Under normal circumstances, where a few defaults don’t threaten the whole economic system, and the government is running close to a balanced budget, and the Fed isn’t in a liquidity trap that they themselves created, there are relationships that are useful for analyzing value in the markets.

CLO & CDO Yield Spreads Indicate Final Phase of Credit Cycle

During those times the slope of the yield curve tells you a lot, and credit spreads tell you a lot as well.  But when the Fed tries to incite yield lust through QE, with Fed funds near zero, all of those relationships end.  The same is true for those who rely on yield curve slope to indicate likelihood of recession or expansion.

These are not normal times.  Yield spread relationships do not reflect risk differentials.  Collateralized Loan and Debt Obligations have returned (CDOS and CL)s).  That indicates we are in the final phase of this credit cycle.  When we begin to lever up junk credit, we have 2-3 years to go or so, before the credit cycle crests.  The issuance of junk bonds has reached new highs, and again, defaults will take 2-3 more years to ripen.  Like 2005-2007, the credit ratings for the junk being issued are more weighted to single-B and CCC debt, rather than BB debt.  2015 could shape up to be really interesting.

For now, does that mean we play on, given that the credit cycle has been seemingly repealed?  Maybe.  If we’re only talking about junk bonds, what matters is being conservative at the time of crisis.  Junk bonds rarely trade off in a slow manner.

The tough question is what impacts the big four economic problems will have on asset returns:

1) Does the Eurozone centralize, dissolve, or muddle interminably?

2) Does China’s GDP growth slow dramatically, or even shrink, or respond to “stimulus?”

3) Does aging Japan finally have difficulty rolling over government debt at low rates?

4) How does the US emerge from long-term unsustainable monetary and fiscal policies?

5) How does the rest of the world deal with most of the large powers attempting to cheapen their currencies, thus forcing them to let their currencies rise, or import loose monetary policy?

Okay, five problems… the point is that when few are pursuing sustainable policies globally, it is difficult to make plans, because there are few historical analogies to guide us.

This is partly a problem because when there does not seem to be anything that is risk-free offering a positive nominal return, investors are even more prone to make subpar investment decisions, because a risk-free asset is needed to allow investors to tune their risk levels.  Retail investors, and most professionals would have a hard time with all assets being risky.

As for me at a time like this, I am trying to manage by avoiding companies that carry too much financing risk, and those with ill-defined business models.  Sometimes it works better, but while the financing bubble expands, I fear my caution is ill-rewarded.

My motto is “safe and cheap.”  I will keep doing this; it does not mean that I will always win, but it does mean that I will likely win in the long run. Lord helping me.

By David Merkel, CFA of Aleph Blog