Danger lurks as investors seek yield

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#1
Indications that global markets are awashed with liquidity and moving towards the penultimate stages of the current cycle. Mkt fears spiked out during the GFCs (3 sharp bear years) and now in the grinding bull stages (likely to be 7 grinding bull years) topping out in the famous crisis years that end with 7s...

PUBLISHED MAY 03, 2014
Danger lurks as investors seek yield

With money to invest but few options available, investors are turning to lower quality, rather than longer maturity bonds. By Floyd Norris

PUTTING MONEY TO WORK
Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality. There are risks to both. - PHOTO: AFP
'It is a very favourable time for bond issuers. There is just a lot of money sloshing around out there. There are simply not a lot of alternatives, and money managers are under pressure to put that money to work.'
- Martin Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors
WHEN buyers demand something, the supply will be created. Especially on Wall Street.
These days, thanks in no small part to the prolonged easing by the Federal Reserve, there is a great demand for investments that provide yield.
Apple, a rich company that borrows for two reasons - to pacify shareholders and avoid paying taxes - came to market this week with US$13 billion in new bonds. That was on the heels of a US$17 billion offering a year earlier.
It was such a smashing success that Hans Mikkelsen, a credit strategist at Bank of America Merrill Lynch, promptly proclaimed that "Apple bonds are Giffen goods". Giffen goods, named after Sir Robert Giffen, a 19th-century Scottish statistician and economist who discovered that they could exist, defy the normal law of supply and demand. Raise the price, and people will buy more.
They are extremely rare.
The classic example - and the only one I had heard of before Apple sold its new bonds - was potatoes at a time when they were the chief source of nourishment for Irish peasants. If potato prices fell, the peasants could afford more meat and would therefore eat fewer potatoes. When potato prices rose, they could no longer afford meat and would consume more potatoes.
Last week, when Apple announced its plans to sell all those new bonds, the price of its existing bonds fell a little, which is what normal supply and demand models would predict. But this week, when the bonds were actually sold, prices rose. Apple's 30-year bonds now cost more, relative to Treasury bonds, than they did before the new borrowing was announced.
"Apple," explained Mr Mikkelsen, "was able to generate increased demand for its bonds at flat to higher prices. That clearly is a testament to continued inflows to credit and the precious availability of bonds, rather than your textbook supply-demand chart."
In other words, investors are desperate for yield and will flock to it.
That is great for those companies that can issue bonds, but it took awhile for those that depend on bank loans to see a similar development. Now banks are making more loans to companies, and even mortgages are becoming easier to obtain.
"The average Fico score on new mortgages is falling, and this is consistent with the anecdotal evidence that banks are easing mortgage lending standards," said Torsten Slok, the chief international economist of Deutsche Bank Securities, pointing to data on mortgages acquired by Fannie Mae. The Fico score measures creditworthiness.
Just why mortgages took longer to ease up is the subject of more than a little speculation. Some say banks saw no reason to go after any but the safest borrowers as long as they were making a lot of refinancing loans to highly qualified borrowers. So they imposed what are known as "overlays" - requirements that were tougher than they had to be on loans that would be sold to Fannie Mae and Freddie Mac.
