Bond funds reaching for risk

It seems everyone is tempted to indulge just a bit more than they should during this wild financial party hosted by the Bernanke Fed.  Those in money market funds are buying short-term bond funds.  Municipal bond owners are extending maturities.  Bond investors are venturing into exotic places like Rwanda and Bolivia.  And now, according to a May 1st Wall Street Journal article, “Bond Funds Running Low On… Bonds,” a total of 352 mutual funds classified as “bond funds” by Morningstar now own stocks. That’s up from 283 in the first quarter of 2012.

“The number of bond funds that own stocks has surged to its highest point in at least 18 years.”

A similar phenomenon occurred during the late ’90s tech bubble as investors simply couldn’t resist the temptation to push the envelope for greater returns.  Remarked Ehrenkrantz King Nussbaum strategist Barry Hyman on December 22, 1999:

“Value players have become growth players, growth players have become momentum players, and momentum players are out of their minds.”

History doesn’t always repeat, though it often rhymes.

Wall Street sausage factory spits out “income” funds

According to a brief article on MarketWatch,

Apparently marketing does make a difference, at least in the mutual-fund world. With interest rates having cratered as a result of the Federal Reserve’s post-recession stimulus policies, retirees and other investors have been scrambling to find investments that will produce the income they aren’t getting from Treasurys and other low-risk bonds. Concisely illustrating that very point, Russ Kinnel, the director of mutual fund research at Morningstar, tweeted this today:

For past 12 mo, the amount of $ flowing into funds with “Income” in their name is 3X larger than funds without “Income” in their names.

If Main Street demands “income,” Wall Street’s role is to comply and supply.

Beware ultrashort-bond funds

The reach-for-yield bubble continues to scale record heights of insanity.  The latest milestone: the recent popularity of ultrashort-bond funds.  These typically invest in high-quality bonds with maturities, on average, of less than a year.  According to a June 3 Barron’s article, “When It Comes to Cash, Less Is More“:

For the trailing one year through April 30, the nearly 50 ultrashort funds tracked by Morningstar have taken in $10 billion in new assets.  “That’s pretty big considering that there’s $52 billion in the entire category,” notes Morningstar analyst Timothy Strauts.

While this is a drop in the bucket compared to the $895 billion in retail money market funds, the vigor in which fund companies are marketing this product should raise red flags:

In the past year alone, roughly a half dozen new ultrashort-bond funds have made their debut – the BlackRock Short Obligations fund, Sterling Capital Ultra Short, and T. Rowe Price Ultra Short-Term Bond among them.  In May, Legg Mason’s subsidiary filed SEC documents for the Western Asset Ultra Short Obligations Fund.

According to Morningstar, ultrashort-bond funds have an average 30-day yield of 0.59%, but is this worth the extra risk?  During the financial crisis, many of these funds posted losses.  In fact the largest at the time, Schwab YieldPlus, lost 35% of its value in 2008.

“Our feeling on ultrashort bonds right now is ‘What’s the point,” says Jeremy Welther, a principal at Brinton Eaton, a financial advisory based in Madison, NJ.  “Any time you get back less than what you put in, it’s not cash.”

Besides gold, cash appears to be the most unloved asset class on the planet.

Worst investments of the next 5 years?

With so many qualified candidates, the challenge is to narrow down to our ten least-favorites, but here goes:

10.  VelocityShares Daily Inverse VIX ST ETN (XIV)  – Volatility measures such as the VIX are at their lowest levels since the top of the 2007 credit bubble.  This ETN is short.

9.  PIMCO California Municipal Income Fund II (PCK) – The bonds in this closed-end fund yield a tempting 6.8% for a reason: California is a fiscal mess.  Even worse, yield-chasers bid the fund’s shares to a 20% premium over net asset value.

8.  iShares iBoxx $ Invest Grade Corp Bond ETF (LQD) – With an average yield of 3.79% and weighted average maturity of 11.8 years, this ETF offers what Jim Grant derides as “return free risk.”  Worse, one-third of the portfolio is invested in bonds of financials: mostly mega-banks and investment banks.  LQD has attracted nearly $8 billion in inflows the past 2 years.

7.  iShares Dow Jones US Real Estate ETF (IYR) – Powered by investors reaching for yield, this ETF boasts a total return of 25.9% per year over the past 4 years.  Unfortunately, valuations are stretched: current yield is just 3.2% and REITs typically trade at 20 x FFO (funds from operations), at the high end of their range.  Worse, access to cheap capital has translated into acquisition binges at some of the portfolio companies.

6.  30-year U.S. Treasury bonds – When entitlements are included, the U.S. government’s debt/GDP is estimated at over 600%, in all likelihood the highest in the world.  For this elevated risk, bondholders are locking in all of 3.18% interest for 30 years.  A default is coming within the next 5 years, either openly by default or insidiously via the printing press.

