New York, New York
The not-so-closely watched ISM New York Index (which measures business conditions in New York City) increased sharply to 68.1 from a prior 60.5. Leading the way higher was the Business conditions outlook, which rose to 70.7 vs 68.0 last month. According to the survey 60% of the respondents stated that the cost of benefits was the biggest impediment for business, while 35% blamed inflation. That 60% of the respondents blamed benefits costs as the biggest impediment is consistent with recent trends of part-time hiring.
To see a list of high yielding CDs go here.
Following last week’s strong Q2 GDP report and less dovish comments by the Fed, we saw a sharp correction in risk assets. However, when Friday’s Nonfarm Payrolls report come in at 209,000 new jobs for July, a sense of calm descended over the capital markets, well some capital markets.
Although the equity markets sold off only moderately last Friday, outflows from junk debt continued to be hot and heavy. Reports from our junk debt contacts late last Friday indicated that prices were down about two points heading into the close. However, while the weakness in the equity markets has been a new development, capital has been flowing out of high yield fixed income for nearly two months. Outflows have been torrential in recent trading sessions. According to Bloomberg News’, Lisa Abramowicz, investors pulled more than $1 billion from one class of junk bond investments last week alone. This class happens to have a large number of hedge fund and SMA participants. Data which we have observed indicate that some institutional speculators have been exiting the junk debt space for quite some time. Still, retail seems complacent.
Late last Friday, we had an email exchange with the Wall Street Journal’s Katy Burne. Although our comments were edited out of her article, comments by other fixed income professionals included in today’s junk debt article echo our own.
Our former Citigroup colleague (and Making Sense reader) Matt King said:
“Everyone is hoping to be first through the exit. By definition, that’s not possible.”
We have often used the “burning room” analogy. Maybe it is a Citi thing.
Jim Swanson, chief investment strategist at MFS Investment Management, told the Journal:
“There’s a question of what happens when everyone tries to sell [bonds] at once, and I want compensation for that.”
We agree with Mr. Swanson. However, still do not believe investors are being sufficiently compensated to take on risks which reside in the darkest regions of the fixed income markets.
The WSJ article reports:
“Tom O’Reilly, portfolio manager at Neuberger Berman, said he believes the swoon in junk bonds will be temporary. Even so, he is keeping cash levels higher than normal and reducing his holdings of riskier debt, including triple-C-rated bonds.”
We believe that the swoon in the overall junk debt market could be temporary, but damage in the CCC area of the market could be more permanent in nature. The aforementioned quotes should sound familiar as we have been advising readers very similarly for many months.
Getting out of the burning room should be a serious concern for junk debt investors. According to Federal Reserve data, dealer inventories of junk debt fell to $4.8 billion in early July. This is the lowest level since April 2013 and similar to levels seen in 2003. However, today, the amount of outstanding junk debt is about twice of what it was in 2003. The stage is being set for a potential liquidity crunch. The WSJ article contains the following account:
“Brian Connolly, co-founder of hedge fund Millstreet Capital Management in Boston, which oversees more than $200 million in assets, said he recently tried to sell $3 million of energy company bonds but couldn’t find buyers for three days. Typically such a sale takes a day at the most, he said.”
“It has become increasingly harder to trade.”
It has been our experience that getting a bid on $3 million bonds should not be terribly difficult. However, the field of prospective bidders is much thinner than in the past.
We believe investors and advisors should have conversations regarding risk and the ability of investors to accept risk and volatility. We believe that risk assets are undergoing a transition where yield-reachers exit and asset prices decline before speculators come in and pick through the wreckage.
Bad to Me
Troubled Portuguese bank, Banco Espirito Santo, was forced to seek a rescue by the Bank of Portugal. As a result, Banco Espirito Santo will be broken up into a “good bank” and a “bad bank.” As a result; senior bondholders and depositors were left unscathed, subordinated bondholders face losses (principal haircuts) as European regulators try to avoid leaving taxpayers on the hook for bank rescues. Shareholders and owners of the bank’s junior debt will be left with Banco Espirito Santo’s most “problematic” assets, including loans to other parts of the Espirito Santo Group and the lender’s stake in its Angolan unit, according to the Bank of Portugal. If this “rescue” occurred next year, after new banking regulations go into effect, even senior bond holders would have been subject to losses.
It is imperative that one understands in what one is invested. This means knowing the bond’s issuer, but also understanding what one’s principal protection may or may not be. Bond Squad is here to help.
The Island of Misfit Bonds
Last week, municipal bond market participants became concerned that the Puerto Rico Electric Power Authority might be forced to restructure its debt unless it was permitted to defer bank loan payments. Last Thursday, PREPA was granted an extension until August 14, 2014. We believe that PREPA is playing for time, but it appears increasingly likely that PREPA might be forced to restructure its debt. As a result, S&P downgraded PREPA debt to CCC. Moody’s published a report stating that Puerto Rico could run out of liquidity by next June.
We believe that investors in uninsured Puerto Rico debt have two realistic choices. One is to sell holdings and move on. The other is to hope for a rescue or an attractive restructuring. We cannot say whether or not a rescue would be forthcoming as it would require political decisions. We would not hold our breath waiting for a rescue. We would view all uninsured Puerto Rico debt as we would corporate junk bonds. B and CCC-rated debt should be viewed as a speculation on recovery while Puerto Rico Commonwealth G.O. and sales tax revenue debt (Cofinas) could be considered as an aggressive and volatile way to generate income. However, all uninsured Puerto Rico debt is not for the faint of heart. We consider all uninsured Puerto Rico paper as unsuitable for moderate and conservative investors. We believe that bond insurance should be there to protect holders of insured bonds.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC