Originally published in March 2021.
Like many readers, I took advantage of the best snow in years to go sledging with my daughters. As Daddy bombed down the hill like Bowser in Mario Kart, my mortality flashed before me and I realised I was simultaneously having fun and in great danger.
I was Schrodinger’s dad – contemporaneously dead and alive, the die had been cast, only the outcome was unknown. On reflection, I realised this is the perfect metaphor for the corporate bond market.
Corporate bonds had a near-death experience in 2020. After a decade where credit markets grew to $10tn,borrowing costs spiked as we stared into the abyss of a global economic shutdown (as can be seen on the chart). We had been warning of this for several years and were positioned accordingly – our unconventional credit protection investments almost doubled in Q1 2020 and this allowed our portfolio to remain flat at the March lows when equities were down 30%.
Effective yield on CCC-rated US corporate debt (%)
But since the US Federal Reserve drenched the market with its money hosepipe, credit is alive again.
Junk gets a makeover
The spiciest end of corporate credit was once known as ‘junk bonds’. Highly leveraged or structurally challenged companies whose survival was uncertain and where lenders demanded juicy returns. They were rebranded ‘high-yield bonds’ in a Wall Street makeover, given a veneer of respectability and somehow have made it into conventional portfolios.
Today the ‘high’ yield on ‘junk bonds’ is just 3.9%. Boom times are back with issuance of $140bn of debt in the first six weeks of 2021. The run rate issuance for the lowest rated CCC-rated bonds is more than double the previous record. When was the last record? Just before the global financial crisis.
As Raymond DeVoe once said, “more money has been lost reaching for yield than at the point of a gun”
An example of the madness: the retailer Party City (been to many parties recently?) raised $750m for five years in February. A year ago, their bonds were on the edge of default and traded at below ten cents on the dollar!
Is lending to companies which are one month’s bad trading (or mandatory lockdown) from insolvency appropriate for most investors? What do these bonds add to a portfolio? Attractive income is available in equities and interesting diversifiers are available in gold or bitcoin. Equity has asymmetric upside, junk bonds have asymmetric downside! Who is buying this stuff?
Reaching for yield
We are troubled by investors’ increasing allocation to this risky niche. As Raymond DeVoe once said, “more money has been lost reaching for yield than at the point of a gun”.
But it gets worse… the true return on high yield is the yield minus what is lost on defaulted bonds. Over the last 40 years, the average default rate is 4%. Some of this can be reclaimed through the courts and the bankruptcy and recovery process: let us say half. So the average expected outcome for a buyer of junk bonds today is around 2% (3.9% yield, 2% lost to defaults). Even that meagre return is before considering inflation, or that leverage is higher, the economy is recessionary, and technological disruption is challenging more industries than ever.
The other side
Frankly, we share the optimism the economy is going to get better due to stimulus and reopening, but this is not the way to play it. We want to be on the other side of this trade.
We have been adding to our credit protection investments. Central bank liquidity injections have anaesthetised this market to risks. Central bankers can prop up asset prices, but they are less capable of stopping bad businesses from going under, and this market is full of zombies.
These investments saved our bacon in Q1 2020. The opportunity set today is arguably more distorted and more mispriced.
So ‘Schrodinger’s bonds’: a lot of these bonds are dead – but until they look inside the box, the owners don’t know it yet.
This article was previously published by Ruffer and is here republished with permission.