"Based on loans we've acquired and our conversations with lenders," said Andrew Bon Salle, an executive vice-president of Fannie Mae, "we know that many lenders have been removing overlays."
They need to do that to keep their mortgage businesses from shrinking.
Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality.
There are risks to both. The prices of long-term bonds fall sharply when interest rates go up. Lower-quality bonds are more likely to default.
These days, lower quality, rather than longer maturities, seems to be more popular. Money has poured into mutual funds that invest in bank loans - often low-quality ones. To a lesser extent, it has also gone into high-yield mutual funds that buy bonds rated below investment grade, known as junk bonds to those who are dubious of them.
"It is a very favourable time for bond issuers," said Martin Fridson, the chief investment officer of Lehmann, Livian, Fridson Advisors and a long-time analyst of the high-yield market. "There is just a lot of money sloshing around out there. There are simply not a lot of alternatives, and money managers are under pressure to put that money to work."
What that money will buy now is low yields, relative to risk. It also buys less protection than it used to in terms of covenants - terms put in bonds that are supposed to protect investors if conditions worsen. In normal times, extremely weak junk bonds at least come with relatively strong covenants. But Moody's Investors Service, which maintains a "covenant quality index", said in March that the lowest-quality new issues had fewer covenants than did slightly better-quality bonds.
That preference - for low quality rather than long duration - is easy to understand. Worries about potential Fed tightening caused long-term bond prices to fall last summer, scaring some investors. But default rates on high-yield bonds remain low.
Mr Fridson says that he thinks that investors are not being paid nearly enough for the risks they are taking and that high-yield bonds are overvalued. But he concedes that has been true for some time, and it is far from clear what will cause that to change.
Late last year, Mr Fridson caused a bit of a stir when he said "the next upsurge in the default rate" was likely to begin in 2016 and last for four years. "During that period," he wrote in a commentary for S&P Capital IQ LCD, "we project that on a global basis, approximately 700 bond issuers and 1,150 debt issuers in total will default. The face amount of bonds and loans going into default should approximate US$1.5 trillion, with the US accounting for US$1 trillion of the total."
He noted that "the projected number of defaulting debt issuers is triple the number that defaulted in the short but severe upsurge of 2008-09 and nearly double the number that defaulted in the five-year upsurge that began in 1999". A currently hot category of fixed-income mutual funds features funds called "unconstrained" or "strategic" by their sponsors. They can use derivatives to eliminate any risk from rising interest rates. Eric Jacobson, a mutual fund analyst at Morningstar, says that some now even have "negative duration", a concept that is hard to fathom. The funds also have the freedom to move in and out of different kinds of bonds, which is supposed to produce superior performance - and will do so if the managers do turn out to be able to call market turns in advance.
Good luck.
Eventually, I suspect that some of those who have poured money into such funds will be surprised to learn that they have purchased lower-quality bonds, something that will be very painful if Mr Fridson turns out to be right.

