Illustration by Christina Janus & Desmond Wong
Low Rates Lure Yield Seekers Onto Thin Ice
Some investors are pursuing the safety of federally insured deposits. Others are dissatisfied with low nominal and negative real returns and are moving further out on the risk spectrum in their zeal for yield, regardless of whether they understand the additional risk they are incurring.
In a speech at Jackson Hole, Wyoming, in late August, Federal Reserve Chairman Ben Bernanke acknowledged this possible consequence of his policies. There are concerns that by pushing longer-term yields lower, the central bank’s “nontraditional policies,” namely quantitative easing, “could induce an imprudent reach for yield by some investors and thereby threaten financial stability,” he said. Yet he dismissed this threat, saying, “We have seen little evidence thus far of unsafe buildup of risk or leverage.”
I see lots of potentially unsafe buildups. Consider the rush into junk bonds, depressing their yields and spreads versus Treasuries. So much money has poured into below-investment-grade debt that it now takes real skill to default. In the third quarter, junk-rated companies sold $94 billion in debt compared with $25 billion in the third quarter of 2011. Nonetheless, the global recession will hype defaults even though many low-rated companies have a cushion of safety from prefunded debt.
Zeal for yield has pushed the returns on junk municipal bonds to just 3.15 percentage points more than investment-grade issues, the narrowest gap in two years. These bonds are usually issued by quasi-governmental bodies to finance schools, nursing homes and other facilities. They depend on the revenue generated, and aren’t guaranteed by municipal governments.
Master limited partnerships are usually backed by energy pipelines and other investments that produce steady revenue from long-term contracts. They pay out 90 percent of their earnings, and are able to promote current returns of about 10 percent annually to investors. But in reaction to the zeal for yield, private-equity firms, with the assistance of Wall Street banks, are unloading fracking sand, gas stations and coal mines into these limited partnerships and attracting investors with mouthwatering yields.
Northern Tier Energy LP (NTI), which operates a refinery and a chain of gas stations, has enjoyed a 55 percent increase in its share price since its July debut because of a 19 percent yield on the initial-public-offering price. The share price of Hi- Crush Partners LP (HCLP), which produces sand for fracking hydrocarbons, has jumped 22 percent since its August introduction. It promised an annual yield of 11 percent based on the IPO price. Because of robust investor demand, the market value of master limited partnerships has jumped to more than $350 billion from $65 billion in 2005.
Slightly less risky are commercial mortgage-backed securities, which are in such demand that their yields are at narrower spread compared with their benchmark than when real estate was still booming and risks were ignored. Such securities backed 75 percent of all commercial real-estate lending at the earlier peak, and are gaining in prominence again. Credit-rating companies, however, are warning that the loan quality of such mortgage-backed paper is weakening, possibly putting investors at risk.
There has also been a stampede into emerging-market bonds and stocks, even though almost all of those economies are driven by exports, the vast majority of which are bought by Europe, now clearly in a recession, and the U.S., which is faltering, too. As early indicators, consider sliding Chinese export growth and the declining Shanghai stock index.
I have long maintained that decoupling ranks with free lunch among things that don’t exist. Export-led developing countries simply can’t grow independently of Europe and the U.S., which directly and indirectly buy most of their exports.
Recently, the decoupling theory was once again disproved. Just look at how emerging-market stocks, anticipating a global slowdown or recession, have underperformed the Standard & Poor’s 500 Index in the past year.
Yet that hasn’t slowed yield-happy investors as they move into the sovereign debt of small countries in eastern Europe and elsewhere. Serbia’s 51 percent ratio of debt to gross domestic product is well below those of western Europe and its inflation- adjusted bond yield exceeds 10 percent. The average debt-to-GDP ratio for the 27-country European Union was 83 percent at the end of the first quarter. Spain’s government expects an 85 percent ratio this year and almost 91 percent for 2013. Hungarian bond yields are down from 10 percent last year though they still pay more than 6 percent. In contrast, Barclays Global Treasury Universal index, which is heavily weighted toward large countries, yields 2.7 percent.
An important reason that small markets offer large bond yields is because they tend to be illiquid, especially in times of strain. This was seen clearly in the Asian and Russian debt crises of the late 1990s. This led to jokes that an emerging market was one you can’t emerge from in an emergency.
As for commodities, I continue to regard them as speculation, not an asset class with a strong upward price trend. I am well aware of the often-repeated reasoning that commodity prices must go up in the long run. There are only so many tons of minerals in the Earth’s crust, and they are more and more expensive to recover. There is only so much arable land to grow food for the world’s exploding population. Diets will be upgraded to contain more meat as countries develop, requiring more crops to feed the animals. More and more people in developing countries will soon be driving cars. This will require metals to build the automobiles, energy to fuel them and cement for the roads they will travel on.
Crude oil has long been the darling of the commodity- shortage crowd, and when its price rose to $145 per barrel in July 2008, many became convinced that the world would soon run out of oil.
This “peak oil” crowd was sure that no big economically feasible oil fields remained to be found, so new finds would continue to fall short of demand increases. What they discounted is that reserves are often underestimated because oil fields produce more than original conservative estimates. Nor did they expect significant substitution for petroleum from conventional and shale natural gas, liquefied natural gas, the oil sands in Canada, heavy oil in Venezuela and elsewhere, oil shale, coal, hydroelectric power, nuclear energy, wind, geothermic, solar, tidal, ethanol and biomass energy, and fuel cells.
Yet human ingenuity and substitutes have always overcome shortages quickly. New extracting techniques cut the cost of mineral production. Caterpillar Inc. (CAT) recently introduced a mining shovel that lifts 120 tons, the equivalent of five pickup trucks. Joy Global Inc.’s new entry is even bigger, 135 tons.
Agricultural productivity increases as nations develop better seeds and fertilizers to be used on larger fields with efficient mechanized equipment. Improved breeding and veterinarian care reduce the cost of producing meat. The advent of plentiful natural gas from shale, the collapse in U.S. prices, and new crude oil finds have shattered the theory of a near-peak in global energy output.
Furthermore, for the past 150 years, during which the U.S. and then Japan rose to become major economies and users of commodities, real prices have been in a declining trend. Sure, the American Civil War, World War I and World War II created temporary demand increases, and the oil shocks in the 1970s slashed supply. But the related price surges were overcome quickly with real commodity prices returning to their long-term declining trend.
(In the final installment, I will examine some potential shocks to the system that could end the Grand Disconnect, as financial markets reconnect with faltering global economies.)
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fourth in a five-part series. Read Part 1, Part 2 and Part 3.)
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