Yellow Flags Popping Up In Junk

Two stories from Bloomberg today reinforce my sentiments toward the junk bond market:

Mr. “Black Swan” Taleb needs little introduction. Money quotes in the article include his thoughts on gold and other commodities (buy what “China will like”) and his recommendation to avoid debt. His reasoning is debt in a deflationary world puts extreme pressure on the financial system whereas equity in the same situation is more manageable. The US government is already taking extreme steps to forcibly convert debt to equity, such as psuedo debt like bank preferred shares and even senior secured debt as in the Chrysler case.

The other article rehashes circumstances in the junk bond market that I’ve discussed previously. The article basically warns against pending defaults (15% by year end) and lower recovery rates post-default (again, ask Chrysler debtholders). Tony James, president of Blackstone Group, thinks the junk market is “a little ahead of itself.” Blackstone are very savvy market players — if you think their stock price is an indication of their quality, keep in mind they sold out at the top while IPO investors and the Chinese played the suckers.

I began moving into corporate bonds but paused after Bernanke began the quantitative easing portion of the reflation plan. Two primary concerns are the long-term value of the dollar and frothiness in junk bond prices in the face of an economic retrenchment. My hunch is the junk bond train has not left the station but if it has, I am willing to miss the ride for safety’s sake.

Caveat emptor.

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6 Responses to “Yellow Flags Popping Up In Junk”

  1. Sivaram Velauthapillai Says:

    Taleb’s views make no sense. He may have been misquoted or something…

    How can he say that a deflationary world that pressures bonds is bullish for equity? It’s highly unlikely for equity to do well if bonds are doing poorly for various reasons.

    One, bonds have higher claim than equity. So if bonds default, equity is largely worth zero.

    Two, if the bond market struggles, cost of capital will remain high. You are bullish on some commodity companies and I’m sure you can point to examples of many commodity businesses struggling because they can’t raise capital in the bond market.

    I don’t know… I don’t see how he can be right… he may be misquoted or something. Maybe he is talking about a narrow portion of the bond market (say bonds of financial companies or maybe low-yielding government bonds). In general, if the bond market remains distressed for years, I doubt equity investors will seem good returns.

  2. Davy Bui Says:

    I think his point is that, from a general economic standpoint, debt bubbles are vastly more dangerous than stock bubbles (as we have now witnessed). So as the feds try to artificially reflate the economy, it’d be much better for them to target a stock bubble by pressuring the system to replace debt with equity which could possibly benefit stockholders @ the expense of debtholders. Also, he makes the point that there are major risks with equity but at least investors know they’re taking risk whereas bonds have hidden risks (like the Chrysler senior debt).

    Another factor to consider, if you’re going to play in these markets, it actually may be safer to play stocks than bonds in the sense that you trade in and out of the bounces. GM, if you jumped in and out of the stock at the right time, has probably doubled a few times now (off progressively lower bases but that doesn’t matter as long as you pick the right entry point). The bonds recovered too but probably not as much & not as liquid — they’re more buy-and-hold instruments.

    You’re right in that many commodity companies are struggling due to lack of debt market access — I tried really hard to avoid those ;-) But their stocks may bounce substantially on the way to zero whereas bonds don’t move like that.

    Keep in mind that if the Merrill Lynch HY index currently has a 9.75% yield with the 10-year treasury @ 3.25%, that’s a spread of 6.5% to buy junk bonds in the face of the biggest default wave in modern history. Most retail investors are buying via bond funds so they’re probably going to get some distribution of the losers. I don’t know if 6.5% is a good risk premium in this economy.

  3. Sivaram Velauthapillai Says:

    I think the latter part of what you say, which is more of a trader strategy than any long-term one, is probably what Taleb is thinking. But I still don’t get the crux of the argument. For instance, what does the following mean:

    “…by pressuring the system to replace debt with equity which could possibly benefit stockholders @ the expense of debtholders.”

    If we are talking about a specific company, how does that help stockholders? Any time you issue equity, it dilutes shareholders. Equity is very expensive (generally far more expensive than debt.) Issuing shares never helps shareholders unless the share prices are overvalued.

    Or is he saying that some portions of the economy, particularly the banks, are going to involve capital injections via shares, while other sectors profit from that. This scenario may involve some benefit for non-financial industries but I’m not so sure. If bank shareholders end up paying a price through dilution and continous share issuance, they are going to, assuming the government hasn’t nationalized the bank, force the bank to curb lending. It’s cheaper for bank shareholders to raise capital by cutting back on lending than it is to issue shares.

    Taleb is a trader and I’m not so I don’t generally understand his views so maybe it’s just me :)

    (BTW, I agree with you that junk bonds @ 10% yield is a poor bet. Moody’s is forecasting default rates of up to 15% and I would not invest in a basket of high yield bonds if it doesn’t get much higher than that.)

  4. Davy Bui Says:

    I’m not much of a trader either and I’ll stop speaking for Taleb.

    So speaking for myself, converting debt to equity would benefit shareholders once you consider what the alternative would be, which is bankruptcy. We’re not talking MSFT, we’re talking companies in major trouble like GM or General Growth Properties.

    Normally, a company defaults, goes into reorg, equity gets wiped out and debt holders wind up owning the company. Now, you have precedents where junior claims are getting more of the company than senior debt holders.

    Debtholders who may have been willing to put a company into default to increase recoveries may now accept restructuring instead of bankruptcy for fear of what may happen. If debt holders are discouraged from putting a company into bankruptcy, that benefits shareholders immensely. You may have massive dilution but it’s better than going to zero and share prices may recover someday.

    I view the government’s actions as putting pressure on debtholders to accept unfavorable restructurings outside of bankruptcy or risk getting it crammed down their throats in court anyway and then being demonized by the President, to boot. A few more of these and debtholders may stop putting up a fight.

    Of course, the CDS issue may complicate matters. Lots of moving parts but that’s my understanding (projection?) of what Taleb meant. I don’t think he was saying that investors will make more money in stocks over bonds in a deflationary environment but maybe just the risk/reward picture is clearer/better for stocks. But I wasn’t at the conference.

  5. Fletcher Wheaton Says:

    I am currently reading “Den of Thieves” about then junk bond king Mike Milken in the mid 80’s during the frenzy of M&A and hostile takeovers. I find it a very interesting read for anyone interested in a little junk bond history

  6. PB Says:

    I am currently reading “Den of Thieves” about then junk bond king Mike Milken in the mid 80’s during the frenzy of M&A and hostile takeovers. I find it a very interesting read for anyone interested in a little junk bond history

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