All this easy credit may not do as much as it could for the economy. Loans that finance corporate acquisitions, or dividends to private equity funds, won't do anything for employment, or at least a lot less than loans that pay for the purchase of new plants and equipment.
As for Apple, the yields on this year's bonds are a little higher than the ones on last year's. The new 30-year bond has a coupon of 4.45 per cent, compared with 3.85 per cent. The 10-year bond rate has climbed to 3.45 per cent from 2.4 per cent. If you bought either bond a year ago, and sold it this week, you would have a net loss.
There is a sense in which Ireland, home of the Giffen goods potatoes, has also produced the newest Giffen goods. Thanks in part to a sweet deal with Ireland, Apple has been able to accumulate a huge cash hoard without paying much in the way of US income taxes, but it would have to pay a lot of taxes if it used that cash to pay dividends and buy back stock. So it borrows money instead.
If all this ends badly, as Mr Fridson expects, there will be a lot of blame heaped on the Fed for keeping interest rates so low for so long, thus encouraging the speculation. At least some of the criticism might be better directed at the Congress. Had it been willing to provide more fiscal stimulus, the Fed might not have been forced to follow the course it has. NYT
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#2
PUBLISHED MAY 26, 2014
Easy money feeding M&A, dividend frenzy globally

US, Japan and UK central banks have been injecting liquidity into markets

[PARIS] Massive dividend payments and mega mergers: With markets flush with central bank easy money, companies have begun to raid their war chests, gobbling up competitors or rewarding investors.
In the first quarter of this year dividend payments jumped by nearly a third and several titanic tie-ups were announced, with the US in the forefront.
Global growth remains sluggish, but its return is sufficient "as all over the markets there is liquidity waiting to be used as everything has been done to stimulate them, especially by the US Federal Reserve and Bank of Japan," said Renaud Murail, a portfolio manager at Barclays Bourse in Paris.
The US, Japanese and British central banks have conducted massive purchases of assets in recent years in order to inject liquidity in the markets and jump-start stalled economies.
On top of this central bank liquidity there are the funds "accumulated by European companies as a precaution after the liquidity crunches they experienced in 2008 and 2011," said Romain Boscher, global head of equities at asset manager Amundi.
With the global economic crisis receding and eurozone tensions dissipating, companies are no longer hoarding cash and the amount they have been paying out to investors has soared. Globally, it jumped by 31.4 per cent in the first quarter of this year compared with the same three-month period last year, according to a study by Henderson Global Investors.
It hit US$228 billion, the best quarter since the end of 2012.
"The lack of visibility led companies to make big restructuring efforts, especially in the United States. American companies have accumulated huge war chests . . . Now there has been a break in the clouds, this cash is coming out of the vaults to finance share buybacks, dividend payments, our mergers and acquisitions," said Mr Murail.
But Mr Boscher noted there is one big difference between European and US companies.
"European companies are very far from returning to their levels of profitability before 2007 and have not yet launched massive share buybacks," he said.
US companies have also been the most generous to their shareholders. With payouts to investor up by 30 per cent in the first quarter, they far outpaced their European and Japanese counterparts, according to data from Henderson.
There has also been a return to the mega mergers of before the global financial crisis: General Electric has its eyes on French energy and transport company Alstom, Pfizer sought to swallow rival AstraZeneca, Omnicom and Publicis tried to create the world's biggest advertising company, while AT&T is buying DirecTV and Comcast is taking over Time Warner Cable in a big shake up of the US market to provide Internet and TV content to US homes.
The mergers are far from being financed from the companies' own funds.
"Companies are benefiting from their ability to borrow at ultra low rates from banks or raise large sums on the markets on very attractive terms," said Mr Murail.
And not only the most solid companies are benefiting: with super low interest rates prevailing, Mr Murail said that investors looking for higher returns are sacrificing a bit on the quality of their investments.
"The wave of mergers and acquisitions is just beginning," said Mr Boscher. "In a period of weak growth, it is more reassuring to buy a competitor than to open a new factory."
A return to more productive investments such as research and development, or expanding or modernising manufacturing capacity, will need to wait for the global recovery to pick up pace, said the investment managers.
Industrial sectors are still weighed down by overcapacity as markets still haven't recovered to pre-crisis levels, while services are fighting price wars that are eroding their margins. - AFP
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#3
http://www.businesstimes.com.sg/premium/...d-20140527

PUBLISHED MAY 27, 2014
Adjust expectations as equity returns are low, investors told
Those wanting much higher returns must be ready to take on significant risks

BYSIOW LI SEN
lisen@sph.com.sg @SiowLiSenBT

WITH stock-market returns being moderate for the foreseeable future because of low inflation, investors should be realistic in their expectations, an investment strategist has advised.
Bill Maldonado, chief investment officer (CIO) for the Asia-Pacific in HSBC Global Asset Management, said: "Over the next decade, you can expect equity returns of about 6 per cent - real return on top of inflation."
Globally and regionally, inflation is not a problem and will be fairly subdued, as growth is still below trend, said the Hong Kong-based CIO, who was recently in Singapore to meet his institutional clients.
Economies have excess capacity and that means interest rates are likely to stay lower longer than many are assuming, he said.
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#4
The return of mortgage-backed securities - amber lights blinking especially when investors are assuming higher risks in search of yield in low growth global environment

http://www.afr.com/p/fortunes_favour_mar...6RfHtjVHMK

Fortunes favour market as trusts invest in growth

PUBLISHED: 16 HOURS 6 MINUTES AGO | UPDATE: 16 HOURS 6 MINUTES AGO
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Securitisation
BRENDAN SWIFT

