August 29, 2019

Reversing the Big Short

For the past month, we have seen reports about negative yields for, of all instruments, junk bonds. How exactly did we get here?

We know about negative bond yields, but up to now it has been on government debt issuances and high-quality corporate bonds. There is a market narrative about those that at least offers a reason investors would buy them. Certain financial institutions – banks, pension funds and the like – are required to buy and hold “high-quality” assets like sovereign and investment grade debt.

But no one is forcing any investors to buy junk bonds. They are a purely voluntary choice when bought for a portfolio. That makes the logic of getting into such an investment seem even more crazy. So why does it happen?

One simple answer is that it is a least bad option. Deposits in Europe are already negative with the European Central Bank charging banks -0.4 percent to place money with the central bank. Banks handle this with clients in different ways, but many are passing on charges to depositors in various forms. Buying a relatively higher-quality junk bond, which averages a 0.2 percent yield, seems a better option, with the obvious caveat that you are also buying a riskier asset.

But there is another theory we heard floated this week, which at least is logical when analyzed. Market participants have been wondering how the ECB will get out of an approaching quagmire. The ECB currently buys sovereign debt of member countries, but never more than 33 percent of a country's supply. The logic there is that they do not want to buy most of the supply as they want markets to function properly without one big buyer in the mix.

From 2015 to 2018, the ECB bought 2.6 trillion euros of government bonds. Some estimates suggest only 150 billion euros remain before the ECB hits its limit. At a purchase rate of 60 billion euros a month, we are a few months away from the ECB running out of supply. And, coincidentally, this seems likely to occur around the same time we have a possible hard Brexit, the withdrawal of the United Kingdom from the European Union.

What will the ECB do if it runs out of bonds to buy? One alternative would be to start buying corporate debt, which could in the end lead to buying junk bonds if it runs out of a future allocation of investment-grade bonds. If this happens, you want to be the one holding those bonds to sell.

My View: This could be a bizarre upending of Michael Lewis's book “The Big Short.” In this case, instead of expecting financial disaster and selling those assets short, here we have investors expecting disaster and choosing a buy and hold strategy, awaiting a hungry ECB buying every class of bond in sight to flood money into the financial system. Sounds like a great movie.

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