The past decade has seen the emergence of the yield junkie. You recognize them from their propensity to pay and subsequently overpay for anything with the tiniest shred of yield from investment grade corporate bonds to sovereign bonds to AAA rated junk. In the past couple of years, the yield junkie has trampled on spreads and thinned out yields across investment grade and high yield bonds. The more hardened ones even buy equities for an at risk dividend payout.

There are various sources of yield. There is duration risk, which tends to be isolated in the sovereign debt of a handful of countries who remain solvent enough to repay their debts or have a sufficiently strong following that they can continually issue their payment-in-kinds until, well, until they cannot. There is credit risk, which is the element of risk over and above the risk free asset of similar duration or tenure, although the concept of a risk free asset is a bit threadbare at the moment, but let’s suspend disbelief for a moment. And why not, the central banks have suspended theirs indefinitely. Another source of yield, and now we are in the realm of Class A drugs, is option premium. Side effects include a healthy dose of negative gamma and often an even healthier dose of built in leverage. Dealers of course would suggest the application of light leverage, only because the application of heavy leverage looks too much like a lit fuse. A mercury switch is much more marketable.

As so often happens, dealers become users when they sample their own wares. Its when management samples the inventory that the wheels really threaten to come off. The largest buyers of US treasuries are private commercial banks and the Fed. The continued debt monetization operations of the central banks flatten yield curves and compress yields leading to mark to market profits for current investors. But what can investors today expect in future returns? The same question is relevant not only of treasuries but also of investment grade and even high yield corporates.

Lets try to find the new drug of choice for the yield junkie before they really get deep in it. What are the prospects for high yield? Average high yield spreads in the last 20 years have been around 590 bps. In the financial crisis, they spiked to over 1800 bps. Today, high yield has recovered to a fairly tight 615 spread to worst. How about leveraged loans? Leveraged Loans have typically traded 140 bps tight of high yield. In the financial crisis, leveraged loans traded in line with high yield, a significant underperformance. Since then they have recovered with equal abandon. However, since the financial crisis, leveraged loans now trade within 50 bps of high yield. Why is this?

The reason lies not in the properties of the asset but the nature of their buyers. The main buyers of high yield are mutual funds. (If ever there was a proxy yield junkie, the long only, index hugging mutual fund is it.) Insurance companies, bank prop desks and hedge funds used to also participate but with increased regulation (read Basel 3 and Solvency 2 which are basically trying to wean the junkie off the poison by allowing them only controlled doses supported by…. Capital), demand is a lot less frantic than before. And besides, hedge funds tend to be long and short the stuff, equally imbibing and dealing at the same time. Leveraged loans, however, were the preserve of the structured credit animal called the CLO, a specific flavour of CDO. CLO issuance has ebbed since 2008, globally, but especially acutely in Europe. As a result leverage loans are relatively unloved. Also, because of the unfortunate nomenclature of credit markets, these senior secured debt instruments have been unloved by the garden variety investor (this includes institutional investors, it’s a big garden.)

Since central banks have fiddled with sovereign balance sheets, banking system balance sheets and real economy relative prices, they have created a situation where interest rates are expected to remain low for the foreseeable and indeed unforeseeable future. Until inflation perks up, or a recovery takes hold, or someone describes the Emperor’s new clothes.

Corporate bonds, investment grade:

• Fixed rate.
• Tight as a drum.
• Implying low default rates.
• Senior unsecured.

Corporate bonds, high yield:

• Non investment grade issuers
• Senior unsecured
• Elements of equity risk
• Fixed rate
• Average spread of 615 bps 

Loans:

• Non investment grade issuers
• Senior secured – senior in claim to second lien and to senior unsecured (bonds)
• Floating rate.
• Average spread of 580 bps.

Loans are no panacea in an over QE’d world, but hopefully, given that garden variety investors will take some time to react to this asset class, yields should not collapse. Also, there is a relative value argument that is pretty compelling. With average recovery rates of 40% for high yield and 80% for loans, and average spreads of 6.1% for high yield and 5.8% for senior loans, conceptually at least, one could buy a dollar of loans and 60 cents of credit protection netting a yield of 2.14% with a loss given default of 16 cents. It is highly highly highly unlikely that you will be able to perform this little trick within the same issuer, that would be too easy. However, the arithmetic highlights the relative value opportunity between high yield and senior loans.

The above analysis is a stretch for the yield junkie but here is something they might understand. When a government is as indebted as the Western governments are, interest rates cannot remain low for long. Fixed rate bad, floating rate good. Unsecured bad, secured good. Subordinated bad, senior good.