Securitisation markets have largely recovered from the worst blows inflicted by the global financial crisis and, as they have rallied, so too have the fortunes of the trust companies which service them.
The issuance of new public market residential mortgage-backed securities rose by about 50 per cent in fiscal 2013 – its highest since the GFC – while the asset-backed securities market has also improved, with issues by Macquarie, Bank of Queensland and Investec.
“The securitisation market has really stood the test of time; there were no losses on Aussie securitisation investment-grade transactions throughout the global financial crisis,” Perpetual general manager, sales, relationship management and product Richard McCarthy says.
Perpetual has been involved in the Australian securitisation industry since its inception in the 1980s and oversees about $300 billion in securitised assets after acquiring major player The Trust Company last year.
McCarthy says the $250 million acquisition of The Trust Company (which was also subject to bids from Equity Trustees and IOOF) will bolster the company’s property and infrastructure market offerings, particularly aimed at managed investment trusts.
‘NICE BALANCE’
“We think that’s a key area of growth for Perpetual’s Corporate Trust which gives it a nice balance to our overall ¬corporate trust business, where we were very focused on our capital markets business,” he says.
The Reserve Bank of Australia’s securitisations reporting initiative presents one of the greatest ongoing challenges to the industry as the central bank moves to implement new repo eligibility criteria for asset-backed securities. The project will reveal more information on asset-backed securities and allow the RBA and industry to better assess underlying balance sheet risk.
McCarthy says the company has been upgrading its ABSPerpetual.com site to collect and disseminate the new information between the RBA, fund managers, banks and research houses.
“We are now having to really ¬redevelop the entire market because the granularity, the standardisation and consistency required by the RBA is materially changing how we will all do business,” he says. “The market certainly rallied and supported the RBA, and the entire market, including Perpetual, has basically tried to make the commitment to get more securities repo-eligible by January 1, 2015, so there’s been huge amounts of work in the industry to actually now be able to deliver to the RBA five data templates.”
In less than a year, $300 billion of asset-backed securities could potentially appear on the RBA’s balance sheet via its Committed Liquidity Facility. The new data it receives from the ¬industry will allow it to improve pricing and transparency.
RBA’s head of domestic markets department, Chris Aylmer, told the Australian Securitisation Forum late last year that the securitisation market continues to recover and the industry supports a move towards greater transparency.
“As for increased transparency in the securitisation market, I don’t get the sense that the bank is pushing against the tide. It’s already happening in other jurisdictions and in my discussions with issuers and investors, it is clear that they both see potential benefits.”
EXCESSIVE LEVERAGE REMOVED
Much of the excessive leverage which drove compound annual growth of 34 per cent over the 10 years to 2007 (the proportion of housing lending financed through securitisation jumped from about 5 per cent to more than 20 per cent during that time) has been removed from the system.
“The trend has gradually come back; I think it’s very positive that the Australian Office of Financial Management closed their requirement to support the industry because it was self-supporting in terms of investment demand for the performance of the securities,” ¬McCarthy says.
For several years after the GFC, the AOFM purchased RMBS issuances to support the market, ultimately buying more than $15 billion in assets.
Companies have also had to adapt in other ways as investment structures have changed. For example, issuers have reduced their use of lenders’ ¬mortgage insurance after credit ratings discounted its importance, while offshore investors have helped drive a move towards bullet structures, which minimise prepayment and extension risk for investors.
The Australian Prudential Regulation Authority has also issued a draft prudential standard (APS120) aimed at allowing the market to continue developing bullet-like structures with master trusts. It could broaden the market, which is still focused on ¬residential mortgages and auto loans as securities, to include assets such as credit card receivables. Another recent shift has been the move to issue covered bonds by Australian banks. It has been more than two years since the RBA allowed banks to issue covered bonds amid ongoing difficult financial markets and, while the take-up by global investors has been strong, trustee fees on covered bonds remain significantly lower than those for other asset classes.
Perpetual Corporate Trust experienced a net outflow in RMBS funds under administration in fiscal 2013 (as households continued to deleverage), which was offset by an increase in RMBS repos and covered bonds, says Lonergan Edwards & Associates.
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#5
"There has been a change to the rules in the United States that should have trimmed activity in this area but there has been an extension granted until 2017 so the banks are buying them while they can and then trying to sell them."

