Sometimes a mistake is so cringe worthy that all you can do is shake your head and laugh. Like this book cover. What the hell were they thinking when they drew up that cover? And how did it make it past the editors? In case you think I have been spoofed by the internet, here is the link to the google book. According to the book’s synopsis, Harpo’s horrible secret is that he thinks he is suffering from Alzheimer’s just like his grandfather.
Alzheimer’s is no laughing matter, but neither is the other secret that Harpo’s grandfather is hiding. You see Harpo’s grandfather has been systematically squeezed by Bernanke & Co.’s zero interest rate policy. Ten years ago, when he retired, he had a decent little nest egg of almost a million dollars that was invested in safe mid-curve bonds. Back then, 5 year US treasuries were yielding over 5% and he could comfortably earn $50,000 to fund his modest lifestyle. However in the last decade, the yield on safe bonds has gradually been reduced to comically low levels. Harpo’s grandfather was forced to either move back in with his kids, or venture out the risk curve in an attempt to pick up yield. Being a proud man, Harpo’s grandfather listened to his financial advisors who introduced him to a brave new world of fixed income products.
High yield ETFs, leveraged bank loan ETFs, oil & gas MLPs – you name it, if Harpo’s grandfather could pick up yield, he bought it. And Harpo’s grandfather was by no means alone. After all, what choice do these retirees really have? They need to produce income.
I have been worried about this new breed of high yield investor for quite some time. They have ventured out the risk curve at the exact wrong time.
For example, one of Harpo’s grandfather’s favourite position is the PowerShares Senior Loan portfolio ETF. His advisor sold it to him as a great t-bill replacement. They are senior loans, so the risk is less than high yield bonds. It has an indicated yield of almost 4% and was supposedly safe enough that Harpo’s grandfather could sleep soundly at night.
As you can see from the shares outstanding, this has been a very popular trade. The shares outstanding went from 10 million at the start of 2012 to 300 million two years later. The trouble is that these purchases were all done when the loans were already fully priced.
The idea of buying leveraged loans is a decent one. But do you really think that by the time Wall Street has figured out how to package them up and stick them into a hot ETF that there is any value left? Or do you think that maybe this might have been the perfect way for the sharks to unload their positions?
These loans were priced for perfection. The credit was too tight. The interest rate portion had limited upside due to the minuscule yield. The best that you could probably have hoped for is that the price went sideways and you earned the yield.
But the problem is that the loans have not gone sideways. The price has started to fall. The majority of the buying of this ETF was probably done between $24.50 and $25.00. Today the price is $24.13 and few holders are onside.
Credit spreads are widening out almost across the entire corporate curve.
This is the result of a bunch of different influences. The Fed’s withdrawal of liquidity, and the backing up of the short end of the curve is weighing heavily. It also doesn’t help that companies are taking advantage of the relatively low rates and issuing bonds at a blistering pace. I think that the past week there was an all time record amount of corporate bond issuance. On top of that, the terrific stock market performance of the past year has convinced the retail investor that maybe the coast is clear and that buying stocks is a good idea. They had previously been hiding in fixed income, so at the margin they are selling fixed income to buy stocks. And finally, the plunging oil price has definitely had an influence on the high yield market as there has been an awful lot of debt issued to fund the shale oil boom. Suddenly that debt doesn’t look so secure.
Add it all up, and you have the beginnings of a shaky credit market. Yet so far, the declines have been manageable.
However, don’t forget about how many Harpo’s grandfathers there are out there. These investors did not enter into these risky instruments out of choice. They reluctantly took more risk, and as the downside becomes evident, they are going to panic. The proliferation of fixed income ETFs during this last cycle has been immense. There was a demand for yield, and Wall Street did what it does best – they created supply. As my old boss loved to say, “they filled them like a butter tart” (he was from a different era…)
The high yield market is a disaster waiting to happen. Harpo’s grandfather should have just moved back in with his kids…