5.  PIMCO High Income Fund (PHK) – The current yield is 11.5%, but a good chunk of this is being paid out of principal as high yield bonds yield close to 5%.  The portfolio is loaded with financial and mortgage-related paper.  For this, closed-end investors are paying a 45% premium to NAV.

4.  iShares FTSE China 25 Index Fund (FXI) – Call us skeptical of the Chinese miracle with its central planning, cronyism, loose lending, artificial booms in housing, infrastructure and commodities, empty cities, rampant waste, and conspicuous consumption.  This popular ETF has a 57% weighting in financials, mostly large domestic banks.

3.  PIMCO Global Stocksplus & Income Fund (PGP) – This closed-end fund boasts a seductive 10.7% current yield and 30.8% compounded annual return over the past 4 years.  Investors may or may not realize returns have been turbo-charged with 50% leverage coming from S&P 500 stock index futures.  Either way, they don’t seem to care, bidding up the shares to a 58% premium over NAV.

2.  Global “Too Big to Fail” bank/investment bank stocks – Fractional reserve banking + moral hazard of TBTF = toxic combination.  The 2008 meltdown claimed its share of these political capitalists always teetering on insolvency (Bear Stearns, Lehman, Citigroup, et. al.).  What sins have the survivors committed during this epic stimulus/sovereign debt/reach-for-yield bubble?  We’re about to find out.

1.  10-year Japanese government bonds – Japan has the second highest debt in the world behind the U.S. with an economy one-third the size.  Debt/GDP is the highest in the world at over 220%, well ahead of #2 Greece and #3 Zimbabwe.  Thanks to the kindness of domestic savers (burned by the bursting stock bubble of the late 1980s), the 10-year yields just 0.83%.  In an effort to stimulate its economy, the Bank of Japan is hell bent on creating 2% inflation.  (We’re guessing they’ll succeed.)  So far, selling by bondholders planning for their golden years has been orderly.  As the government strains to meet higher interest payments, these patriotic creditors could turn tail and run.

Let the race to the bottom begin!

Yield-chasers line up to buy Bolivian bonds

Under the You-Can’t-Make-This-Up category of sovereign debt insanity, the May 17th Grant’s Interest Rate Observer files this report:

Many these days are picking the poison of foreign places – Bolivia, for instance.  Last fall, the scenic, private-property expropriating, contract-abrogating and formerly hyper-inflating South American nation issued its first international sovereign debt since 1920.  And the Bolivian 4 7/8s of 2022 this year have rallied by 57 basis points, “the most among sovereign bonds with BB-minus ratings tracked by Bloomberg.” [according to Grant’s analyst Evan Lorenz]

The Great Bond Bull Market began in September, 1981 (over 31 years ago) with U.S. T-bond yields over 15%.  Yields on the 10-year now stand just a shade below 2%.

Precisely 2 years ago, Jim Grant was quoted in an Associated Press interview:

I think it’s useful to imagine how things might look ten years hence.  What will one’s children, heirs or successors think about a purchase  today of ten-year Treasurys at 3.25 percent? They’ll look back and say,  “What were they thinking?”  The (federal deficit) was running at 10  percent of GDP, the Fed had pressed its interest rates to zero, it had  tripled the size of its balance sheet, and they bought bonds?  Treasurys  are hugely uninteresting, as is similar government debt the world over.

Today the Bolivian government can borrow for 9 years at 4 1/2%.  Have bond investors completely lost their minds?

Japanese government bonds take biggest 2-day hit in 5 years

As Tyler Durden of Zero Hedge reported, 10-year JGBs took their worst 2-day plunge since the financial meltdown of Q4, 2008:

The last 2 days have seen JGB prices plunge at the fastest rate since the post-Lehman debacles in Sept/Oct 2008 smashing back to 13 month highs.  5Y yields are surging even more – trading above 34bps now (up from 9.9bps on March 5th). These are simply astronomical moves in the context of JGB history and strongly suggest Abe & Kuroda are anything but in control of the quadrillion Yen domestic bond market as they jawbone inflation expectations into the psychology of the people.

Meanwhile, the Japanese yen has fallen off a cliff as the Bank of Japan (BoJ) opens the monetary floodgates:

Jeff Berwick, editor of The Dollar Vigilante Blog weighs in on the bond vigilantes calling the BoJ’s bluff:

Traders should take note of Japanese Government Bond prices.  On April 4^th the Bank of Japan made the announcement that they intended to DOUBLE the money supply and buy government bonds roughly equaling $80B a month.  Does this number sound familiar?  It should since the US Federal Reserve’s own quantitative easing program is roughly $85 B a month.  An important data point to remember here is that the Japanese economy is only 1/3 the size of the US economy, but its own quantitative easing program equals that of the US.   To say Japan is “doubling down” on the same failed policy approach it has taken for the last 20 years would be a bit of a misnomer.  This is Japan’s “all in” move as I try to keep the gambling metaphor rolling.  A gamble is exactly what this is, a very big gamble with no precedent in economic history.

