Steve Eisman shot to fame after Michael Lewis's book The Big Short, which homed in on his profitable bets on the US housing market collapse which tipped the world into recession. Now the New York fund manager is eyeing another menace to the financial system: corporate bonds hovering just above a junk rating.
The market for triple B-rated bonds – the lowest rung of investment grade – has exploded in size since the financial crisis. Outstanding issuance of such bonds has grown from $750 billion (€651 billion) at the end of 2007 to about $2.7 trillion now, as debt-laden companies have been kept alive by low interest rates and a generally improving economy.
But size is not the problem, says Mr Eisman, who is now a portfolio manager at Neuberger Berman, an investment group based on Sixth Avenue which was spun out of Lehman Brothers a decade ago. Rather, he says, it is that big banks have cut their trading inventories of triple-B bonds by about 80 per cent, to $20 billion, as they try to comply with tougher rules on capital and liquidity. With the traditional market-makers on the sidelines in the next recession, Mr Eisman says, the only way to sell such bonds will be at painfully deep discounts – forcing big marked-to-market losses on funds holding them.
Mr Eisman does not see an economic slump around the corner: “You can’t have a recession when consumer credit quality is as good as I’ve seen it in my whole career,” he says. But companies with outsized debt loads should be hit hardest, when the contraction does come.
Triple B-rated corporate bonds have been wobbling for a while. The asset class has returned 109 per cent since the beginning of 2009, much better than the broader US bond market’s 40 per cent gain over that period. But the bloom came off in 2018, as the bonds lost over 3 per cent, their worst year since the financial crisis, according to an ICE BofAML index.
Analysts say investors may be responding to the expansion of the market through downgrades by the credit rating agencies of giant issuers such as General Electric and Altria. The net volume of corporate debt relegated from a single-A to a triple-B rating reached $115 billion in 2018, up from less than $1 billion in 2017, according to Bank of America.
Meanwhile, other supports for the market have begun to fall away. Steve Boothe, lead portfolio manager of the global investment-grade corporate bond strategy at T Rowe Price, notes that in 2017, volatility was depressed while valuations were propped up by expansive central banks and synchronised global growth. Now, he says, "we are unwinding that".
"Liquidity across the market has been diminishing" for about a year as a result, he says, attributing the fall to interest-rate hikes from the Federal Reserve, which increases the relative appeal of safer assets, and less buying by foreign investors as the dollar rises. US bond funds have seen six straight weeks of investor outflows, according to EPFR Global.
There are doubts, too, whether banks burdened by new rules will perform the same shock-absorbing roles of the past. Bob Summers, who manages portfolios of investment-grade bonds at Neuberger Berman, says that the big banks were never a panacea in moments of real market stress.
“Even when [dealers] had more available capital, when you had volatility, they took a step back. But the market would re-price, and liquidity would eventually return,” he says. The same process should happen now, but more suddenly, Mr Summers says.
Another wild card is the behaviour of retail bond-fund investors and institutions which have arrived in force in the BBB market, seeking yield. Previously, such investors – Mr Summers calls them “renters” – tended to invest in higher-rated bonds.
Over the past year, as the Fed has lifted short-term rates, these investors have started to migrate out of the market. So far, Mr Summers says, the renters’ departure has been “orderly”, and “you would have to have something materially change in terms of the global economy” for the race for the exits to get messy.
Rajeev Sharma, director of fixed income of Foresters Investment Management, notes that markets for corporate bonds in certain sectors such as food and autos are already illiquid. With certain car-company bonds, he says, it is impossible to find buyers at the prices quoted on trading screens.
The catalyst for a real crunch, he thinks, could be a big issuer of triple B-rated bonds getting downgraded to junk – a rating many investors’ mandates forbid them to hold. Mr Sharma thinks markets for the downgraded bonds could feel like the markets for energy bonds after the oil price crashed in 2014. “You couldn’t sell your bonds, there was no bid,” he says. “Even for strong companies, no one was touching it.”
Nikolaos Panigirtzoglou, a JP Morgan analyst, says there is a "pretty elevated" risk of a spate of triple-B bonds getting relegated to junk this year, causing a "disorderly" dislocation in both investment grade and high-yield debt on both sides of the Atlantic.
Mr Sharma notes that those who did not sell their energy bonds in 2014 eventually recovered their investments. The big question, as Mr Eisman points out, is how many people will be able to survive investors’ demands for their money back – and hold on to their triple-B bonds. – Copyright The Financial Times Limited 2019