August Review: Yield Chasing Everywhere

Jonathan Rochford

Narrow Road Capital

The key theme for August was yield chasing, with evidence of it seemingly popping up everywhere. Articles from UBS and BAML pointed to this in the credit markets, with the Wall St Journal noting that catastrophe bonds are another area that has seen spreads fall sharply. European coco’s are back in favour with recent sales seeing order books ten times the size issued. The fears earlier this year that Deutsche Bank would have to skip payments and the expectation that Bremen Landesbank will skip its payments shortly haven’t turned off yield starved buyers.

To get just a little bit more yield foreigners are going long duration in US debt. Japanese investors have been fleeing their home market and its negative yields with US mortgage debt the latest target. Money is going the other way though, with Pimco and Chinese investors buying Japanese bonds as after they include the pick-up from the currency swaps they are getting positive yields. If you want to understand why this is happening here’s one investor explaining why he is buying preference shares because bond yields are so low. If you are tempted to join the herd here’s five reasons not to chase yield.

The gold medal article on yield chasing included the following quote: “Which is riskier, buying a double-digit yielding sovereign bond or buying a negative-yielding government bond? I’ll take the yield any day, knowing that there’ll be some volatility but knowing that over time you’re going to make a lot of money.” The portfolio manager at Legg Mason is right in the short term, that trade will generate more yield. But if the bonds default and he gets a 10% recovery rate he and his investors will learn that there’s no free lunch.

Behind the yield chasing lies central banks, who haven’t yet realised that the drugs don’t work, they just make it worse. Central bankers are from the same group that brought us LTCM; academics without market experience. They rely on models and untested theories rather than opening the window of their ivory towers and seeing the havoc they have created in markets. The Chairman of the Rothschild Investment Trust labelled central bank actions “the greatest experiment in monetary policy in the history of the world”. One headline on Bloomberg illustrates the problem, “Central Bankers Spurn Call for Radical Approach at Jackson Hole”. A rational person would take that to mean dumping negative interest rates and quantitative easing, but no, those policies are only considered “unconventional” now.

The enormous purchases of government and corporate debt is crowding out European investors, who’s capital has to head elsewhere. This cascades through investment grade debt, high yield debt and then to equities. When combined with low reserve rates asset valuations get pushed ever higher. A real estate mogul noted the impact of cheap debt and said that US real estate is “bubblicious”. Citibank detailed six ways that central banks have distorted markets.

Central banks are no longer just part of the investment environment, they have become the key factor in it. Investors no longer just ask what will Janet Yellen do, but what can she do without wrecking the global economy. High yield and emerging market debt sectors are already unstable. A series of interest rate increases could kick a leg out from under those chairs. It’s not surprising that many investors have concluded that rates will never increase materially, because the damage would simply be too great.

Another key theme for August was the very low levels of volatility. Jesse Felder noted that short volatility positions could be wiped out with one day of large falls. Most would take that to mean that now is a terrible time to be selling put options, but US pension funds are doing that as a new way to generate returns. Over a cycle, selling options and being long volatility pays off. But for a pension fund it means that you are even more exposed to the downside, particularly if there’s a sharp sell-off. It looks like a double or nothing proposition, to cover the underfunded position more risks are taken but if assets sell-off the underfunded position get an awful lot worse.   

In a world where interest rates are trending lower the recent spike in LIBOR is notable. Some view it as concerning as a spike in LIBOR preceded the last financial crisis. This time it seems there’s a basic explanation for the increase. The strange beasts that are US money market funds are undergoing reforms that require daily mark to market on unit prices, unless all the securities owned are government debt. That change has seen a major shift out of commercial paper issued by corporates to short term treasuries. As a result of the loss of buyers the interest rate benchmark for those securities, LIBOR, has jumped. There are differing views on whether the higher levels will hold or whether supply and demand will balance in future months and LIBOR will then drop back down.

