As the corporate loans approach maturities, companies have been refinancing them by issuing bonds (some $60 billion of HY issuance has been used to pay down loans this year). With demand for fixed income continuing to surprise on the upside, new bond issuance has been quite strong.
However some weaker, more leveraged, or less known names, had to use a trick to entice investors. As the collateral pledged for loans got freed up (with loans getting repaid), the companies pledged it to the new bond holders. These are the so-called secured bonds, and unlike standard corporate bonds which are general obligations of the company, these bonds have specific collateral pledged against them. Nearly 40% of recent bond issuance has been in secured bonds.
The chart below shows that such bonds were generally used as a refinancing tool (instead of capital investments or acquisitions.)
source: Thomson Reuters
The question still remains whether this is a long-term trend. It would mean that the leveraged loan market at least in part is getting replaced with secured bonds. But demand for leveraged loans also continues to be high, especially as some existing inventory is getting paid down. If the loan syndication market recovers, secured bonds may become a temporary phenomenon.
Remember California IOUs? Other states are starting to face budget realities as well. Reliance on easy credit and credit related tax revenue created a spending momentum (bordering on criminal) that's about to hit a wall. Debt maturities are looming.
NY Times: Without a budget deal, New York will be left with just $36 million in the bank by the end of December, according to current projections.
The state muni CDS markets are starting to widen, as reality sets in. In the chart below we exclude California and Michigan, as their problems have already been well publicized.
State financing is relatively simple. Many states can not run deficits by law, and even those who can will end up paying increasingly wider spreads. The two remaining choices are raising taxes or cutting budgets. Raising taxes only works on the so-called "wealthy" (as NY did in April), otherwise there will be a revolt in this environment. The "wealthy" in states like NY have enough mobility to simply move to other states, reducing tax receipts to the state further. And even if they don't, the impact of such tax hikes is generally insufficient to move the needle. Tax hikes also damage businesses and reduce hiring.
That leaves spending cuts. But employees of many states have significant influence over state politics, including influence over governors and state legislators. Those politicians who cut budgets - particularly if they cut state jobs - will simply not see another term. New York's Paterson for example knows he will not get reelected, so he has the guts to do the right thing and implement the cuts. The legislators however will fight him on this to the last minute. Other states will hit this wall soon as well, and more state IOUs (instead of cash) are sure to follow.
The latest JPMorgan survey of institutional clients continues to show elevated inflation expectations. The majority of those responding believe inflation in the US and the UK will run above targets.
source: JPMorgan
Curiously, more than the central bank policies, it is the fiscal policy that is viewed as the largest contributor to inflation risk. Apparently institutions view government spending driving inflation more than low rates and quantitative easing by central banks.
Amazingly, the primary CLO market, which has been shut down since late 2007, may be making a comeback in 2010. The volumes will be a fraction of the peak, the capital structure will be simple, and the equity structures will be thicker, but the deals will get done. Unlike other securitization markets such as ABS and CMBS, it seems that the vast majority of the original AAA tranches will get their principal back in spite of record levels of corporate loan defaults. The AAA subordination of 25-30% has been sufficient to cushion the senior tranches from principal losses. In addition, deals that have had a relatively large portion of their collateral default or get downgraded have been forced to start using income to down the AAA principal, amortizing/deleveraging the transactions early. These facts may bring institutional investors back into the market.
The secondary CLO market spreads have come in dramatically as the chart from Citi/Reuters shows.
In order for the primary CLO market to work, the spread between the leveraged loan yields and the AAA tranche rate has to reach a level that will make the "excess return" attractive. As an analogy, consider what happens if you were to buy a rental property. If the monthly payments on the loan you take out is higher than the rent you collect on the property, you would never buy the property. In fact the differential between the rent collected and the interest expense on the loan has to be attractive enough to make you want to put down a downpayment on the property. In this analogy the CLO equity tranche is the "downpayment", the AAA tranche is the mortgage on the property (with lower rated tranches being "second mortgages"), and the collateral portfolio of corporate loans paying interest representing the property paying rent.
To make the equity returns work, one needs a relatively low financing spread ("mortgage rate") and a sufficiently narrow equity tranche (the "downpayment"). The chart below illustrates the expected return levels (roughly) as a function of the financing spread (blended spread of all the tranches above the equity).
The three lines represent the different equity tranche thickness ("downpayment"). As the AAA tranches continue to tighten in the secondary market, at some point the return on equity starts to make sense for some investors and the new transactions would get done. This may be the first securitization market that comes back (even as a shadow of what it used to be) without government (TALF) assistance.
2009 was the year for major structural changes at hedge funds. According to the latest E&Y survey of hedge funds, lowering the management fees has been one such key change. Apparently the majority (87%) of managers has lowered their fees or plans to do so shortly. For those who are fans of Venn diagrams, the chart below is a good illustration of the structural changes taking place.
source: E&Y survey
Coincident with the fees dropping are the increasing lock-up periods. As existing lock-ups end and redemptions loom, managers are trying to extend the lock-ups in exchange for fee reductions to attract/retain investors.
