advantageous to themselves.  The resulting mix is particularly foul smelling.

John Kenneth Galbraith in The Great Crash, 1929 describes “bezzle” theft where there is an often lengthy time period between the crime and its discovery.  The person robbed continues to feel richer as he does not know of his loss, at least yet.  In favorable markets, bezzle increases, only being exposed by changed conditions. Today, investors, either directly or through pooled funds, are being “bezzle-d”.

Since 2009, low returns and loose monetary conditions have driven a search for yield. Investors looking for income initially moved out of traditional safe investments into corporate bonds and high dividend paying shares.  As returns fell further, investors have increased credit risk and their exposure to long dated fixed rate bonds as well as assuming non-traditional risks.  The volume of high yield, non-investment grade bonds, leveraged loans and collateralized loan obligations issued over the past four years totals about $3.5tn, compared with about $1.3tn in subprime mortgage loans outstanding in 2007.  Many loans have minimal covenant protection for lenders.  Some are payment in kind, or Pik, allowing interest to be paid in the form of further IOUs rather than cash.

Moving beyond well-known emerging markets, investors have embraced riskier African and Asian frontier economies.  Attracted by high yields, investors oversubscribed many new issues…Many issuers are economically fragile, dependent on commodity revenues, foreign aid or International Monetary Fund support.  Funds were sometimes not used for their intended purpose.  Some $850m raised at an interest rate of 8.5 per cent by Mozambique, one of the poorest countries on earth, was allegedly not used for the planned tuna fishing venture.  Even where used as indicated, proceeds frequently financed pet vanity projects which may not prove economically viable.  Much of the debt is denominated in U.S. dollars.  A rising dollar and higher U.S. rates will increase the debt servicing costs, creating solvency risks.  Most issuers also face refinancing risk as the borrowings were three to five years in maturity.  With yields on some frontier bonds now in double digits, some issuers have lost market access…

Investors have also increased duration, purchasing ultra-long dated bonds, whose prices are more sensitive to changes in interest rates.  In order to meet the costs of developing offshore oilfields, Petrobras, the state-owned Brazilian company, borrowed extensively.  In part, debt compensated for its inadequate operational cash flow reduced by artificially low domestic administered energy prices.  In June 2015, Petrobras issued century (100-year bonds) yielding 8.45 per cent.  Investors purchased the long maturity convinced that there is minimal economic difference between a 30-year and 100-year bond because present value mathematics means that the principal is a small component of return.  Within three months of issuance, a combination of low commodity prices, concern about high debt levels, and a corruption scandal saw the bonds lose about 30 per cent of their value.