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Last Time Housing, This Time Bonds

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Over the last couple of months, we’ve focused a lot of attention on the stock market bubble. But some analysts say we should be watching the bond market bubble. Last summer, former Fed chair Alan Greenspan issued an emphatic warning: Beware, the bond bubble is about to burst. And when it does, it will take stock prices down with it.

Last week, Mint Capital strategist Bill Blain issued a similar warning.

The truth is in bond markets. And that’s where I’m looking for the dam to break. The great crash of 2018 is going to start in the deeper, darker depths of the credit market.”

Blain noted that the People’s Bank of China recently dropped $47 billion into its financial system where bond yields have risen dramatically amid growing signs of wobble.

The game’s afoot once more. The result is global stocks bound upwards. Again. It suggests central banks have little to worry about in 2018 – if markets get fractious, just bung a load of money at them. Personally, I’m not convinced how the tau of monetary market distortion is a good thing. Markets have become like Pavlov’s dog: ring the easy money bell, and markets salivate to the upside.”

With all of this easy money available, companies have piled up debt.

The 2008 crisis was the result of consumer debt pumping up a housing bubble. This time corporate debt is pumping up the bubble and the inflating asset is the stock market. That’s why Blain is focused on bonds.

But, I do think the next financial crisis is likely to be in corporate debt and will be a credit market analog to the consumer debt crisis of 2008. The hi-yield market is the likely source – as markets recovered banks started lending again, and low rates forced investors out the credit-risk curve to buy returns. The funds who used to buy nothing but AAAs are now buying speculative single B names. Such is the demand for assets, these companies have been able to lever up and refinance, increase leverage and refinance further, at ever faster rates. It’s been exacerbated by private equity fuelling returns through debt. As demand has increased exponentially, borrowers have been able to slash covenants, making it easier and simpler for over-indebted companies to raise more and more dosh. Where does it end?”

When Toys R US declared bankruptcy earlier this year. Everybody pointed to Amazon as the culprit. Lost in all the chatter about consumers moving to online retailers was the fact crushing debt pulled the giant toy seller under. The company has piled up more than $5 billion in debt. Toys R Us reportedly pays more than $400 million a year on debt service alone.

The story behind the Toys R Us bankruptcy gives us a glimpse at a fundamental problem with easy money created by central bank monetary policy. The ability to borrow a lot of money at low interest rates fuels speculation. Malinvestment distorts the economy and inflates bubbles that eventually pop. This is the story of Toys R Us. An article in Forbes explains what happened.

In 2005 KKR and Bain Capital (which included former Presidential candidate Mitt Romney) bought Toys R Us for about $6.6 billion, plus assuming just under $1 billion of debt, for a total valuation of $7.5 billion.  But the private equity guys didn’t buy the company with equity.  They only put in $1.3 billion, and used the company’s assets to raise $5.3 billion in additional debt, making total debt a whopping $6.2 billion.  Total debt was now a remarkable 82.7% of total capital!  At the time of the deal interest rates on that debt were around 7.25%, creating a cash outflow of $450 million/year just to pay interest on the loans. At the time Toys R Us was barely making a profit of 2% – so the debt was double company net profits.”

The Fed dropped interest rates in 2002 in response to the dot-com collapse. Rates were creeping back up in ’05, but they were still at low levels. The Fed wanted people to borrow and spend to “stimulate the economy.” They did. The equity guys would have found it much more difficult to swing this kind of deal in a normal interest rate environment. This vividly illustrates how the central bankers feed the business cycle and the unfortunate side-effects of their policies.

Blain said we will see more “Toys R Us moments repeated on a grand scale” as central banks try to normalize interest rates.

The rise of and fall of zombie companies that simply can’t meet debt payments is bound to contage, not just the rest of the credit market, but also stocks. More immediately, the realization a crisis is coming feels very similar to June 2007 when the first mortgage-backed funds in the US started to wobble. (The first few pebbles rolling down the hill before the landslide?) It explains why we’re seeing the highly levered sector of the junk bond markets struggle, and companies correlated to struggling highly levered consumers (such as health and telecoms) also in trouble. Basically, very little is really fixed since the 2008 financial crisis. Ten-years later, here we are with the next bubble about to burst. Corporate debt, watch out.”

 

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