PS

What are the chances that strategies like this will be offered in a regulated, risk managed, transparent, fund format to investors? Professional gatekeepers and experts stand in the way, and unfortunately the industry contains professionals who may lack the intellectual faculties or experience to understand strategies or matters in general outside a very tightly defined remit. Fear of the unknown, superstition, insularity, and reckless extrapolation plague certain parts of the industry. These elements limit the scope of investment opportunities to the general public to the detriment of all.

The need for political correctness is the tolerated, celebrated suppression of honesty. It conflicts with the goal of transparency. Yet today’s world seems to drift toward more political correctness, rhetoric and oratorical populism.

It is as if people have lost faith in their past heroes in the boom years and cry out for new direction only to find a gaggle of game show hosts, used car salesmen and worse, politicians, chasing their dollars, votes and adoration. This is dangerous because humans are generally weak minded and seek to be led. This encourages those who wish to lead, including those who are driven by greed, glory and ambition which may be independent of the causes of the people they seek to lead.

It is in this sweltering climate of famine, inequality and oppression that this species has elected some of our worst madmen to replace our erstwhile oppressors. Those fed us lies of prosperity through the application of credit, rising housing prices, ever falling interest rates and a persistent sense of entitlement. What will the new generation sell us? It almost seems that we cannot survive without some form of oppression.

What could Washington sell Americans still drunk on the inevitability of the success of the American Way? More QE? More credit? Rising house prices? More useful jobs certainly wouldn’t hurt.

What might Beijing sell a billion witnesses to the failure of Western Capitalism, the apparent triumph of the Chinese model, unbridled greed in the coastal cities and an inequality of wealth unmatched in the Western Democracies? Affordable housing? Lower food inflation? Greater equality? Within? Without?

And what could European leaders sell their collection of people’s shoehorned into union by a broken currency union? Closer union? Fracture? Fission?

Morality and social norms are informal rules of law which humans invent to deal with conflicts which do not yet warrant formalization in law. Morality exists for pragmatic reasons, the result of a Folk Theorem.

Humans are entirely self interested. I offer this without proof because it is patently self evident. Charity or selflessness is only the product of fear, guilt, mistaken strategy and superstition. Individually, the human being is interested in one thing and one thing alone and that is to achieve whatever they wish to achieve unimpeded. How do we pass from the self interested individual to a system of social norms or morality that governs collections of individuals? Humans interactive repeatedly, thus engaging in repeated games, and hence any grim trigger strategy will punish deviation to such an extent that cooperative behavior becomes accepted as a social norm or a form of morality.

It is useful to understand behavior with these basic axioms. The analysis can be extended to policy makers, government, individuals, economic agents, crowds and markets. These axioms do not replace the basic motivations of fear and greed. They do, however, animate these motivations.

Prior to the financial crisis of 2008, the world was driven by greed, not fear. The objectives of profit, of gain, dominated the world. Under our assumptions of human behavior, the boundaries of moral and socially accepted behavior, even lawful behavior would be tested by the most ambitious examples of humankind. The types of behavior under greed were concentrated in fraud, the inflation of one’s own abilities or achievements in order to obtain acclaim or reward. Some of this fraud has been discovered but it is almost certain than some have escaped detection, at least until another day.

The current climate is characterized by a shrinking economic pie and increasing desperation, resulting in a more contentious atmosphere, protectionism and a latent state of conflict. Fear will drive behavior and test the boundaries of social norms and morality for the foreseeable future. Our analysis of human behavior should be advised by this regime.

• Protectionism and Mercantilism including for example, competitive currency debasement.
• Martial conflict, over resources and territory for example. As a species we have matured beyond conflict over ideology and other such high principles.
• Fraud to hide weaknesses rather than advertise strengths.
• Risk of expropriation by means direct or indirect, overt or covert, including financial oppression.
• Increased risk of Class Conflict arising from wide and growing disparity of wealth, income, and opportunity.

Never write off the US consumer, particularly when the Fed is providing them with financing.

There is a recovery underway in the US, beginning in housing, but through legislation and Fed policy, expected to extend to consumption through the potential monetization of home equity.

The Fed is not only no longer the safekeeper of the punchbowl, they are spiking the brew.

Given the track record of the experts, the EUR is likely to be strong, and European yields will go to zero in the long run, supporting bonds of Eurozone members, at least the ones who are less insolvent than others. Check out Euro area competitiveness and trade balances if you think I’m crazy.