In the short term this is bad news for corporates and banks that rely on LIBOR linked securities for funding. They will most likely shift to issuing longer term fixed rate bonds, which is better for their liquidity profiles and will have a more stable interest rate. It also impacts some leveraged loans, which pay a margin on top of LIBOR. However, as 91% of leveraged loans have some form of LIBOR floor not many will have seen a material interest rate increase. The biggest losers appear to be Asian debt markets and CLOs. CLOs have seen their net interest margins squeezed as the interest rates they pay increases, but the interest rates they receive largely hasn’t. This is another concern for CLO investors, in addition to the increasing number of defaults and lower recovery rates. 


High Yield Debt

There’s been many warnings on US high yield, with detailed analysis from Marty Fridson well worth a read. The numbers are simple; margins have fallen whilst defaults are rising and recoveries this cycle are particularly ugly due to the near wipe-out results common for defaulting energy companies. Without a dramatic lift in oil and natural gas prices, many more energy credits will default. Fitch has 49% of their “loans of concern” list from this sector.

Non-energy credits are also seeing their margins at tight levels, even though defaults there are rising as well. US corporates have never been more indebted and when the cash balances of a handful of elite companies are excluded cash balances are low. Michael Lewitt called the current credit environment “the late stages of the Ponzi finance”. With so much dry wood a bonfire is inevitable, but the timing remains unpredictable. One article tried to put a positive spin on this, arguing that high yield is bad but equities are worse.

Amongst all of the silliness Australian alternative credit remains an island of opportunity. While many fund managers are worrying about whether they can justify buying overpriced assets, I’m making choices about where to spend my research time on a list of great value opportunities. I caught up with a founder of an Australian fintech lending business and we were sharing stories about why non-vanilla Australian credit remains under appreciated.

My summation is that many Australian institutional investors are scouring the globe for trophy property and infrastructure assets all the while ignoring that Australia is arguably the least competitive developed credit market. Australian banks having the highest return on equity in their peer group is the most obvious proof of this. The one risk that would change this is our overpriced housing market. Whilst the risk appetite has been reigned in for foreigners buying apartments locals can still borrow more than they can comfortably service.


Government Debt

John Mauldin correctly noted that Italy’s upcoming referendum on large scale economic and political reform is a very big deal. Something needs to change as without it Italy is tracking towards default. Portugal is looking like it will need another bailout. Illinois might be on the road to bankruptcy, but it is planning to issue AAA rated debt by diverting sales taxes for this new class of debt. That’s bad news for the holders of general obligation bonds as they see their revenue streams further reduced. One article compared today’s highly indebted governments to the tech boom’s posterchild for hubris



Signs are emerging that China’s economy is slowing more than expected. The larger than forecast fall in imports indicates weaker domestic demand. This aligns with the slowdown in credit growth, which was at the lowest levels in two years. Copper imports have fallen to three year lows but steel prices have rebounded allowing the industry to return to profit. Cathay Pacific posted ugly results noting that travel in and out of Hong Kong is weaker.

The crackdown on hedge funds is expected to see 10,000 funds close, with 40% of all funds thought to be fraudulent. It will be interesting to see the reaction of investors when such a large amount of capital is written off. A potential offset to this could be more foreign investment, with the government relaxing a number of restrictions on foreign capital. Some foreigners might be scared off by the murky bankruptcy process in China, where recovery rates tend to be all or nothing. Credit investors are fighting back, rejecting debt to equity swaps. Some in China are hoping that the development of a CDS market will help troubled companies access more debt, it’s more likely to attract foreigners looking for a way to short unsustainable businesses.

A listed peer to peer lender that had previously seen a huge run up its share price fell 35% in four days. The Chinese super-bus is in trouble, its funding came from peer to peer loans and investors are asking for their money back. The banking regulator is again telling banks not to withdraw lending from troubled companies. Several Chinese provinces have compiled lists of zombie companies but aren’t telling banks who’s on the list. In sign of just how underdeveloped credit markets are the banks are complaining that the list is being withheld from them. In more developed markets the banks know who the zombie companies are and the government and regulators are trying to find out.

