Overheating Credit Markets
'One of the most difficult jobs that central banks face is in dealing with episodes of credit market
overheating that pose a potential threat to financial stability.'
Jeremy Stein, US Federal Reserve Board Governor
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'This is the hardest time to be an asset allocator. Normally, you find that safe-haven assets are expensive
and riskier assets are cheap – and vice versa. But today, largely because of the central banks around the
world, we've got a very distorted opportunity set, such that there is nothing you can buy and hold.'
James Montier
'We are concerned by the growing downside of zero-based money and QE policies – among them a
worrisome distortion in asset pricing, the misallocation of capital and ultimately a dis-incentivizing of
risk taking by corporations and investors.'
Bill Gross
'If something cannot go on forever, it will stop.'
Herbert Stein
'Never underestimate the value of doing nothing.'
Winnie the Pooh
RE:CM holds minimal funds in bonds at present.
This article discusses how we see the current
credit market conditions and explains why we
choose not to participate for now.
Credit markets are currently artificially priced
Both developed and emerging market economies
are currently characterised by record low interest
rates and a global search for yield. Stimulus
programmes like quantitative easing (QE)
introduced in the US, Europe and Japan have
injected increased liquidity into global financial
markets and kept interest rates low in these
economies.
Central bankers manipulate monetary policy in an
attempt to stimulate economic growth through
increased spending and bank lending. The result is
that markets distort as continuous intervention by
central banks suppresses the yields on traditional
safe haven assets and prevents efficient price
discovery. The entire yield curve shifts down
as the risk-free rates of government bonds are
depressed and yield seeking investors are forced
towards higher risk assets.
Bond investors refer to this behaviour as 'reaching
for yield', where capital is allocated to riskier
assets in order to generate the returns they were
accustomed to earning before the decline in
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yields occurred. Following the global financial
crisis of 2007/08, the main beneficiaries of excess
liquidity in capital markets have been emerging
market government bonds and non-investment
grade corporate bonds in the US, more commonly
referred to as junk bonds. Strong investor demand
and record new issuance have pushed yields in
these credit markets to historic lows. But are these
yields sustainable without the constant flow of
easy money from QE? If markets are artificially
priced then buying these assets purely for yield
will have dangerous consequences for investors
once the market normalises.
South African government bonds have appealed to
foreign investors
Along with emerging market peers, South Africa
has attracted large foreign capital inflows into
government bonds over the last few years. Why
do foreign investors like our bonds? Interest rates
are near zero in developed market economies
and emerging market bonds offer significantly
higher nominal yields. The spread of South
African government bonds over equivalent
maturity developed market bonds is appealing
to yield oriented investors searching for income
generating assets. The 'carry trade' is therefore
attractive to foreign investors as they can borrow
money at low rates in developed markets and
invest in higher yield bonds in emerging markets
like South Africa.
losses if they bought without an adequate margin
of safety.
The downside risk for foreign investors is volatility
in currency markets, where the base currency of
the country invested in depreciates and erodes
the purchasing power of foreign investors' money.
Foreign investors tend to withdraw capital from
bond markets when a currency is particularly
volatile and this was evident during the rand's
recent depreciation.
Mispricing is also evident in South African
corporate bonds
Chart 1 shows how foreign investor demand for
South African government bonds has increased
since 2008 with record issuance of around R90
billion recorded at the end of last year. Foreigners
make up just over a third of the market for South
African government bonds and the sell-off in the
local bond market over the last month showed
that a change in sentiment could easily trigger
an exodus of capital. The repricing of markets for
the normalisation of US Treasury yields once any
Fed stimulus is eventually scaled back will see
foreign investors becoming more risk averse and
thus less amenable to owning local government
bonds at their current prices. The expensiveness
of local government bonds means there's a risk of
a sharp correction when the market re-prices and
investors are likely to suffer permanent capital
With foreigners bidding yields down on benchmark
South African government bonds, local investors
have moved down the credit curve into corporate
bonds in search of yield. Chart 2 shows the recent
growth in the domestic corporate bond market.
Annual new issuance of corporate bonds has more
than doubled between 2011 and 2012 with around
R30 billion issued at the end of 2012. Total market
issuance has also increased to approximately
R122 billion and includes corporates, financials,
municipalities and State Owned Enterprises and
securitisations. Strong local investor demand for
investment grade corporate bonds has resulted in
higher prices and lower yields with new issuance
regularly
oversubscribed.
