Credit Markets: Gone Crazy?
It’s been a strange few weeks (or perhaps months) in the credit market. Tight bond offerings, negative interest rates, and compressed CDS spreads have completely skewed any notion of understanding risk/reward. We, along with several other investors we know, have scoured the market trying to find assets that give you a good trade-off between risk and reward but have come up short. For example, for one client we tried to find short-term cash solution for some liquidity that they would need in a few months. We explored corporate bonds, short-term funds, fixed income ETFs, but were so disillusioned with the risk/reward (and private banking fees!) we decided to just leave the money in a fixed deposit (which barely covers the rate of inflation). With another client, we got so desperate to find yield that we caught ourselves exploring Equity-linked notes, but luckily we fought our desperation and quickly backed away from a path we knew we’d regret taking.[1]
Now the question you may ask is are we in another credit bubble? Honestly, we couldn’t tell you. Any market timing/bubble judging prediction we accurately make would be due to luck. But what we can do is point out when things look off to us. Below, are a few examples of what we see as irrationality in the credit markets. We’ll let you decide if we’re in a bubble or this is all par for the course. Do note – we will be the first ones to admit there are many factors at play here, so if you have reasons why the below examples are standard for credit markets, we would love to hear them (email us via contact details in the footer of the page).
History forgotten
10Y Greece Gov Bond Yield - 10Y US Treasuries Yield
The above graph was posted by the Heisenberg Report which showed that the difference between the Greece 10Y Government Bond Yield minus the US 10 Year Treasury Yield. Now we know that although these are not directly comparable as one is in Euro and one is in USD, the trend does imply something very off. Investors have become so desperate for yield that a country, which just over 10 years ago was on the verge of default and had to be bailed out by its neighbors, can now borrow more cheaply than the US government. If for a second you can avoid the mental gymnastics (yields aren’t comparable, Greece debt is more stable than before, rising US Debt/GDP etc etc), certainly you would at minimum, get the inkling that something looks wrong.
Yield found on Trains?
A few weeks ago, the Indian Railway Finance Corporation (IRFC) issued a 10 year bond yielding 3.429%. To put this in perspective, the 10 year US treasury yields around 1.56%. The IRFC (owned by the Indian government) has a credit rating of Baa2 rating whereas the US government has a triple-A rating. This implies that for you to take the additional risk of holding IRFC paper over holding US treasuries (which is 8 notches higher on the credit rating agency’s scale), they will only pay you 1.86% more a year. Basically for every $100 you lend the Indian Railways versus the US government, you’re only earning an additional $1.86/year.
Now, we don’t know what the correct premium should be, but this amount instinctually feels low. To put some thinking behind this feeling, we looked up the 10 credit default swap[2] spreads for the Indian government. At the end of Feb 2019, they were trading around ~180bps and just a year later, they have tightened to 120bps. This implies that lending to the Indian government throughout 2019 has gotten ‘less risky’ but considering that expectations of Indian GDP growth were slashed throughout 2019 by rating agencies, this surely shouldn’t be the case. One reasonable explanation points to an irrationality of the market driven by investors turning to emerging markets to find some sort of yield, driving up prices, and driving down spreads.
Has the world turned upside down?
Most of our readers/clients know that there are more than $15 trillion worth of bonds priced yielding negative rates. While as investors, we’ve seen this for a while and it has become a new normal, if we take a step back and think about it, the concept of “negative interest rates” sounds insane. It essentially means you are PAYING someone to lend them money. Imagine that! Not only do you get to borrow money but you get more money for doing so! Of course we are being a bit tongue-in-cheek and currently, it’s only A rated European (and Japanese) governments/financial institutions that receive this ‘privilege’ but the real world applications are both funny and sad, as aptly described by Howard Marks’ conversation with his European lawyer when he transferred some money over a weekend to complete a deal:
Lawyer: The money has arrived. What should I do with it between now and Monday?
Howard Marks: Put it in the bank
Lawyer: You know that means you’ll get less out on Monday than you put in today?
Howard Marks: Okay, then don’t put it in the bank
Lawyer: You have to put it in a bank
Howard Marks: So put it in the bank
What this implies is instead of a lender getting compensated for risk (lending money) they instead are instead willing to ‘pay’ for the security of lending their money to someone secure. If you think about how upside down this sounds, you might also think a world where people just buy bigger mattresses and thicker locks on their doors to store their money at home doesn’t sound all that crazy.
What does this mean for you?
While this credit market seems quite upside down, we can’t tell you what’s next. There is a perverse incentive for central banks to keep rates negative (they’re getting paid to borrow your money!), so expect that to last for a while. What we do strongly feel is that yields are very low for the risk most investors are taking, and this is before the effects of the coronavirus are fully known. Thus, as always, even with the risk of sounding like a broken record, our advice remains the same. Proceed with caution and prepare your portfolio for its worst day. What does this mean? Here are a few thoughts.
Don’t chase yield! Do not sacrifice asset quality for just 1-2 more percentage points. You will regret it if the market turns. Be patient instead.
Look through your fixed income portfolio. Are there any assets there you wouldn’t want to hold in a 2008 like scenario? Sell them, lock in the profits
Reduce leverage – yes, if yields continue to fall means you’ll miss out, but better to miss out then get knocked out.
Use common sense when you’re adding to your bonds/debt funds to your portfolio. Often investors will use a ‘relative value’ analysis to justify their purchase, where when they compare the asset they are considering buying to its peer/rating group to justify valuations. But if the whole group is mispriced, then the relative value is irrelevant.
Happy Investing! And as usual, with the ongoing environment - stay healthy!