The Chinese central bank is concerned about creating a liquidity trap and is asking for more fiscal stimulus. The level of stimulus is already very high, with government debt and deficits much higher than generally thought. The spike in fixed asset investment by state owned entities is slowing whilst private sector investment is now negative. The quality of that investment remains dubious with a UBS economist noting that “malinvestment is still hard at work”. Harry Dent sees China as having the “mother of all bubbles” in its property markets. 

On the surface Chinese banks appear to be in decent shape having very healthy returns on equity. However, Bloomberg’s case study on the Bank of Tangshan shows how there is more than meets the eye. It’s profits and capital ratio of 11.25% indicate all is well. But most of its lending is via shadow loans, which inflates the capital ratio. Tangshan has 59% of its lending in Caofeidian, an industrial area that has been referred to as a ghost town. Yet its balance sheet shows a non-performing loan ratio of just 0.06%, amongst the lowest in the world. It’s not hard to see why many credit experts are tipping a credit crisis for China.


Emerging Markets

There’s been no lack of articles about the flood of money into emerging markets. One writer thinks there isn’t enough EM bonds to meet the demand. EM debt has returned 7.6% in the last three months and US global debt funds now have their highest exposure to the sector in the last four years.

Mongolia appears to be rapidly heading towards a default and IMF bailout after its debt to GDP has gone from 26% to 78% in six years. The trajectory is awful with the budget deficit forecast to be another 19% of GDP this year. Adding to the unsustainable debt load of Venezuela was a decision to award $1.2 billion in damages to a Canadian miner that had its mine in Venezuela nationalised.

The credit default swap auction following the default of Puerto Rico set a recovery rate of 58.5%. That might prove to be the high watermark as the territory’s pension system is massively underfunded which points to debtors being crammed down so pensioners get paid. The legislation passed by the US for Puerto Rico’s default is particularly punitive on creditors with no default interest allowed, secured liens can be involuntarily swapped for deferred payments and far beyond normal blocks apply on ipso facto clauses. It’s one thing for debt investors to be subordinated to employees and pensions in a bankruptcy, it’s another thing altogether to trample on their legal rights to collect their debts. Sovereign debt buyers take notice, this is what happens when you lend to people who also make the law.


Private Equity and Hedge Funds

One scathing criticism of hedge funds is that they have forgotten how to make money for investors and have forgotten how to hedge downside risks. In a turnaround from results last year small funds are outperforming large funds. This isn’t surprising as the flows into the mega funds have only served to make them less nimble, which is a great enemy of funds management returns. An example is the massive increase in capital in merger arbitrage strategies, which has pushed down returns. The negative commentary has turned into outflows with the biggest month of outflows since 2009. Bloomberg noted that hedge fund outflows are concentrated in long/short equity strategies.

Blackrock’s fund of hedge funds is looking to invest with managers who will charge a 1% management fee and 10% performance fee, rather than the stand 2% and 20%. In what might be the start of a sea change Steve Eisman (one of the managers profiled in The Big Short) is now at Neuberger Berman managing for a flat 1.25%. It looks to be an ideal time to be backing managers with credentials in shorting overpriced assets.

Private equity funds are also struggling to justify their fees with a major study finding that US private equity funds haven’t beaten public markets over the last decade. US regulators fined Apollo $52.7 million for failing to disclose monitoring fees it charged to the companies it had bought. It’s no wonder Australian retirement funds are at war with the private equity industry over fees.


Autos and Uber

The US auto sector is facing a series of headwinds that will play out over the next ten years. In the short to medium term excess inventory levels and subprime auto lending are unsustainable and will reverse. Subprime auto lending has gotten so bad that John Oliver of Last Week Tonight covered it. Incentives are spiking in the US and China in order to keep sales at elevated levels. Add in the potential for a recession and the car makers could see a repeat of the awful sales in 2009 all over again.

