Tom Brakke, the Research Puzzler, has started up yet another site to display bits of interesting information that he has run across — Research Puzzle Pieces. His first piece was an interesting one, and I would like to give you my spin on it.
You may remember some of my writings in this area:
- Yield is the Last Refuge of Scoundrels
- Yield, the Oldest Scam in the Books
- On Con Men, Advanced Edition
One major ploy of Wall Street is to induce people who need to stretch their income to buy a high yielding security that has weak protections. All of the options are held by the bond seller. They might think:
- If things go really bad, we can default. We’ll start another firm later; thank God for limited liability, and forgetful lenders.
- If things go neutral-to-bad, and we need to conserve cash, we just pay with more bonds at a slightly higher rate. In that scenario, there is no way we could borrow more at a similar rate, so we win there as well.
- If things go okay, and we don’t have cash needs, we pay the coupon and bide our time. (This is the only good scenario for bondholders.)
- If things go really well, we call the bonds after the first year, paying off the investors who probably do not have great reinvestment options.
For the bondholder, the upside is capped, and the downside is 100%. The optimal outcome is that you get paid principal & interest to the stated maturity from this bond that is deep in junk territory, CCC+/Caa1-rated, where the proceeds of the deal don’t increase the value of the firm, but are paid as a dividend to the equity holders.
As I said, the bond issuer holds all of the options here. And what might you get as yield? 8.5-9.0%? Given the risks here, that is not enough.
Problems of a Yield-Starved Market
PIK bonds and bonds from dividend deals tend to default with higher frequency and severity than equivalently rated deals lacking PIK and/or dividends. But people invest, hoping that they will come out okay, even in the face of structural bond weakness. They need the income, because they don’t have enough capital.
This is not a problem unique to investing. As for PIK toggle bonds, securities underwriting is not all that much different from insurance underwriting. In the first part of the bull phase of the cycle, pricing/risk margins decline due to competition. After that, terms & conditions get weakened before the cycle turns.
It is common to see protections in debt securities decline as we get closer to the end of the credit/equity risk cycle. We may have months to go here, or maybe two years to the peak at most, but we are living on borrowed time in the debt markets at present. One more sign: premiums paid for loan participation and junk bond closed-end funds. Most junk closed-end funds are at a premium, which means that there is an incentive to sell more junk debt.
What a world. Let Bernanke know that his plan to make people take more risk is working, but when you do, tell him it is working for bad, not good. As for my clients, we are reducing credit risk.
By David Merkel, CFA of Aleph Blog