What are the consequences of rapidly increasing government spending, monetizing $80B a month in debt, and flooding the market with yen?  It is hard to miss the headlines as the Yen on the futures exchange is now trading at below 100 yen to the USD for the first time in four years.

Berwick offers an explanation as to why bondholders are beginning to act more rationally:

Why are bonds trading lower?  Think about this from a prudent lender’s point of view and you will have your answer.  If I give you yen, and you give me a security (bond) that says you will give me back my yen with interest in 10 years, then why would I sit with that security and let you pay me back with a devalued currency?  Well, in Japan bondholders appear to be speaking with their market participation.  Bond holders are doing exactly what they should be doing.  Bond holders should be liquidating bonds and converting money out of yen into non-yen denominated securities and investments (note all the M&A activity from Japanese companies in the last seven months as the smart money runs and not walks out of Japan and the yen).

How can the savers in Japan be sitting idly by and watching the purchasing power of their savings being destroyed?  We are on the first chapter of a very ugly time in Japan where policy makers decisions will strain the very social fabric of the country.  We will have a front row seat to the failings of the Keynesian economic philosophy.  It will not be pretty for Japan. And it could very well be the first major event in The End Of The Monetary System As We Know It.

Last Friday, in his Daily Rap, Bill Fleckenstein mentioned the possibility of a Japanese canary in the sovereign debt coal mine:

Japan was the epicenter of fireworks that spread around the world, as last night their equity market rallied 3% even as their debt market had a bit of a nasty spill. However, it must be kept in perspective that the change was rather small and rates have only backed up to where they were in February. So it is not exactly huge trouble, but it could be the start of a shift. At the moment, the bond and currency markets are declining in Japan. Should that continue and should the bond market worsen materially, it would be an early sign of what an eventual funding crisis would look like.

Of course, as long as Japan’s central bank is buying such huge amounts of paper it can thwart that for a time, but it could be the first sign of a bond market anywhere revolting against the printing press. As I say, it is very early days and I don’t want to make too much of it, but a trickle can eventually become a flood, and a trickle has to start somewhere.

Over three weeks ago, in our Q1 letter to investors, we mentioned the possibility of a “Wizard of Oz moment” as the BoJ accelerated its monetary experiment:

Two weeks ago, the Bank of Japan announced a doubling of its asset purchase program.  In Pavlovian response, speculators bid up Japanese government bonds strongly, with the 10-year yielding just under 0.40%.  The following day those gains completely evaporated.  Had the BoJ lost control and the market called its bluff?

For now Goldilocks prevails, but for how long?  Fleckenstein considers the glaring (and widening) disconnects:

So we continue to be in the most perverse sweet spot in the history of the money-printing era that began over 20 years ago. Between the BOJ and the Fed, we are printing about $1.8 trillion a year, along with massive deficit spending, and those policies are regarded as a panacea for equities and just fine for bonds, but horrible for assets that protect one against inflation. Of course, that makes no sense, but when you are in a warped environment (and this is the most warped ever), crazy things not only happen, they lead to even crazier outcomes until the madness finally stops, after which all hell breaks loose.

So much for the notion that central bankers are in control.  Did the global reach-for-yield bubble just go “pop”?

Reach-for-yield bubble goes exotic

According to an April 29th Bloomberg.com article titled, “Rwanda’s Junk-Bond ‘Dash for Trash’,” the global reach-for-yield orgy is now venturing into remote areas not exactly for the faint-of-heart:

Although low interest rates haven’t conquered unemployment in the rich world, they’re having a big impact elsewhere. Junk spreads are exceptionally low and the issuance of bonds with weak underwriting standards has soared. Yield-starved investors are gobbling up new “covenant lite,” “payment in kind” and “dividend recapitalization” bonds at a faster pace than during the credit bubble.

One recent beneficiary of this “dash for trash” is the small landlocked country of Rwanda. Last week, the government of Rwanda sold $400 million in dollar-denominated 10-year bonds at an annual yield of just 6.875 percent and a bid-to-cover ratio of nearly 10. (Typical U.S. sovereign debt auctions have a bid-to-cover ratio between 2 and 3.)

And Rwanda is not alone among exotic sovereign borrowers:

Moreover, Rwanda is far from unique in its ability to borrow at very low cost for extremely long maturities. Panama has issued dollar-denominated bonds that won’t mature for 40 years, yielding less than 5 percent. Lebanon, which may soon have to deal with spillovers from the ongoing turmoil in Syria, has sold more than $1 billion in debt lasting 10 to 15 years at a lower interest rate than Rwanda.