In the long term, self-driving cars are set to revolutionise the need for car ownership. One study found that US car owners only used their vehicles 3% of the time. That’s an awful lot of slack capacity that a fleet of self-driving cars would be able to monetise. Add in the ability to ride share, where technology will pool customers in the same suburb to share a car heading to the city in peak hour, and the number of cars needed plummets. Much of this isn’t that far away. Uber is about to start using self-driving cars in Pittsburgh and already has a ride pooling service operating in New York city.

All of these developments might seem like a gold mine for Uber and its peers. Unfortunately for them, this isn’t the case. Private car companies and applications are relatively easy to start, with the obvious way to gain market share being to reduce the standard 20% commission that Uber takes. For instance, a new business could offer to only take a 10% commission, splitting the savings 5% each to drivers and customers. There’s little to keep drivers or customers loyal to a particular platform. In the most profitable markets, this is already happening with new providers springing up in New York City and San Francisco. Uber’s $62.5 billion valuation at its last capital raising seems optimistic, with one expert arguing it is only worth $28 billion. The substantial losses in the first half of this year, margin pressures and the difficulties in continuing to grow revenues at the current rate are the key issues.



The big news in regulation this month was the whistleblower formerly at Deutsche Bank refusing his share of a $16.5m award.  In an article for the Financial Times he wrote “I will not join the looting of the very people I was hired to protect" and “we must protect shareholders from executive wrongdoing” The backstory is that Deutsche Bank was inflating the value of derivatives during the financial crisis in order to make its very low capital levels look better than they were. The whistleblower reported this through official channels and was fired. His gripe with the award is that it should come from clawback of the bonuses of the executives at the time. He’s got a very good point as those executives would have benefited from higher bonuses as a result of the lower losses on the derivatives.

Despite the unusual rejection of the award, the process illustrates where ASIC and others who insist Australia shouldn’t have a similar reward scheme get it so wrong. This Bloomberg article nails it with “the whistle-blower's dilemma is usually easy to understand, if hard to solve. Choose the ethically honest path and you face ostracism and the sack; head down the less honest route and you may have more job security and better promotion prospects.” The Wall Street Journal quotes from a lawyer who works with whistleblowers “whenever there’s a big award there’s an uptick of filings and submissions” and “those large awards show these programs work, and that the risk of stepping forward may be a risk worth taking”.

The experience of the IOOF whistleblower is a chilling example of how ASIC and the Australian system treats those who seek to right wrongs. The whistleblower was fired and was subject to a smear campaign by IOOF management. ASIC ignored the whistleblower and chose not to fine IOOF for its misconduct. When asked what he would do if he had his time over again the whistleblower said he’d go straight to the media. Management of many big businesses and ASIC simply can’t be trusted to deal with whistleblower reports efficiently and fairly. Compare this to the US where awards of US$22 million and US$3.75 million were recently made, the latter to a former employee of BHP.

Australian journalist Adele Ferguson won another award for her work in August, this time a Kennedy award for the coverage of 7-Eleven and Comminsure. Both of these relied heavily on whistleblowers to gather evidence. She’s arguably been the biggest winner from CBA stuff ups also winning a Walkley Award for exposing their financial planning scandal. CBA management hasn’t been a loser from all of this though as the CEO received $12.3 million in salary and bonuses last year. As long as the management that presides over misconduct keeps their jobs and gets bonuses and whistleblowers get fired for doing the right thing there won’t be any meaningful cultural change.

If we are serious about tackling corporate crime, we need more whistleblowers. There’s three things that are needed to encourage whistleblowers to come forward:

(1) an ability to remain anonymous;

(2) financial incentive for taking career risk in reporting criminal activity and misconduct; and

(3) an expectation that their evidence will be taken seriously.

The US system can offer all three but ASIC currently offers none of those. Whilst the first and third items could be easily addressed if ASIC was concerned, the second is far more problematic. Until ASIC has a track record of issuing large fines there’s unlikely to be any money available to reward whistleblowers. Without that, whistleblowers face a high probability of downside and virtually no probability of upside, making the risk of reporting unacceptable to most.  

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Jonathan Rochford
Portfolio Manager
Narrow Road Capital

Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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