One of the themes that we have been highlighting this year is the growing bubble in corporate bonds. It is pointless in the first instance to discuss whether super easy monetary policy that has fueled this bubble is appropriate or not. The main thing for investors to countenance is that the current monetary policy regime is having unintended consequences through the formation of a bubble in increasingly scarce liquid fixed income instruments.
In May, when we put out our report on corporate bonds, we described what we saw as the seeds of the next global crisis. In particular we emphasized the fact that there are now more corporate bonds outstanding in the US than there are mortgage-backed securities. That chart remains a key chart five months hence.
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The total stock of corporate bonds outstanding in the US is up more than 10% on the year (2Q13 numbers) standing at $9.3 trillion. In comparison, the stock of mortgage-backed securities has declined every single year since 2010 from $8.4 to $8.1 trillion.
One issue in particular worth highlighting here is the surge in low covenant leveraged-loan demand which is the real bugbear in our view. According to Reuters, covenant-lite issuance is 74% higher this year than in all of 2007. Issuance of these loans is up more than five times the $35 billion issued in the first nine months of 2012.
This suggests an incredible supply/demand mismatch in the market for fixed-income securities, a mismatch which is particularly worrying from the point of view of market liquidity. Even in securitised form (eg through CDOs (collateralised-debt-obligations)), leveraged loans are notoriously illiquid.
On their own they are as illiquid as you can get, often being, as it were, one of a kind. The surge in demand for high yield corporate bonds and leveraged loans is creating a very dangerous shortage of liquidity in fixed-income market which will exacerbate any downside price action.
Generally, the shortage of high quality and liquid assets in the wake of the Fed sucking up up marketable assets is not a new theme. It was widely discussed in the middle of 2012 too.It is well known for example that the increasingly creative and large scale QE has taken the Fed well out of the standard short duration reservation.
Source: RBS, November 2013
According to RBS, a British bank, responsible for the chart above the Fed is now monetizing 70% of all net supply measured in 10y equivalents. This signifies a reliance on the Fed which is unprecedented.
However, the debate has been re-ignited recently by the increasingly worrying decline in primary dealers’ corporate bonds held in inventory. The following chart comes from Citigroup (via FT Alphaville) and paints a picture of an increasingly small exit
Source: Citigroup, Matt King November 2013
Further analysis suggests that liquidity is likely to be very tight indeed in the context of higher rates that forces a flush in interest rate linked securities.
Source: RBS, November 2013
The chart above, also from RBS, shows a wide and growing divergence between disappearing inventory at primary dealers and increasing mutual fund holdings of corporate bonds. It interesting to note here too that the supply side’s response to the shortage of assets has so far been to revert to old tricks. For example, institutional investors led by Blackrock who have spent the past 2 years snapping up US properties on the cheap are now in the process of securitising the rental income from said properties.
Now they are beginning to package the rental proceeds from those homes into the kind of “sliced and diced” securitisations that proliferated before the bursting of the housing bubble in late 2007. This week Blackstone sold the first of these bonds – a $479m deal that bundled the cash flows from more than 3,000 single-family rental properties scattered across Arizona, California and Florida.
Such financial ingenuity is obviously sorely needed in a world where there is not enough assets to go around, but what happens to this supply/demand mismatch if rates go higher, the Fed starts to taper or even both? Our guess is that it won’t be pretty.