http://www.afr.com/p/markets/structured_...CLWYvH378N

Structured debt at a post-GFC high
PUBLISHED: 20 JUN 2014 14:20:08 | UPDATED: 21 JUN 2014 02:38:31

Structured products are big business again as global investors continue to chase any sort of yield on offer. Photo: AP
Baker
PHILIP BAKER
In the lead-up to the financial crisis investment banks on Wall Street spent millions of dollars looking for a way to buy into the hedge fund business.

These days it looks like they lend money to them so the hedge funds can buy the structured products the banks sell. Structured products helped cause the last sharemarket crash and could do so again if the use of some arcane derivative or fancy form of gambling, dressed up as a real business, doesn’t do it first.

But structured products are big business again as global investors continue to chase any sort of yield on offer.

This time it’s collateralised loan obligations, which combine all sorts of loans made to companies, making the front running in the sector.

These CLOs, as they are also known, can also include some high-grade bonds, but other securities are usually thrown in to boost the yield.

According to data from S&P Capital almost $US83 billion ($88 billion) of these types of loans were sold in 2013, a post-financial crisis record, while so far this year sales have reached $US55 billion ($58.5 billion), on track, perhaps, to eclipse the record of $US97 billion ($103 billion) packaged up and sold in 2006.

In March of this year just over $US11 billion ($11.7 billion) were sold, the largest amount for a single month since May 2007 when $US10.82 billion ($11.5 billion) were soaked up by investors.

There has been a change to the rules in the United States that should have trimmed activity in this area but there has been an extension granted until 2017 so the banks are buying them while they can and then trying to sell them.

Strangely enough the toughest part of these loans to sell is the safest, triple A-rated piece that, naturally enough, has the lowest yield. No one wants that loan but it’s imperative to the overall deal that someone buys it to get the rest of the deal done.

So to entice hedge funds to buy them it’s been reported that Société Générale and RBC Capital Markets banks have offered to lend money to help facilitate a deal. It’s an extension of the “carry trade’’ and in theory there isn’t too much risk if all the loans behave themselves, which means no defaults, and borrowing rates remain low. Global interest rates and borrowing costs are either at, or close to, record lows, sparking debate that credit markets are mis-pricing risk again. This week the US Federal Reserve said interest rates would be kept low for quite some time but Janet Yellen, the chair, noted there was “some evidence of reach-for-yield behaviour”.

It all goes back to how much debt investors have and how prudent they are with it. If interest rates were to rise again suddenly then it could cause problems.

In August 2007 there was a trigger for panic, which many see as the start of the crisis, when there was a decision made by BNP Paribas to block withdrawals from three hedge funds because of what it called a complete evaporation of liquidity.

In the United States, interest rates don’t look to be going up any time soon – but they will eventually, as the world’s largest economy recovers. Ms Yellen made that much clear. And investors in Britain got a jolt last week when Mark Carney, governor of the Bank of England, said interest rates there might have to rise sooner than everyone expected.

The global financial crisis was caused by the collapse of the sub-prime housing market in the US, which basically lent money to people who couldn’t pay it back. Ever since, there’s been a raft of experts trying to make a name for themselves by predicting the next one.

That’s why there is so much talk of bubbles, of a new speculative mania, of lessons not learnt.

A quick look at history suggests that a certain amount of time has to elapse to erase the memories no doubt before the next crisis hits, combined with a period of decent growth.
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