“Bond Girl“, Kristi Culpepper, an expert on capital projects chimed in on junk bonds recently. For all the talk that this is “not 2008” again, Culpepper claims what’s happening in junk bonds is not unlike what happened in the housing bubble.
Let’s tune into her article The Great Paper Chase in Reverse to see the parallels.
If you take a step back and look at the new structure of the bond market, what has been happening is not all that different from the model of lending that contributed to the housing bust. I know — hold on, let me explain.
Central banks drove interest rates into the ground and kept them there for years. One of the explicit purposes of this policy was to discourage hoarding and get investors to take on more risk. And a great yield chase began.
Wall Street did what Wall Street does in response — it created a myriad of new products and investment vehicles to organize demand for lower rated, higher yielding paper and facilitated as much new borrowing for those issuers as possible. Thus, the amount of high yield debt issued in this credit cycle has been multiples of what was issued in previous years.
And as Lorenzen observed, most of the debt was being passed on to credit tourists — investors who are incapable of assessing the risks involved with the debt, and likely did not care so long as the vehicle they were investing in provided liquidity. Sound familiar?
The fragility of this system is on full display now. From TCW’s January High Yield Update, here is a chart of high yield fund flows on a monthly basis. High yield funds have had 10 months of outflows in the past 11 months.
It seems like it is is impossible to spend fifteen minutes on Twitter without someone talking about how concerns over commodities prices have “spilled over” from energy to non-energy sectors in high yield — with the suggestion, of course, that these credits are being unfairly treated and are perhaps investment opportunities.
On the contrary, this is exactly what you would expect from a bond market governed by hot money as fears of a global recession take hold and there is a general flight to quality (compounded in effect by the introduction of experimental negative interest rate regimes).
Bonds that are actually trading at distressed levels do not reflect a broad spillover effect either. Here is distressed debt by sector (from Markit’s Distressed Bond Numbers Rising at an Alarming Pace)
In fact, it looks to me like we are seeing increased differentiation in credit for the first time in a long time.
As we’ve seen, more traditional banking activity has been pushed off to the shadow banking system, which is where the last financial crisis started. I suppose we are testing the “safety” of this system right now.
So, does that mean it’s 2008 again? Perish the thought.
For those in need of a laugh, please consider Pater Tenebrarum’s extremely humorous post “Experts Agree: It’s Not 2008”.
Mike “Mish” Shedlock