Prices in the junk bond market
There are various ways of deciding how valuable something is. People spend some amount of time talking about “the current value of future earnings til the end of time” as a rule-of-thumb measurement. That sometimes works (i.e. jives with what the selling price is), but it’s certainly not robust – in a given case, plenty of people think there’s a good reason a stock should be worth more than that, if their personal growth projections are rosy (you could argue that they are still valuing future earnings, but they’ve got a different projection than, say, the current dividends continued as is. Another possibility is that they’re simply valuing future values coming from other people). Similarly, some stocks are underpriced with respect to this baseline. Could it be that they’re cooking their books? If they don’t last til the end of time then they could hardly be making earnings til then (Groupon).
Of course when you go down that road, nothing lasts til the end of time. Never mind companies, the industry in which the company sits will be dead before too long unless it’s food or cosmetics.
Anyway, throw out the future earnings price for a moment, and replace it by something else entirely: there’s a certain amount of money invested in the (international) market at a given moment, and it has to go somewhere. I think of it as a big pot that sloshes around and achieves equilibrium depending on various things like relative interest rates in different countries, and to a lesser extent, regulation in different countries and access to markets. Like, the carry trade is kind of a big deal, and depends almost entirely on the Japanese interest rate being tiny.
Of course it’s not really that simple, since people can and do remove money from the market at certain times – it’s not a closed system. But not as much money is removed as you might think, because if you think about it, lots of people have set up their livelihoods to be investing large pots of money, so they need to appear busy.
Articles like this one from Bloomberg make me think about the “where should we put our money that we need to invest somewhere?” effect is particularly strong right now. We see people “chasing yield” in the junk bond market, buying junk bonds that have positive yields because their options are limited while the Fed keeps the rates really low (this is not a side-effect of the Fed’s keeping the rates low, it’s their goal. They want people to invest in financing businesses, which is what buying junk bonds is).
But they (the investors) all want the same stuff, so the prices are too
low high, which is another way of saying the yields are a lot lower than they’d otherwise be if there were other things to buy. This might be a good example of where the price of junk debt is not particularly good at exposing the actual risk of default. Well, it might be an ok indicator of the very short-term default rate, but that’s just because money is so cheap right now, businesses in trouble can just borrow more. It’s kind of a set-up for a bubble.
The article makes the point that once the Fed raises rates, people will flee this market, since they will actually be able to make money again with less risky bonds. The slower actors will be left with much-reduced-in-value junk debt. The big pot of money which is the market will have an entirely new equilibrium point, and there will be lots of death and destruction in the transition. It’s become even more crucial than usual to time the Fed’s moves, but keep in mind money managers are going to stay in there as long as they possibly can because they don’t want to miss yield while their bonuses depend on it (“opportunity costs”). It’s a game of chicken.
Staying with the meta-analysis, can someone do a back-of-the-envelope estimate of how much built-in interest rate risk we’ve taken on by the issuance of so much junk debt in the overall international portfolio? Is it sizeable?