Bubbles In Bond Land—-A Central Bank Made Mania, Part 3
by David Stockman • August 24, 2016
The Giant Volcano Of Uncollectible Capital Gains In Global Bond Markets
…….In short, the global bond market has become a giant volcano of uncollectible capital gains. For example, long-term German bunds issued four years ago are now trading at 200% of par.
Yet even if the financial system of the world somehow survives the current mayhem, the German government will never pay back more than 100 cents on the dollar.
What that means is there will eventually be a multi-trillion dollar bond implosion as speculators and bond fund managers alike scramble to cash-in their capital gains at the first sign that the global bond markets are breaking and heading back to par or below. And it is not just the “winners” who will be stampeding for the exists.
There will also be an even larger and sorrier band of “losers” in an even greater state of panicked flight. We refer here to all the Johnny-come-lately bond managers on the planet who are today buying trillions of bonds at a premium to par. For example, the premium price of the 4% coupon Italian bonds that have traded up to a 1.2% yield owing to Mario Draghi’s $90 billion per month buying spree will get absolutely monkey-hammered when the ECB’s Big Fat Bid finally ends.
To be sure, these befuddled money manages claim to have no choice or that these premium bonds still have a slightly better yield than subzero. Yet what they are actually doing is strapping on a financial suicide vest. These premiums absolutely must disappear before maturity, and most probably suddenly, violently and all at once when the great global bond bubble finally implodes.
Likewise, there is nearly $3 trillion of junk bonds and loans outstanding in the US alone, and that is double the level extant on the eve of the great financial crisis. But double the money embodies far more than double the risk.
That’s partially because the drastic, central bank induced compression of benchmark bond yields has been transmitted into ultra-low absolute levels of junk bond yields via spread pricing. Compared to all of modern history, current junk bond yields in the 5-6% range are just plain ridiculous.
After all, long-term junk bond losses have been in the 3-4% range, inflation is still running close to 2% on a trend basis and taxes have not yet been abolished. So the sheer math of it is that the average single B junk bond today has negative value——and that’s before the next default cycle really kicks into gear..
And junk bond defaults like never before in history are coming with a vengeance. That’s because a very substantial portion of current junk credit outstandings went into speculations that even LBO shops wouldn’t have entertained 15 years ago.
To wit, it was used to fund radical commodity price speculations in the shale patch, mining and other commodity plays, subprime auto lending schemes and financing for stock buybacks and dividend recaps by highly leveraged companies. Accordingly, the embedded business and credit risk in the $3 trillion of outstanding US junk bonds and loans is off the charts.
Already by mid-year 2016, defaults in the shale patch had taken down 40% of outstandings. Even cautious rating agencies like Fitch now project high yield bond defaults will hit nearly $100 billion in 2016 or double last year’s already elevated levels.
But as usual the rating agencies are far behind the curve. Standard and Poor’s, for example, projects that by June 2017 today’s rapidly rising defaults will only hit the 4-7% range. But they are smoking the same thing they were in 1989, 1999, and 2007!
In fact, the junk bond sector will soon be hit by a double whammy that will push loss rates to unprecedented levels. That’s because there is already a deeply embedded loss due to the distortions of ZIRP/NIRP on benchmark bond pricing. When the central banks of the world are eventually forced to shut down their printing presses and permit rates to normalize, these losses will be transmitted across the entire credit spectrum.
On top of that, the massive global deflation/ recession currently unfolding means defaults will easily soar far above the prior 11-12% peaks. And the next peak default cycle will last far longer than the historic results shown in the chart because this time the central banks will not be in a position to reflate the bond and other financial markets.
The prior default peaks shown below are part of the two-decade long super-cycle of global credit and investment growth. Each junk bond market break was quickly reversed by successive rounds of central bank money printing.
But the world economy is now stranded at Peak Debt and the central banks are out of dry powder. The latter have reached the limits of subzero rates, the credibility of QE is fading fast and Bernanke’s fleet of helicopter money drops will never get off the ground in the US or Germany, and that’s mainly what matters.
So this time recessionary conditions will persist and the implied revenue growth in most junk bond deals will never happen. The resulting cumulative build-up of cash flow shortfalls, therefore, will be immense. This means that a far larger share of issuers will eventually default—-especially given the elevated credit risk already embedded among commodity oriented issuers.
Moreover, as the junk bond default rate continues to rise, the “extend and pretend” market, which has forestalled defaults in the last few cycles, will also dry-up. Consequently, hidden defaults will finally come to the surface and issuers will resolve their inability to pay in the bankruptcy courts, not in the junk refinancing markets.
Financial Explosive Devices (FEDs) And The Coming Financial Carnage
Yet the junk bond sector is only a small section of the coming bond market carnage. The scramble for yield generated by central bank financial repression, in fact, has systematically impregnated the global markets with FEDs (financial explosive devices).
Even as approximately 200 principal central bankers and senior staff have spent the last seven years pushing interest rates toward the zero bound or below, there have been millions of financial operators and capital users scouring the earth for ways to escape it.
Recently, one of these zero bound escape routes blew sky high when the 9.5% contingent convertible bond of 2049 issued by an obscure German bank, Bremer Landesbank (BLB), plunged by 40% from 120 to 73 in just minutes—–a move which has, in turn, spooked broader global markets.
It turns out that Bremen LB is a $29 billion German state-owned bank heavily invested in shipping loans that is now facing massive write downs and the need to raise capital from its principal owners—-German Landesbank NordLB, the city of Bremen, and the savings banks association in Northrhine Westphalia.
Here’s the thing. All the parties involved had stumbled into risk that extended way over the end of their financial skis. Indeed, the cliff diving bonds shown below were at the very end of a long chain of mispricings emanating from today’s central banking regime.
It originated awhile back when central banks made cheap debt available to households in the US and Europe. That caused a consumption boom there, and an oversized export boom in China and the far east.
Next, more cheap capital enabled by the Asian central banks funded an artificially large investment boom in China and among its EM supply chain, which, in turn, caused demand for bulk, crude oil and container ship capacity to surge.
Needless to say, still more cheap capital generated a massive excess of highly leveraged ship-building capacity that needs cash flow to service its debt. So the huge state enabled ship-building industries of China and South Korea built new ships like there was no tomorrow and, to move the iron, priced them near marginal cost.
Then, even more yield hungry capital hooked-up with the growing surplus of these “new builds”, funding on high leverage what is ultimately a day rate commodity (i.e. shipping capacity).
Even then, the daisy chain was not done. The bank arrangers and other intermediaries who bought and financed the surplus ships that the central bankers indirectly built needed to enhance their own returns. So they funded their newly acquired “assets” with yield-bait like the Bremen LB contingent bonds which blew sky high on a moments notice.
The one thing that is absolutely true in a $300 trillion global financial market is that Bremen LB is not a one-off. After a $20 trillion central bank printing spree and 90 months on the zero bound these kind of FEDs exist in their tens of thousands.
Soon we will know their names.
After all, creating this kind of fiery demise is what central banks ultimately do……