Last week made me think of a scene from one of my favorite movies, Frank Capra’s It’s a Wonderful Life (I am a sap).  Early in the movie, there’s a scene of a bank run on the Bailey Building and Loan.  Bank runs were very common leading up to the Great Depression.  There would be some catalyst that would cause some investors to want to pull out their money and in the process this would cause more people to want to pull out their money and before you know it, that institution would become defunct.  If things got bad enough, it would not just be that institution affected, but other related institutions.  And if things got really bad, even completely unrelated institutions would be affected and the entire financial system would freeze up.  It took a while but we found some ways to significantly reduce bank runs, via a system of deposit insurance, capital requirements, and central banks being the lender of last resort.

 

151214 CCC 5 yr spdInterestingly, there is no real “backstop” for other investment vehicles, like say, distressed bond funds.  I suppose you can incorporate some local measures like slowing/stopping withdrawals, but those are not the same as having a broader set of measures.  You have minor catalysts, like the Fed raising rates, oil/commodities plummeting, a global climate deal, next week being the first quarter moon, whatever.  You have whispers of some funds in trouble, and you have a fund close, another restrict redemptions, and the selling just builds on itself.  Add some folks like Messrs Icahn and Gundlach throwing gasoline on the fire, presumably first positioning themselves accordingly, and you’re created a crisis.[1]

 

I want the focus to be on high yield markets.  I’m no expert, but there’s probably a reason these things are called “junk.”  Otherwise, they would have been called “investment grade,” which literally means “worthy of investment.”  The junk chart everyone focuses on is this one on the right.  Yes – it does appear that we are doomed…  CCC bond spreads have gone to the moon!  Or has it?

 

151214 CCC max spdI would like to present to you two other charts.  The first is the chart on the left, which shows this same exact data set over a longer period.  Are the current levels really that horrible?  I’m not saying the current levels are great, especially when factoring in how low the yield on Treasuries are.  However, you need to factor in that a large amount of CCC bonds are related to energy, mining or other commodities.  And those sectors have their own set of issues.  It’s not clear the Fed can do anything to help some oil company that is getting crushed on falling prices.

 

151214 BBB max spdThe most important chart however, is that of bonds in the adjoining sector, BBB (investment grade).  Because what we really care about is what kind of contagion effects we are going to see from junk bonds into investment grade bonds.  You have to look really hard to see anything here.  I’m not saying the current situation couldn’t get worse.  But in my opinion, the media seem to be overreacting.

 

The prolonged Fed accommodation is partly to blame for the current junk bond situation… when you have low long term rates, you cause investors to go away from more conservative investments and grab for yield/return… like high yield or equities.  So it is only normal that as you take away accommodation, you should get a normalization of risk-taking.[2]  Unfortunately, the initial stages of unwinding can be volatile – especially when the Fed has been so accommodative for so long.

 

Currently, my panic-meter is probably lower than the rest of the market.  The reaction in high yield and equities are pretty much what you would expect on Fed liftoff.  I suppose the matter is complicated by oil and commodity sectors getting hit.  The key is, could a continued sharp selloff in high yield cause other things to unravel?  This is hard to picture, in an environment where the major central banks are all driving rates low.  There are people currently willing to lend Greece ten year money at 8.6%, when you KNOW they will be in bigger trouble in a few years.  I’m not sure if a bunch of speculative oil company bonds going to zero is that terrible for the economy as a whole.  Defaults happen – that’s why investors get a premium over Treasuries.  Look for signs of distress in BBB before overreacting to CCC.

[1] This may or may not be intentional – there’s a fine line between speaking your mind and intentionally trying to manipulate the markets (later post).

[2] Interestingly this hike will not have as large an effect, since the long end refuses to sell off.  But that is a story for another day.