How Did That Get Into My Bond Fund??

Towards the end of financial bubbles, people who previously paid little attention to things like “quality” start trying to figure out what they actually own. The result is either funny or terrifying, depending on the point of view.

This time around bonds are (finally) getting a closer look. From today’s Wall Street Journal:

Decade of Easy Cash Turns Bond Market Upside Down

Debt deals set records from Tajikistan to East Rutherford, N.J., as investors keep hunting yield.

Last fall, a hydroelectric dam in Tajikistan, the government of Portugal and a cruise-ship operator all issued debt at unusually low interest rates. The seemingly unconnected deals are part of a proliferation of aggressive bond sales influenced by a decade of loose monetary policy and a demographic shift in global investing.

Historical limits on who can borrow, and at what cost, have broken down as fund managers agree to previously unpalatable terms.

Central bankers in the U.S., Europe and Japan helped shape the new breed of deals by simultaneously purchasing over $1 trillion in high-quality bonds since 2009 and lowering benchmark interest rates to jump-start their faltering economies. Modest economic growth came, but the strategy crowded private investors out of safe debt, prompting them to buy riskier bonds to boost returns.

Retiring baby boomers amplified the trend by moving their investments away from stocks into bonds, boosting assets in U.S. bond mutual funds to $4.6 trillion in November from $1.5 trillion a decade earlier, according to the Investment Company Institute, a trade group for investment firms.

The article goes on to present some examples of bonds that might not exist in less bubbly times. Here are three:

• Tajikistan borrowed $500 million to finish construction of a hydroelectric dam that was started under the Soviet Union. This is one of the world’s most corrupt countries – a fact noted in the offering prospectus — and the dam’s electricity will be sold to Afghanistan, which, as most Americans know, is in the middle of a civil war that the “good guys” might easily lose (also mentioned in the prospectus). The deal’s investment bank, Citigroup, initially marketed the bonds to yield 8% but received such a warm welcome that it cut the rate to 7.1%. Buyers included big U.S. firms like Fidelity, which bought $14 million of the bonds, presumably to boost the yield of funds sold to retirees.

• The American Dream Mall in East Rutherford, N.J. broke ground in 2003 but ran out of money to finish construction. In 2017 the mall’s current owner—its third—employed Goldman Sachs to sell $1.1 billion of 6.9% muni bonds, fully half of which were bought by the Nuveen fund family. “Unlike most malls, American Dream will derive most of its revenue from experiential attractions that can’t be replicated online, rather than depending on retailers,” said a Noveen executive.

• On Nov. 8, Portugal sold €1.25 billion ($1.55 billion) of 10-year bonds that yielded 1.94%—the lowest rate ever for the country. Portugal needed an international bailout in 2011 and still has a junk credit rating. It’s one of the most heavily indebted countries in Europe, but the auction set its borrowing cost below that of the U.S. government, which sold 10-year bonds in November to yield 2.31% [those bonds now yield 2.7%].

What does all this mean? In a nutshell, crazy stuff has been happening under the placid surface of the fixed income market. None of the three bonds profiled here are especially good bets, and retiree and pension fund portfolios are full of similarly toxic paper.

When a few such deals blow up – as bubble assets always eventually do – investors will start wondering what’s going to blow up next. And they’ll find not just a few but many, many bad ideas lurking in their “low risk” accounts. The resulting stampede for the exits will look familiar to anyone who lived through the tech stock and housing busts of previous decades.

With one big difference. This time around crappy, crazy paper is not just in tech stock and ABS portfolios. It’s everywhere. Trillions of dollars of sovereign debt will tank along with the sketchy shopping mall and emerging market infrastructure bonds. The resulting bust will be more broad-based and therefore way more interesting than anything that’s come before.

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