CLO & CDO Yield Spreads Indicate Final Phase of Credit Cycle

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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For now, does that mean we play on, given that the credit cycle has been seemingly repealed?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

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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