“Every reaction has an equal and opposite reaction.” The words of Sir Isaac Newton could not be more true when addressing the fixed income market.
When the Federal Reserve decided to lower interest rates to nearly zero percent several years ago it affected the market in two very distinct ways. First, it eventually revived the housing market (albeit sluggishly), in relation to it ghastly state of the late 00s. When interest rates are low it encourages those with mortgages to refinance, and an uptick in home buying. This was great, as a recovering housing market is vital to the heath of the broader market. But low rates also had another effect: treasury yields reached very low levels (bond prices and yield have an inverse relationship). The unattractiveness of treasuries was compounded by the bull market in equities, in fact some point out that capital flows from the bond market into equities (stocks) is one of the main catalysts of the multi-year bull market.
So what does a fixed income investor do when treasuries cannot generate a desirable return? The simple answer is they start buying lower rated, but higher yielding corporate or sovereign debt. This means that these investors became creditors to companies or countries whose ability to meet its debt obligations was in question, their variable levels of yield serve as an barometer of creditworthiness (higher yield=higher risk). High yield and distressed debt offerings have been oversubscribed in recent years, as the desire for higher yields intensifies.
Not only have investors been piling into riskier corporate debt, but they have increasingly been engaging in structured finance transactions. Structured finance deals are very complex in nature. Some structured finance products, such as the collateralized debt obligation (CDO) gained notoriety during the financial crisis. Without going into too much detail, the structure of CDO is as follows. Before a CDO is structured, fixed income assets, such as mortgages or car loans are first warehoused, this simply means gathered and set aside for eventual use. These assets are pooled, and then they are broken into components called tranches. Tranches are determined by risk profile of the assets within. The highest rated assets make up the “super-senior” tranche. In relation to the rest of the CDO, the super-senior tranche has the lowest risk profile, and thus the lowest yield. Depending on the CDO, after super senior comes the senior, then mezzanine, and then the eventual equity tranche, which is the most risky, but also provides the highest yield. The kicker in these deals is that typically the issuer of these products holds onto some of the initial super senior. That means that the criteria of super senior (and thus all proceeding tranches) may become porous. Some prime may become super senior, some mezzanine prime, and that cascades down the tranches. It’s easy to spot the risks in some of these deals, but clients play a heavy role in the selection of the underlying securities that go into CDOs, so whatever the final product becomes, it is meant to service their needs.
If one were to make the argument that this eventual search for yield was a function of free markets I would not argue, investors have every right to make any investment they see fit. However, investors aren’t receiving adequate returns for the risks they are incurring. More volume in the high yield/distressed debt markets leads to tighter spreads. Although higher volume leads to more liquidity, the crowded market diminishes the ability to generate the usual rate of return. When risk becomes discounted one must be even more watchful and examine whether they are really making the best choice of investment. Rates won’t be at such depressed levels forever, the dovish Fed looks to ready to raise rates (in 2015) for the first time in years. When that happens there will be a probable mass exodus from high-yield corporate/sovereign, and back into treasuries, and may even serve as the catalyst for a pullback in equities.
For more information on CDOs, checkout http://pages.stern.nyu.edu/~igiddy/articles/synthetic_cdos_illustrated.pdf
Before The Tape 