HOME >Non Beta Investing: the Ugly Duckling. For now.
In the past several months the global search for income and carry has reached not only a monumental level but also a dizzying speed. A good example is Switzerland, where in July the government bonds under 48 years maturity had started having negative yield. If the assumption is that fixed income investors are still looking to make a positive real return, this situation implies the expectation of a severe continuous deflation for the next several decades. The assumption is wrong, as prices in this market are set by yield insensitive investors like central banks or regulated institutions (e.g. banks). The goal of the former has been to push the tide of yield-searching investors down into corporate assets, all the way to equities. For banks and other systemically important financial institutions this is mostly a regulation-induced behavior. It affects their profitability but it does not seem that there is much they can do around it.
Therefore, when the fixed income market is so crowded by yield insensitive players that the surplus started spilling into equities, where does the market go? Today investors close their eyes, and maybe their critical thinking as well, and take the plunge. The market deems “safe” the next tier of assets, and runs into investment grade, high-yield corporates, all the way to dividend paying stocks. Corporates are the new sovereigns, high-yield is the new investment grade and equities are the new bonds, especially if they are dollar denominated. Therefore $6Bn goes into high-yield funds in July only, and $272M into loans. Maybe one would not think that this is such a big deal, except that it happened when 89% of the IG index had already been priced above par, while 57% of the HY index also traded above 100. As for the cheap bonds, good luck. A full 2% of the IG index had been priced below 90, and only 21% of HY index below the same value. All this before the July wave of investments.
To some extent, this seems rational. As long as the central banks can be the put on equities, today and indefinitely, large/dividend yielding equities are indeed bonds and corporates are sovereigns. In this scenario, the taxpayer is the one taking the first loss; therefore, the taxpayer is de facto the global holder of an invisible new form of security situated below equities. Today and forever – because, remember, equities do not have maturities. But this is a fanciful scenario. In terms of willingness, we did see that the central banks can be the put on sovereigns, even on some bank securities – but not seamlessly. It does take a bail out and most likely a crisis for them to act in this manner. In terms of capability, there is no central bank or any other institution able to shift the world capital structure one level higher, neither today and certainly not forever.
To complicate the problem even more, some central banks have become large direct buyers of equities, even other country’s equities. It is just amazing to us how the Swiss National Bank, the world’s largest hedge fund, directly purchased $15.4bn of US equity in Q1 2016 alone, owning $1.5bn of Apple and $1bn of Microsoft, among many others. They do not stock pick, they just buy what is large and liquid enough. What will happen to the equity indices, we ask ourselves, when the bank will want to reverse its monetary policy and start selling foreign currency and buy back Swiss francs? In short, the put at the bottom of the public markets is not a real put, it is just the belief in it.
Where does this leave us as debt investors? In a generally simple environment. For the most part, any security that can get a credit rating (investment grade and high yield alike) or can be structured as a public equity – preferably yielding some income, is priced with an extremely negative convexity, i.e. the upside is much smaller than the downside. The more it can be accessed in a low cost/passive format, the more dramatic this negative skew and, therefore, its riskiness are. Then there is another universe of securities that either cannot be rated (e.g. non-performing, in restructuring, complex, port-reorganization equities, etc.), that do not yield, and/or are not big or liquid or mainstream enough to be accessed in a beta way. This is the space where positive convexity (i.e. the upside is much higher than the downside) can be found. It is interesting to observe how the more extreme the rotation into riskier assets becomes, the smaller this non-beta universe becomes. More securities are sucked into the tide – the latest example in June-July being the stressed but still performing bonds. However, in the same time, the attractiveness of the remaining non-beta universe has increased significantly, not least because, as alpha investing lags the beta – and it has done so for a while now, pro-cyclical herding of capital accelerates[1]; less and less capital pursue non-mainstream opportunities. Moreover, the more overextended the new “safe” corporates become, the better the opportunities lying ahead of distressed investors. Because central banks cannot change one thing: the secular, technology-driven trends that will put many of these levered companies under severe stress (or out of business) and their bonds and loans out of mainstream.
– Sorina Zahan, Ph.D.
Contains excerpts from Core’s July 2016 partner letter.
[1] To have an idea about the scale of institutional herding we recommend IMF’s excellent working paper from Feb 2016: “Institutionalizing Countercyclical Investment: A Framework for Long-term Asset Owners” authored by Bradley A. Jones.