Low rates lure yield seek­ers onto thin ice

The Pak Banker - - Front Page - Gary Shilling

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 longert­erm 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 quasigov­ern­men­tal 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 as­sis- tance 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 yield­happy 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.

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