The other day I was doing some research and listening to a local bond manager’s conference call. At one point during the call he began describing the relentless dumb bid that had swept into the floating rate bond market. Like a dog that smells the hamburger unwrapping, my ears immediately perked up. Although this manager had seen his share of cycles, he was amazed at the price that investors were currently paying for floating rate product such as bank loans. His opinion was that the credits were getting increasingly poor (mostly just Private Equity levering up garbage companies to get their equity out) and due to the structure of these loans, the payoff profile was very much a “heads I win tails you lose” scenario against the investor. He mentioned that there was also a strange new participant in this market that was buying the most stupid stuff. This new entrant was the ETFs which were blindly buying everything in sight, with Wall Street only too happy to fill the demand.
I have often wondered where the excesses were going to be this cycle. A lot of investors worry about housing or CDOs – but not me. Markets rarely immediately repeat the same mistake. The fact that investors are worried about these assets causes them to never reach the point where they will crash again. The crashes are always out of left field. By their definition they have to be something that no one expects.
Markets that become bubbles always start as solid sound fundamental investments. It is when this investment no longer becomes grounded by attractive pricing, but continues rising because players are attracted to the price action that they become bubbles. As Soros says;
“…market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.”
As the Fed lowered rates to zero, it made sense for investors to invest in floating rate securities to protect themselves against future upward moves in interest rates. However this “theme” has become more of a mania. There is such a demand that Wall Street is once again off loading their crappiest floating rate notes.
Have a look at this chart of BKLN. According to Bloomberg, BKLN can be described as:
Powershares Senior Loan Portfolio is an exchange-traded fund incorporated in the USA. The fund seeks investment results that correspond (before fees and expenses) generally to the price of the yield of the S&P/LSTA US Leveraged Loan 100 Index.
PowerShares Senior Loan</a> </div>
I have plotted out in yellow the total number of shares outstanding for this ETF. At the beginning of 2012 there was a mere 8 million shares outstanding. In the next year they added 55 million shares. And then in 2013, they added more than 200 million shares! This was all new money flowing into the bank loan market.
There is no way that this money is anything but dumb money. Although I understand very little about the nuances of the leveraged loan market, my suspicion is that the vast majority of BKLN investors know even less.
With interest rates still hovering at absurdly low levels I understand the desire to lock in a floating rate to protect against future rises. But I very much doubt that this product will behave as most investors hope in that environment.
Instead I think they will find that Wall Street has once again duped them, and that they are left holding the bag.
The increased popularity of these ETFs and this asset class in general has created a large amount of weak longs. When rates start to rise and these investors realize that their investments are not protecting them, there is going to be a mad rush for the exit. This is a disaster waiting to happen.
I am not going to short this product yet, but I will put it on my radar. I think that when it cracks, you shouldn’t be afraid to sell the dip because it is going to go down a lot further than anyone imagines.
Long March 2014 VIX Futures. Conviction 2.
Short 10 Year US Treasury Futures. Conviction 3
Short US 5 Year Treasury Futures. I expect the Fed to continue to withdraw stimulus aggressively. Conviction 3
Short US 2 Year Treasury Futures. I think the downside is a move from 31 bps to 25 while the upside is a move up to 50 bps. Conviction 4
Long a tiny position of puts on TSLA and FB. Just for shits and giggles. Conviction 1. Stop – none: when they go to zero the market will do it for me.
Short Euro. Added to this trade into the recent rally. Conviction 4
Short Nasdaq 100 futures, short Eurostoxx futures, and short Nikkei futures. Fed is going to taper until something breaks. Conviction 3. No stops for now
Short European stocks via ESTX50 index vs Long S&P 500. I continue to believe that the ECB is too tight relative to the Fed and the BoJ, and that this will translate into relative weakness of European equities. Conviction 4
Short Yen. Conviction 3
Short JGB futures. I can’t call myself a macro trader without this widow maker on the sheets. Small position for now, but will add aggressively at the first sign it is working. Conviction level: 1. No stop.
Long Yen volatility. I believe we are entering a period of increased volatility for the FX pair. Conviction: 3
Long 30 year US treasury volatility. Swapping half of this position into Yen volatility. Conviction 2
Long various deferred crude oil futures contracts. I own a variety of different expiries in years from December 2014 all the way to December 2020. Conviction level: 4. No hard stop.
Long precious metals smorgasbord. Long gold, silver and platinum futures. I also believe that the closed end ETFs (CEF.A CN Equity or PHYS US Equity) which are now trading at discounts versus years of trading at a premium are a good way to play this idea. Conviction level: 4. Using the year end lows as a stop for half the position.
Long grains. Long deferred corn, wheat and soybean futures. Conviction level:5. No stop period.
Long Ithaca Energy IAE CN Equity. See previous posts. Conviction level: 5
Long Input Capital INP CN Equity. I have not yet written this up, but I really like this story. More to come in coming days. Conviction level: 5