The small play and the big play

Image:  Ryan Stone  via  Unsplash

Image: Ryan Stone via Unsplash

You've lost that lovin' feelin'.

A couple of months ago, we asked, “Where did all the money go?”.

This was our attempt to scrape beneath the surface of the distortive impact that more than 10 years of Quantitative Easing has inflicted on markets, particularly the private sphere. The conclusions we drew from that exercise were instructive, and in the months following, we’ve picked up more and more anecdotal evidence that the reckless idealism of value accretion (or creation) in private markets is coming to a head.

The key takeaway from our first foray into this topic was that with the injection of copious liquidity into the monetary system, hurdles of required returns started to move lower for issuers of capital. Yet the demand for higher returns remained, leading economic actors in the system to take on ever-increasing risk as the curve of returns/risk was shifted downwards.

It wasn’t that investors were taking more risk – they were still minimising risk, subject to a need to maintain a minimum performance hurdle. To each, his own, though most notable is the catch-up in risk-taking that pension funds are increasingly under pressure to make, as these traditional stalwarts of “safe” investing face widening pension deficits.

This time, however, we think it’s interesting to explore the inverse perspective. While one could argue that pension funds reallocating into illiquid, long-dated private assets is a conscious shift in risk appetite (in response to a growing need for returns to satisfy a widening funding gap), it would be inaccurate to say they’ve lost their sense of risk. Pension funds – perhaps – are the exception here.

Yet it does seem the rest of the market, not particularly compelled by the need to fund a gap, has (in the immortal words of the Righteous Brothers) lost that lovin’ feelin’, replaced by a blind faith in – amongst others – central bank watching. This spectator sport might, whilst satisfying their need for speed, create exponentially growing risks of a crash and burn.

Nb. For those who haven’t picked up the clues: Top Gun: Maverick is due out in exactly a year’s time, with Tom Cruise as the only constant. Checking out what the rest of the original cast is like now should now be on your weekend to-do list.

The distortion of risk.

Many of us would like to think we have a solid internal compass by which we measure risk. From standard deviations of price movements, to credit scores, to cashflows, to qualitative factors like corporate governance. And indeed, those are very important inputs into any process that seeks to determine risk.

Yet in reality, our perceptions of risk have been constantly shifting. Disagree? Then how do we square up the fact that the 10 year US treasury bond trades at around 2.1% yield, while the Italian 10 year government bond trades at about 1.6%, and the Greek 10 year bond trades at about 2.3%? And let’s not even mention the Austrian 100 year bond with a yield of 1.2%. Or “high yield” (aka junk) bonds that have negative yields?

Of course, risk-free rates have been coming down as a result of QE, but what has also been compressing has been the spread between high yield bonds and treasuries, a direct consequence of the relentless search for returns – and not just any returns, but the fixed-income variety.

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But why fixed-income in particular? Because of a deep-seated belief that equities are risky, crypto is off-the-scale riskier, and at the very least, with a fixed-income instrument there’s always the option to hold to maturity and get back the notional.

The answer to too much debt? More debt, of course.

Of course, that is only a snowflake at the tip of the iceberg when it comes to the real factors driving demand for fixed-income instruments. The consequence of more than US$20tn of liquidity created over the past decade is in effect debt – liquidity given to banks to be lent out, and subsequently liquidity that has landed in the pockets of anyone who took up the offer of cheap credit, now demanding a financing return. In demand: constant and recurring cashflows to creditors.

And that is why a portfolio of equity instruments won’t do – the timing of cashflows doesn’t match up with the demands of the liability. It’s ironic, then, that we have a world that’s so indebted that the only way to service the debt is to invest in (no surprise) MORE debt.

As a result, it now costs a high yield (read “Junk”) issuer less than 4% to borrow money for 10 years from the bond market, a rate which would make Michael Milken proud. Add to the mix the ETF antagonist, and things start getting potentially problematic. Of course, nothing ever goes wrong when nothing goes wrong. Things only go wrong all in one go.

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As pointed out by one of our readers who is a semi retired bond trader in the US, the illusion of liquidity in the bond market – even in the US – could very quickly dry up in the face of mass selling, with dealer inventory largely allocated to primary issues, while secondary liquidity has largely been taken for granted. The risk we see is that ETFs offering daily liquidity on bonds, especially those which are off-the-run, could find they’ve promised much more than they can actually deliver.

A throwback to the 2007 mortgage fiasco.

And as if junk bonds aren’t risky enough, the market for bank loans (typically more risky than bonds, but fixed-income nonetheless) has been buoyant, with Invesco’s Senior Loan ETF (BKLN US) yielding a tidy 5.2% on just over US$4bn of assets under management. An ETF you say? Indeed, it is traded on the NYSE, holding stakes in senior bank loans to more than 110 borrowers. Is it safe? As long as they stay solvent. Will they? Who knows, but S&P for one doesn’t want to be caught sleeping at the wheel again, pointing out that credit quality in bank loans is actually deteriorating.

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Does the market know? We’d have to presume so, since more than US$3.5bn of outflows have been registered on BKLN this year alone. So what could plug the gap in coupons?

In a throwback to the mortgage fiasco of 2007, a brand new old friend has emerged on the stage in the face of deteriorating credit quality in the junk market: Enhanced CLOs. To borrow from the first two paragraphs of the WSJ’s article “Wall Street’s Answer to Risks in Loan Market: Bundle Lower-Rated Loans”:

“A growing number of money managers are embracing a new strategy designed to benefit from volatility in junk-rated corporate loans, a sign of building worries about riskier borrowers and the market that supports them.

"Since November of last year, three different money managers have issued $1.6bn of so-called enhanced collateralized loan obligations that are set up to hold a much larger amount of loans with extremely low credit ratings than typical CLOs.”

We’ve lost that lovin’ feelin’, the feel for risk, and now it’s gone, gone, gone. And let’s not even start down the road of what happens when a link in a chain of loans intertwined with each other defaults.

The small play and the big play.

As managers, our domain is largely equities, but there is no dispute as to the consequences of a debt market meltdown on equities. In fact, it is almost always debt which causes pain, since losing money on equities simply translates to a loss, while failing to deliver on a liability becomes a much more unpleasant episode.

Having said that, the biggest mistake investors can make is to get ideological about markets. As spelt out in the eternal wisdom of Larry Livingstone aka Jesse Livermore,

“You would think, wouldn’t you, that shrewd men who have made millions in their own business and in addition have successfully operated on Wall Street at times would realise the wisdom of playing the game dispassionately. Well, you would be surprised at the frequency with which some of our most successful promoters behave like peevish women because the market does not act the way they wish it to act. They seem to take it as a personal slight, and they proceed to lose money by first losing their temper.”
– Reminiscences of a Stock Operator, Edwin Lefevre

The risks are clear to us. Credit is over-extended, while investor protections have been weakening. And there is evidence of widespread frenzy and complacency as fundamentals are increasingly disregarded in order to make room for ever-wilder assumptions of forward earnings, cashflows and returns, nudging assumptions that are amplified into ever-higher justifications of asset prices.

The most important thing for us is to carefully consider all the possible pathways the market can take from this point forward, and dispassionately plan for them. And that’s where process and discipline comes into play. That’s the big game, and we’ll get there when we do.

But the small game is to play the market as it is. As John Maynard Keynes wryly observed, “The market can remain irrational longer than you can remain solvent.” And for the moment, it looks like the market still wants to go up. At least, the politicians and central banks want it to. And never forget, their balance sheet is much larger than ours.

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