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There Shall Be No Yield

Governments around the world are literally up their eyeballs in debt.  They need to find a way out of this situation, and debasement of currency is the best means of accomplishing this.  Tax increases or spending cuts could conceivably work too, but the levels of change required would be so untenable to citizens that those options are effectively off the table.  No, financial gimmickry is the only real option.

Central bankers are hard at work every day doing their very best to help make this happen by insuring a continual flood of liquidity.  Many investors may feel they are experiencing a déjà vu moment, harkening back to 2005-2007, when a similar flood of liquidity led to an asset value bubble that ultimately collapsed. There is a major difference this time around that will insure that the same collapse will not happen.  Back then a good deal of the global liquidity was provided by a highly leveraged system that was facilitated by institutions like Lehman, Bear Stearns, the former Goldman Sachs, the former Merrill Lynch, and the former Morgan Stanley, all of whom were untethered to the Fed and its money printing press.  Today the financial system is surely highly leveraged, but is mostly tethered to the Fed’s printing press.

That is not to say that a collapse cannot occur, only that if it does it will manifest differently.  The current flood of liquidity has led to incredible yield compression in the financial sector.  Investment risk is being boarded by investors today at levels that make little sense when taken in recent historical context.  Junk bonds, for example, cracked the 5% level this past week, with newly issued debt priced with yields in the 4’s.  Analysts take comfort, in my mind mistakenly, that spreads to Treasuries are still not completely out of whack, but the problem lies in the absolute yield levels.

I ask myself, with the 10 year UST yielding 2.6%, and the after-tax return closer to 1.5%, who in their right mind would choose that return/risk over just holding the cash and earning 0%?  The marginal gain of 1.5% in yield just is not worth the risk that rates might increase and destroy principal value.  Some might say that I’m missing the point here that no taxpayers buy this bond; only the Fed, their bank clients, and sovereigns, none of whom have any real choice.  This might be true, however, the rub is that the rest of the financial instruments that people do buy have yields that are all priced off of the UST.  So, when you add a normal spread by historical standards to the gimmicked too-low yield of UST, investors are buying only trouble.

Pension funds require a yield level for their portfolios, generally estimated around 7%, in order to meet their liabilities.  To have a prayer of obtaining that, just imagine the sort of risks that they and their designated investment managers must take when considering where junk bonds are yielding.  For now, ultra-low interest rates make everything look OK.  Borrowers of all sorts have been rescued.  Formerly underwater commercial real estate borrowers, homeowners, corporations, etc, etc, that would struggle to meet debt service obligations with rates at 6-7% can do so at 3-5%.  In this world there is no distress, and there is no yield.  Opportunists and yield seekers are forced to buy things like Spanish defaulted mortgages in bulk, praying for the day that Spain’s economy rebounds and creates many jobs that facilitate broader home buying.  This is what the search for yield has come to.

The race is on.  If the governments and central bankers and opportunistic investors playing the leveraged investing game get lucky these ultra-low rates will finally inspire real economic growth that will enable borrowers to pay higher, more normalized debt service levels and there will be no cracks or distress.  If that growth doesn’t come, ultimately borrowers will not even be able to pay at the 3-5% debt service levels and defaults will ensue, which negative effect will be multiplied significantly by the leverage currently being deployed by investors striving for targeted yields.

The recent signs from China, formerly thought to be the world’s engine of economic growth, is not comforting.

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