Home Business As Retail Investors Reach For Yield PIK Bonds Become Hot

As Retail Investors Reach For Yield PIK Bonds Become Hot

As Retail Investors Reach For Yield PIK Bonds Become HotTom 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:

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

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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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