There's Been a Bezzle-Fueled Boom in Bonds

Easy money and the confidence that comes with it conceals a wide variety of risk.

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Economist John Kenneth Galbraith has written many words we should all read, but one in particular is proving especially relevant as cracks in the credit markets continue to spread.

That word is bezzle. It describes the period in which an embezzler has stolen a man's money but the victim does not yet realize he's been swindled. It is, as Galbraith puts it, a time when there is a "net increase in psychic wealth." Charlie Munger, Warren Buffett's longtime investment adviser, later built on the idea with his coining of the word "febezzlement," which (perhaps unnecessarily) formally extends the concept to include completely legal but nevertheless unexpected appropriations of wealth.

Whichever term one chooses, it looks increasingly likely that the world has experienced a massive fe(bezzle) in corporate credit.

Years of low interest rates since the financial crisis have encouraged investors to pile into the asset class, reaching for the higher yields on offer from such securities as sliced-and-diced packages of commercial real estate loans, leveraged loans, and crucially, corporate bonds. An ever-ready supply of eager lenders and investors has kept borrowing costs low, enabling companies to fund a share buyback and M&A spree that has helped propel the recovery in the stock market, fueling the wealth effect on the overall market.

The bezzle is what has enabled companies to be continuously rewarded for rollup strategies or embarking on ever more-complex corporate structures. It's what's allowed the average level of indebtedness at U.S. corporates to rise to its highest level in a decade. It is the thing that has masked potential risks in the credit system, leading to billions of dollars of underwriting fees for banks and a market for new-issue bonds in which prices are only ever expected to *pop* thanks to a perceived massive imbalance of demand and supply.

It is what has allowed a host of dollar-denominated emerging market bonds to infiltrate the U.S. credit market, or the riskiness of benchmark bond indexes to quietly increase. As David Keohane of FT Alphaville points out this morning, citing a UBS analysis, the portion of triple-C issuers in the Citi U.S. High-yield Cash Bond Index is currently at 13 percent using an average of ratings from the big three bond graders. Using just the ratings of Moody's, the most conservative of the three rating agencies, the proportion of triple-Cs increases to 20 percent.

The confidence that comes with the bezzle is also what has allowed banks and investment houses to enjoy higher commissions or returns while simultaneously cutting back on the number of credit analysts they employ. UBS analysts Matthew Mish and Stephen Caprio have previously pointed out that "simply put, the growth of the credit markets [has] not been matched by the addition of research resources (e.g., credit analysts) in many of the silos," citing the example of high-yield money managers with one energy analyst responsible for covering $200 billion in bonds outstanding across 300 separate debt issues.

Money managers' allocations to corporate bonds are now at a record 35.7 percent, according to the Stone McCarthy Money Manager Story.
Money managers' allocations to corporate bonds are now at a record 35.7 percent, according to the Stone McCarthy Money Manager Story.
Source: Bloomberg

It is what has allowed money managers to load their portfolios with corporate debt—allocations to corporate bonds are currently at a record according to the Stone McCarthy survey of money managers that has been going since 1999. And crucially, it is what has allowed investors to continue to load up on corporate bonds even in the face of the first interest rate hike from the Federal Reserve in almost a decade.

As Galbraith writes, the bezzle "varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly."

As the ready supply of money retreats, the bezzle is arguably only just beginning to be exposed.

Investors have in recent weeks and months become choosier when it comes to the corporate credits they are backing, with energy companies so far bearing the brunt of that new-found selectiveness, but many analysts are speculating that the pain could spread. Riskier companies that have relied on a steady stream of investors to refinance their debt continuously will likely feel the effects' of markets' new-found shrewdness the most, though even investment-grade companies boasting stronger balance sheets may not prove immune.

Source: Bloomberg

Meanwhile, the cost of funding credit positions has been increasing, with the three-month general collateral repo rate ticking up for the first time in many years. As David Schawel, portfolio manager at New River Investments, notes, the rise in funding costs is important as the confidence-boosting effect of the bezzle, combined with financial suppression caused by low interest rates, has encouraged many investors to leverage their assets to juice their returns. "The fallout from higher funding costs can end up having a chain reaction that can lead to further pain in the credit markets," he says.

Bezzles do not necessarily have to end in big busts, though they do tend to be susceptible to a rapid reassessment once confidence—Galbraith's "psychic wealth" effect—begins to evaporate.

Put simply, everything tends to go fine until it doesn't. 

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