Home > finance, musing, news > Prices in the junk bond market

Prices in the junk bond market

March 1, 2013

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?

Categories: finance, musing, news
  1. FogOfWar
    March 1, 2013 at 9:52 am

    Dead on balls accurate (it’s a technical term).

    Quantification would be a really tricky exercise.

    FoW

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  2. High and Dry
    March 1, 2013 at 9:55 am

    “but it’s certainly not robust” – you can say that again.

    I ended up on the high yield desk of a major investment bank and my job was to price bonds. My boss’s “method” – everyone’s method it seems – was to simply eyeball the prices of a handful of similar bonds (there were always some mismatches be it risk profile, tenor, terms, whatever), stick his finger in the air and then proclaim the price.

    I suggested there might be a more robust way of doing things and built a pricing model… and was promptly told to kill the model because a model simply cannot capture how complex and nuanced the whole pricing problem is (code for “if anyone realised you could model this we’d be out of a job”). It was made very clear that I was to never again attempt applying science to the problem.

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  3. Michael H
    March 1, 2013 at 3:35 pm

    *ahem* “But they (the investors) all want the same stuff, so the prices are too 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.”

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  4. Gordon Henderson
    March 1, 2013 at 4:04 pm

    Markets exist because the future isn’t certain (if it was, we wouldn’t need money), and transactions happen in part because market participants reasonably have different views about what will happen: scale of cash flows, discount rates etc. Not everyone is going to be right all of the time, so some people are going to make money and others are going to lose it.

    As long as everyone is informed about laws of nature – bond prices going down as interest rates rise, for example – what is the problem with the interest rate risk that they’re incurring through bond purchases? I’m not saying that the risk isn’t there – it self-evidently is – but just that you have to have an explicit expectation about interest rate changes when you trade in FI, and pricing that risk is kind of your job.

    To go back to a distinction you elide in your opening paragraph, there’s a difference between price and value. Value is the sum of future cash flows discounted back to the present at the appropriate rate. Price is whatever people are willing to pay for them. If you want to think about it temporally, price is knowable now, and value is only knowable after the fact. The price that people are paying for bonds reflects their estimation of value… they’ll find out later if they were right or not, but again – figuring out the value (which in this context necessitates having a view on interest rate risk) is what they’re supposed to get paid for.

    And to answer your question directly, FOW has it down: yes, there’s shit loads; adding up the sensitivity would be really hard; but, there’s nothing about that aspect of this market that isn’t transparent, so is there really a problem?

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  5. March 2, 2013 at 12:21 pm

    The ancient rule you are looking for is: “When there is nothing to invest in, you’ll have to put your money in the market.” Of course, that makes the prices go up and the yields or inverse P/Es come down. If the economy were robust and incomes were rising, there would be all sorts of investment opportunities. You could build new factories, stores, land, goods, labor and sell their produce at a profit. You might even be tempted to invest more. We haven’t really had any income growth since the 1970s, so returns on investment have been slowly falling. Combine this with pro-savings and low inflation policies, and we have a huge savings glut. As you noted, it has to go somewhere, so asset prices inflate and yields plummet.

    In the 1960s and 1970s, we had demand driven inflation, so the prices of goods and services went up. This hurt tenured asset holders, so they made a conscious decision to end economic growth. (If you believe standard economic theory, inflation is how resources are allocated during times of growth. No growth means no inflation, and that suits some people just fine.) Since then we’ve had a series of asset bubbles as too much money chased too few business opportunities.

    —–

    Gordon Henderson is 3/4 right about the price/value issue. The fact is that prices are real. They are measurements. Value is a derived property estimated by looking at what are considered comparable prices. As you noted, brokers produce bid and ask prices by looking at “comps”, comparable prices. Naive investors assume these are values. Classical economics lets one compute “value” by multiplying a recent price level times the quantity, but only when the quantity is small compared to the general market value and the item is a commodity. Otherwise, value is a fiction. (A model is just a way of using a small number of prices to estimate a broader range of bid and ask prices. There is no royal road to valuation.)

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  1. March 1, 2013 at 7:44 am
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