Unsurprisingly,
corporate issuers have taken advantage of cheap
financing rates
So do corporate bonds offer good value to
investors? In our view, they do not. It's important
to remember that corporate bonds price off
benchmark government bond yields. So in a
situation where government yields are at record
Chart 1: Foreign Purchases of South African Government Bonds vs. 10-year Government Bond Yields
Source: I-net Bridge, JSE, Absa Capital, RE:CM
RE:VIEW VOLUME 25
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Chart 2: South African Corporate Bond Issuance (R billion)
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Source: JSE, Standard Bank
lows and corporate bonds only provide a marginal
uptick over those benchmarks, the starting yield
isn't adequately compensating for interest rate,
credit or liquidity risk. Companies issuing these
bonds are the big winners in the growth of the
corporate bond market as they're able to leverage
or restructure their balance sheets at much lower
financing rates than those available through the
primary banks. This isn't a win-win situation. What
corporates gain, investors must give up.
US junk bond yields are plumbing historic lows
US junk bonds are trading at their most expensive
levels relative to US equities in over 20 years.
Chart 3 shows that US junk bond yields fell below
the earnings yields of the S&P 500 for the first time
ever at the end of 2012. The earnings yield is the
inverse of the price-to-earnings ratio and can be
used to compare equity and bond valuations. To
put this anomaly in context – the lowest quality
bonds are priced to yield less than the equity of
the highest quality companies. Junk bonds should
always pay a premium over equity as the risk of
default and capital loss is high enough for rating
agencies to assign a speculative grade credit
rating to their debt.
This pricing anomaly in junk bonds is a classic
example of investors reaching for yield with
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record issuance of $330 billion recorded in
2012 despite (or, more likely due to) the obvious
mispricing. Instead of attracting less capital as
yields have declined and prices have risen, the
recent performance of junk bonds has validated
investors' belief in the asset class and actually
resulted in increased market issuance. Not only is
this a sign of the market overheating, but if this
trend continues the junk bond market is well on
its way to overheated territory. As value investors
we have a preference for the more senior tranches
of debt in a high quality business as opposed to
speculative or junk bonds.
Real yields on South African bonds are far from fair
value
With bonds, what you see is what you get – yield
is the largest component of total return so it's
important to lock in a sufficiently high real yield
upfront to protect against the risk of rising interest
rates and inflation. Chart 4 shows that the average
real yield on a 10-year government bond since the
introduction of inflation targeting in 2000 is 3.2%
with average inflation at 5.9% over the period.
While inflation can fluctuate widely over shorter
periods of time the evidence would suggest that
over a 10-year period the reserve bank would be
able to manage monetary policy in line with this
historical average. Our valuation therefore uses
Chart 3: US S&P500 Earnings Yield vs. BofA ML US High Yield Bond Index
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Source: Federal Reserve Bank of St. Louis, Thomson Reuters Datastream, RE:CM
Chart 4: Real Yield on a 10-year South African Government Bond (Nominal Bond Yield Less Average
Inflation of 5.9%
Source: I-net Bridge, Bloomberg, Stats SA
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average inflation at 5.9% as our best estimate of
future expected inflation. A real yield of 3.2% is
therefore the minimum investors should expect to
earn on a 10-year South African government bond.
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The nominal bond yield on the SA 10-year bond
(R2023) was around 7.1% at the end of May which
provides a real return of 1.2% based on inflation
at 5.9%. A real yield of 1.2% is more than one
standard deviation below our estimate of fair
value, which means that the market would need to
normalise fully before we'd consider bonds to be
attractively priced.
Theoretically, government bonds shouldn't carry
any credit risk as the government has the ability
to print money or tax its citizens to meet its debt
obligations, but corporate bonds should provide
an additional margin of safety to compensate
investors for credit and liquidity risk over the full
life of the bond. This is especially important in
South Africa where bond markets aren't as deep
and liquid as our developed market counterparts.
We are watching and waiting
In the immortal words of Winnie the Pooh 'Never
underestimate the value of doing nothing.'
Choosing to do nothing isn't the same as not
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doing anything at all. The decision not to actively
participate in bond markets at this point in the
cycle is a choice we're conscious of in protecting
investors' capital and not exposing our clients
to a permanent loss of capital. Bond markets are
overheating because yield-oriented investors are
indiscriminately allocating capital to higher risk
assets and discarding the critical relationship
between price and value.
We aren't certain when bond markets will
normalise, but the recent sell-off in South
Africa and emerging market government bonds
demonstrates that valuations in global bond
markets are currently stretched. The artificial
pricing of markets through unconventional
stimulus programmes isn't sustainable in the long
term.
Economist Herbert Stein wryly stated, 'If
something cannot go on forever it will stop'. As
value investors, we believe that opportunity
comes to the prepared. The current overheating
in bond markets will provide attractive buying
opportunities when the market ultimately corrects
in the future.
Sean Neethling