Correlation is introduced between assets by vehicles which connect them in unexpected ways. For example, US treasuries being widely used as collateral in total return swaps can correlate with swap reference assets even if they are unrelated in any other way. Think of Gold ETFs done on swap.

Yield addiction beats rationality every time.

For every yield junkie, there exists a dealer.

Note that the US economy had begun its recovery in October 2011. Stage 1 of the recovery came from exports. Countries that benefited were not the natural exporters like China and Japan but rather anyone exporting to emerging markets, since they were the only importers with any ability to pay. Now even this game appears to have run its course as every country on earth seeks to export amid the current synchronized slump. Exacerbating this is a dearth of trade finance whose natural source has been the European banks who now find themselves a little bit short on capital.

Thus the global synchronized economic slowdown rolls on, and it took the announcement of unlimited quantitative easing by both the Fed and the ECB to stop the rally in risk assets. All other central banks have already got with the program and are minting empty promises at best speed.

In June, the market wrote off India as a lost cause, mired in political deadlock and stagnation. This seemed to be the catalyst for some maneuvering by the Prime Minister to push forward a slew of reforms, which have yet to be ratified, but have boosted expectations and the Sensex into a 20% rally. Whatever happens, the fiscal deficit is bound to widen on the back of more pork barrel politics.

On this basis, the weakness in data from the UK and the acutely poor sentiment for the UK economy suggests that the UK economy has probably troughed. Unfortunately, there is a corollary to Murphy’s Law that says that you cannot make it rain by washing your car.

We have already noted in the past that QE limited on unlimited is only half of the equation, that it represents the financial part of a reorganization but not the operational side of it. As a business reorganization, QE is therefore incomplete and requires in addition, a new business plan to demonstrate a viable path to recovery. We have not seen such a plan on the fiscal or budgetary side. Austerity seems to be the only tool in policymakers’ toolkit; however, this is to be expected since in most debt negotiations, creditors drive the discussion, that is, until default or liquidation.

So extremely inflated is the monetary base and so great the expansion of the banking system’s balance sheet that one should consider the current strategy of the central banks highly non-robust to errors in policy. It has become difficult if not impossible to predict the consequences of policy, because all predictions are probabilistic and subject to envelopes of uncertainty, so high has this uncertainty become that it must encompass all manner of ‘tail’ possibilities.

Macro strategy based on expectations for economic variables and their impact on liquid assets pricing is therefore extremely prone to error. The only safe alternatives are direct lending and arbitrage.

There is a shortage of bank capital and thus bank lending. As a result private capital is finding less competition. On the other side, excess demand for funding allows lenders to be pickier and for underwriting standards to be higher. Trade finance, factoring, payroll finance, mezzanine finance, venture capital, private equity, real estate sale and leasebacks, equipment leasing, are lucrative investments. Even leveraged loans, particularly in Europe are looking interesting as European regulations drive capital away from the securitization markets. If the economic cycle proves less rosy than expectations, exchange offers and debtor in possession financings will not be far behind. 

Arbitrage or quasi arbitrage opportunities are also usually available in abundance when markets dislocate. Bank regulatory capital relief trades, capital structure arbitrage, convertible arbitrage, all involve a mispricing of different claims, either for regulatory reasons, or adverse selection reasons. Either way, in credit, when demand and supply are driven by psychology and differing claims imply differing default probabilities or recoveries, arbitrage becomes possible. In equities, the trade is more one of relative value than arbitrage, a far less robust strategy prone to being confounded by persistently irrational markets. Only in event driven hard catalyst strategies can equities be more robustly applied to arbitrage. In the absence of an announced event, price convergence is subject to excessive extraneous factors.

If I was a macro strategist, in other words a betting man, I would say that the UK economy will outperform, so will the US, while Germany slips into recession taking the rest of Europe deeper into the abyss, and India slip
s back as fiscal constraints strangle pork barrel policies and China continues to slump taking the commodity countries with it. The trade expression is even more unclear; shorting German (and other developed countries’) exporters to China is top of the list, shorting high yield (still an expensive trade to maintain), buying non-agency mortgages and US homebuilders (to capitalize on the housing recovery, and even that is pretty uncertain), selling Italy CDS protection and buying German protection is a convergence “the Euro will hold together trade (which incidentally is a short Brent trade in disguise), US 5 10 flatteners through the cash or through payers and receivers (the other wings are too expensive),