Mar 17, 2015

Recently a guest on CNBC, a noted money manager, mentioned in passing that the size of the “High Yield” (Junk) bond market has grown from $3.5 Trillion in 2007 to Hogs-yield-hoggeryaround $7 Trillion in 2015. [1] Rock bottom interest rates, strong demand by investors for income producing securities, expanding demand for credit by lower than investment grade companies, (especially in the energy exploration industry) have all contributed to the huge expansion of the junk rated securities market.

But Junk Bonds are not the only asset class that has grown immensely in size and exposure since the great crash of 2008. Yield seeking investors have gratuitously purchased a variety of less than highest quality income assets from CLOs, (Collateralized Loan Obligations, the idiot younger brother of the CMOs that proved so toxic in 2008), to “Senior Loans” the sometimes questionable debt of less than top rated businesses, Junk Auto Finance debt, the loan that goes bad right before the repo man arrives, Emerging Markets bonds issued by default-prone sovereign governments of the “don’t cry for me Argentina” variety and other classes of income producing securities that can go south if the US or global economy slips back into recession.

But why have investors been so anxious to buy all sorts of low grade debt securities, no matter the well-established track record of risk? In a word, it’s what I call “Yield-Hoggery”. On Wall St, a “Yield Hog” is an investor, either a big, supposedly sophisticated institution or hedge fund, or a small mom and pop level retail buyer, who insists on trying to get a yield that is higher, often substantially higher than prevailing market rates for higher grade, lower risk assets.

Near-zero interest rates on T Bills, Bank deposits and other safer means of earning a yield on invested money in recent years has driven both big and small investors into the better paying junk credit markets.

And now, we may again be heading toward the proverbial tipping point, where the sheer size of the exposure of junk debt begins to stress the entire global financial system. Just one junk issuer, the Brazilian energy giant Petrobras, owes some $170Billion to global investors, and already seems like a possible default situation.[2] Other energy issuers are also in possible jeopardy as lower crude oil prices pressure their ability to make good on debt.

The main downstream risk of an increasing stress scenario in junk bonds is one where a perceived contagion into other credit markets can cause a systemic downturn, as unrelated and undamaged asset classes are sold wholesale as investors sell their good quality holdings to cover their losses on junk assets that have gone bad.

There is no institutional memory; remembering past mistakes is a luxury many institutional investors do not have. Professional asset managers working for hedge funds, trading firms, banks, even mutual funds are under daily pressure to produce competitive yields in the day to day demolition derby of income asset sales. If you want new investor inflows, you need to show a strong current yield; even if you have to reach into the toxic pool to get it. The irony here is one where prudence in asset selection can actually be bad for business.

We now face a market where big asset managers as well as small retail investors feel obliged to in indulge in Yield-Hoggery, reaching further and further into the junk pile in order to pump up current yields in a near zero interest rate world. So what can investors do to protect themselves from the hazard of the financial markets collective Yield-Hoggery? The next installment of this blog will offer some solutions.

[1]-CNBC March 2015
[2] Bloomberg TV March 2015