BOND BOMBS-Not All Secured Bank Debt Created Equal
The first article below, Not All Secured Bank Debt Created Equal , makes reference to the default rates on bank loans versus bonds. What the article does not state is that the recovery rate on bank loans is skewed up by their forcing companies to refinance bank loans into bond offerings. The highest profile case of this this year was GE's 100 billion dollar spin off of short term bank loans into longer term bond debt. Their debt has not defaulted but the process has been the same for many that have.
The banks see trouble on the horizon and force their commercial borrowers to replace the bank loan with a bond. The money raised from the bond offering pays off the bank loan and the bank is safe.
The bond; i.e. hot potato, is then sold; i.e. passed, into the capital markets and in many cases makes its home in a retail dominated bond fund. If the company then defaults on the it is the small investor that takes the hit rather than the bank.
This forced selling of risk by the institutional banks to the bond market is the equivalent of passing the hot potato to the retail investor. It is also one of the reasons the speculative grade bond market credit spreads have been widening this year.
Be very careful about what corporate bonds or bond funds you buy. As, much money from retail investors has passed to them by the investors selling stock and attempting to protect assets in the bond market these funds have been awash with cash and have been buying much of the risky debt.
In essence the retail investor, not understanding this dynamic, has actually increased their principal loss risk; the proverbial going from the frying pan into the fire.
The other aspect of this that is exaggerating the differences in default rates between loans and bonds is the "work out" viability.
Banks can "work out" new repayment schedules on loans in order to keep them from defaulting. The banks however will only use this feature if they are caught unawares or can't replace the loan with a bond.
Bonds on the other, due to regulatory requirements allowing them to be sold to retail investors, generally have very limited "work out" provisions. The borrower that issued the bond either pays on time or defaults. In the event of a default the buyer of the bond almost always loses big time as the article makes clear in the last line; getting pennies on the dollar.
In effect the regulation that is put in place to protect the retail investor often times come back to hurt them by tying the hands of the bond issuer.
The most recent evidence of this is the apparent default and resulting bankruptcy of UAL. This will almost assuredly wipe out the shareholders as well the bond holders.
The assets will be transferred from the shareholders to the bond holders, wiping out the shareholders. However, there are few hard assets in an airline, so the bond holders too will be wiped out.
As this process of wealth transfer from asset holders to debt holders begins to sink in with investors the prospects for further equity valuation decreases as shareholders move to cash in order to protect principal in the face on increasing perceptions of risk in both stocks and bonds the US markets and economy are experiencing an increase in liquidity trap risk.
The liquidity trap is what occurs when the FED prints money and lowers rates but investors continue to slow investing and consumers slow spending. This is also known as the pushing on a string scenario.
In other words the Fed can put money into the system but they can't make people use it to invest and buy stuff.
This is known as velocity of cash flow in economic terms.
The velocity of cash flow has been falling recently even as the speed of cash moving through the economy has been stable.
Velocity and speed are not the same. Velocity denotes direction; speed is random. In economic terms velocity means purpose and purpose means investment rather than spending, and that requires corporations to begin expanding. Velocity can be disguised as speed, i..e. consumer spending for a little while but not for long.
The US economy has had shrinking velocity being offset by random consumer spending. Spending consumes moneys value, investing enhances its value in the future.
The point is that consumer spending can not compensate for a slow down in corporate investment and expansion forever and it has seen the peak of what it can do already.
If corporate spending does not pick up strongly soon the prospects for economic resurgence decrease at an increasing rate.
In other words the risks of an economic contraction are increasing faster than the prospects for renewed corporate investing. And the longer corporations wait to borrow, invest and spend the greater the risk is that they will wait even longer.
So, the question must be asked, what are the prospects for corporate expansion increasing now? The easiest indicator to monitor for this is capacity utilization.
Capacity utilization, on average at about 75%, is well below the level at which companies will begin considering borrowing again because they already have the ability to supply much more than is being demanded of them.
What's worse, is that the longer capacity utilization stays low the greater the prospects are that companies will be forced into reducing capacity through employee attrition rather than through increased production.
Which puts us right back into the economic cycle discussion we have had all year.
If companies begin to lay off in order to reduce capacity, unemployment rises, consumers begin to slow spending, revenues fall, earnings fall, new loan risk increase driving up the cost of money to corporations, credit spreads rise, bond defaults increase, and equity valuations fall as assets are transferred from shareholders to bond holders to compensate for the defaults.
As this occurs of course the Fed will fight it by lowering short term rates further, printing more money, and buying long term treasuries in an attempt to drive down mortgage rates and pull even more home buyers and cash out home refinancers into the market to offset the corporate consolidation and debt bubble popping.
That's the most probable course I see for the US and the world from here as well.
Just my opinion. I hope it made sense.Roger Bentley Arnold |
