Saturday, 23 June 2018

Time for the Fed to vote for Christmas, the turkeys never will

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  • James Saft - June 2014

James Saft on whether the Fed should hold fire.

Just as turkeys are opposed to Christmas on culinary grounds, so investors in risky assets like junk bonds are forever and always against interest rate hikes.

There are several plausible reasons why the Federal Reserve, expected to lift rates from zero on Wednesday, might weeks ago have signalled a delay, but a bit of a sell-off in higher-yielding corporate bonds does not qualify.

Lucidus Capital Partners, a high-yield credit fund, said on Monday it would give investors back US$900m it managed, following close on the heels of upsets at other funds; Third Avenue Capital, which shut a similar US$788m fund and hedge fund Stone Lion Capital, which suspended redemptions.

All were hit hard not just by declining fundamentals of the bonds they held, particularly those in the hard-hit energy sector, but also by growing illiquidity in the market.

This sparked a certain amount of talk that the Fed ought to hold fire, as well as dark comparisons to the beginning of the subprime debacle in 2007.

“I’d have to believe that if they met today that they wouldn’t raise rates,” bond fund manager Jeffrey Gundlach of DoubleLine Capital told Reuters on Friday, citing the accelerating sell-off.

Is this a sign that investors should lighten their exposure to riskier assets? Yes, but that sign was already flashing for weeks on end as the Fed prepared to hike.

Is it a valid reason for the Fed itself to delay interest rate hikes? Surely not, not if we look at the broader picture.

Firstly, with energy issuers comprising about 15% of the junk bond market, much of the weakness in the sector is tied to a phenomenon, falling energy prices, which if anything is a support to the broader economy, putting more money into consumers’ pockets.

As for the comparisons to 2007 and subprime, it falls apart in two important ways; it isn’t tied to the banking system in the way housing was, and corporate debt hasn’t got the layers of embedded leverage in the investment structures to anywhere near the extent that subprime bonds did. So the fact that the high-yield market is now larger than subprime was in 2007 is beside the point.

That leaves less scope for contagion, though obviously it is fair to expect a certain amount among riskier asset classes like equities.

Sunk costs

Which is not to say the Fed and its seven years of zero-interest-rate policy are not implicated in the high-yield sell-off. They most certainly are, and it is no coincidence that high-yield and leveraged loans as an asset class have more than doubled, to about US$2.2trn, since before the financial crisis.

The Fed’s hair of the dog remedy for the great recession was predicated on tempting investors into speculations which might themselves create more economic activity. That worked, sort of, but there was inevitably going to be a butcher’s bill to pay.

“Essentially, no one should really be spooked by the prospect of investors losing money from having taken risks that didn’t work out,” George Magnus, senior economic advisor to UBS writes.

“Higher rates are part of the toolkit of financial stability, perverse though that may sound to finance professionals.”

There are interesting lessons to be drawn from the high-yield market, but these are conclusions that regulators and observers have been drawing for quite some time. One is about liquidity, which was never ample in the high-yield market, a fact that investors in supposedly liquid instruments like exchange traded funds tended to elide over.

Liquidity in financial markets is worse in some respects than formerly, but this is a feature of a safer banking system rather than a bug of new regulation. The only problem is it implies a lower value for bonds and tougher selling conditions for those whose business that is.

Rather than expect the Fed to re-arrange reality to suit the sunk costs of investors we might instead spare a moment to regret the poor use to which so much of the borrowed money has been put.

While a lot of money has gone into energy development which now looks highly doubtful, those were investments which seemed reasonable at the time. Much of the money from both high-yield and the corporate bond market generally has gone, not to productive investment, but to financial engineering.

Companies commonly use the proceeds from bond issues to fund buybacks or dividends, flattering earnings and potentially increasing their stock price but doing nothing to make a company a better longer-term bet.

Markets will fall, and loss build upon loss, but the real policy error by the Fed would be to hesitate.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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