In order to address the "too large to fail" issue the Fed has begun a campaign to promote their solution: some form of a resolution regime for systemically significant financial firms. The Fed's goal is to broaden their regulatory reach and to prevent the US Congress (filled with populist fervor) from trimming the Fed's power. What the Fed is proposing is actually a complex piece of legislation that will span beyond the banking industry. It has the potential to engulf large insurance firms, financial advisory and securities firms, and even asset management firms.
Dan Tarullo's speech (included below) provides a good outline of such legislation. Other Fed governors are starting to carry the same message as part of their campaign to vastly boost the Fed's powers. You can see it gently inserted on slide 26 in James Bullard's recent speech for example (see included). Here are the three pillars of this special resolution process:
1. When the Fed determines that a institution that is on their too large to fail list is about to fail (or take some other action that threatens the financial system), the central bank would invoke the "special regime" to take control of the institution. The Fed would then have a broad authority to dissolve or restructure this company, including liquidating assets and businesses, as well as the ability the ability to set up a temporary firm to purchase and "warehouse" certain assets. Note that this is similar to the authority the FDIC holds in dissolving banks they regulate.
2. The shareholders and some creditors of the failing firm would bear the losses associated with this process. It's not clear to what extent the creditors would be hurt by this, because The Fed would clearly have to step in and guarantee some of the liabilities of the organization (for example institutional bank deposits or repo financing). Otherwise such liquidation may be no different than what the courts would do in a bankruptcy scenario. The model may become similar to that used in restructuring the US auto firms - some form of direct negotiations with creditors. Depending on the level of Fed's independence, the process may even become politicized.
3. The Fed would set up an "insurance fund" similar to the FDIC's fund to be used in orderly liquidation operations. The "too big to fail" organizations (again not just banks) would be assessed ongoing fees to capitalize the fund. Over time the fund would be significant enough to support a failing institution through the restructuring/liquidation process.
Developing such legislation is a massive undertaking with numerous key unanswered questions such as which organizations would be deemed too big to fail, how will the creditors be dealt with, how would the regulation of these institutions be different, will this make the Fed too powerful, etc. The model of course is the FDIC's bank takeover process - but on steroids, as these institutions are infinitely more complex. Of course no matter what form this process takes, it does create a form of moral hazard by backstopping certain risks in the financial system.
Each year the meetings of the China's Communist Party heads concludes with the same number - the number 8. Culturally it's an important number in China. In Chinese mythology for example it represents the Eight Immortals.
It is also consistently the target for China's GDP growth - year after year. The Party leaders have been convinced for years that 8% is the growth rate needed to prevent any major social unrest. As long as such growth is maintained, the people will not demand democracy the way they did in 1989.
And it looks like China is on target to get to (or exceed) 8% again this year. In the past the growth was driven by exports. As the chart below shows, this year however exports are not keeping up with the GDP.
So you start hearing stories about the domestic consumer demand all of a sudden picking up the slack. Hardly. The differential between GDP growth and slow export growth is picked up up by the government stimulus programs and tremendous domestic liquidity. As an example, take a look at this post/video on the Merrill Over Matter blog. This is what happens when central planning and corrupt politicians direct capital flows (as the asset bubble continues to build). Easy come, easy go.
The goal is simple: maintain this growth rate by all means possible until the US consumer is back. That's why any concern about China refusing to roll their US treasuries positions is overblown. PRC needs the US consumer back in spending mood, in order to return to that export-driven growth (at least in the near-term). Keeping the funding flowing to the US and dollar rates low is key to get the export growth back to historical trend. Whether and when this will actually happen is another story.
The 3-month T-bill yield has collapsed to new lows, yielding half a basis point.
That means if you plow a million dollars into 3-month bills right now, in 3 months you will walk away with your million plus about 13 dollars. After inflation is taken into account, you are down about $3,000 (depending on the assumptions). Why would anybody do this?
Trading desks everywhere are told - we are done for the year. We've made out money for the year; let's bring it home. Unwind as much risk as you can before year-end. And all that cash is flowing into T-bills. Except that people don't want the 1-month bill because it will mature before year-end. There is much less liquidity at the 2-month point. That means the 3-month bills are the only game in town for short-term liquid riskless paper, even if the yield is zero (negative real rates).
That bid for the 3-month paper has created an inverted T-bill yield curve.
It's a strange phenomena because this curve implies negative forward rates (so much for the so-called "arbitrage-free" interest rate models). This means the market sees short term yields going negative before the end of the year (this happened in Japan a few years ago). One way to interpret this is the market is anticipating the economy to get worse before it gets better - possibly weak holiday sales. Another is simply a sudden drop in risk appetite through year-end.
