Investors Are Too Inured to Markets' Repeated Records

(Bloomberg View) -- After several boom-and-bust cycles it's clear many investors have exhausted the term “bubble.” Instead, they will recall this cycle with another word: “record.” The question is: Will the memories be tinged with regret?

The answer is an unequivocal “yes.” The stock market closes at a fresh high with such frequency it no longer triggers news flashes. The mirror image of these daily records is found in volatility, which has cascaded to record lows.

The bond market, though, is where the real action has been since 2011. If the current pace of sales persists through the final quarter of this year, 2017 will mark the seventh consecutive year of record U.S. corporate bond issuance.

In exchange, investors are extending issuers record lax lending terms and receiving near-record low returns. It is no longer uncommon for bonds to price at yields that are beneath an issuer's leverage as gauged by debt as a multiple of earnings.

Moreover, three-quarters of loans sold into the $1 trillion leveraged loan market are of the “covenant-lite” variety, meaning they do not give investors protection against issuers loading themselves up with debt. Buyers have responded by pushing leveraged loan volumes up by more than half this year compared with 2016; issuance is on pace to surpass 2007's record $534 billion.

And while it isn't at record lows, the yield spread over comparable Treasury bonds that investors receive for investment grade-rated credits has only been lower 20 percent of the time since 2000. In the case of high-yield credit, the spread has only been lower 14 percent of the time in the past 17 years.

The differentiating factor in the years 2004 through 2007, when spreads were at their tightest on record, is the relative dearth of securitization, a process by which pools of loans were divvied up into tranches engineered to disperse risk. Investors learned the hard way as the credit crisis unfolded that these “collateralized” vehicles did not perform as well as the underwriters advertised.

And yet, while there's no question the collateralized mortgage obligation, or CMO, hasn't even flirted with a comeback, the same cannot be said of its cousin, the collateralized loan obligation.

In September, CLO issuance volumes surpassed $82 billion, well past the $75 billion high end of what analysts had been forecasting for the full year. Volumes are running at twice last year's pace and could easily surpass 2007's record $89 billion level.

What's curious is that forecasters had been conservative in their 2017 issuance estimates. Last December, risk-retention rules stemming from Dodd-Frank went into effect, requiring managers to hold 5 percent of their funds. Clearly, they've not proven to be the deterrent that was expected.

As Bloomberg reported, even so-called synthetic collateralized debt obligations have risen from the grave. These instruments invest in credit default swaps and other noncash assets to effectively create exposure to a portfolio of fixed-income securities.

The one thing that has not changed since the crisis is the appeal these structures hold for investors. Credit-rating companies magically convert individual junk-rated loans into AAA-rated securities in their post-securitized newly bundled form. This parallel has left some industry watchers weary even as new CLO products open to small investors hit the market. Some managers have even contrived funds that allow mom-and-pop investors to gain exposure to private equity funds that have typically been open only to institutional and other qualified investors.

Retail investors are not alone. Public pensions have also been piling into illiquid credit funds to offset the income their portfolios cannot generate against a backdrop of near-record low yields in safer bonds. Canaccord Genuity's Brian Reynolds tallied $25 billion in fresh allocations on pensions' part in the past 12 weeks alone.

Since Detroit's 2012 bankruptcy, Reynolds figures pensions have plowed upwards of $350 billion into credit funds that have in turn fueled the stock market rally via the share buybacks issuers finance with the proceeds.

Are pension fund managers and small investors to be drawn and quartered for taking on undue risks at this late stage in the credit cycle, even in the face of a record number of records? As has been the case for the better part of two decades, safer alternatives simply don't pay, so what's an investor to do?

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of "Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America," and founder of Money Strong LLC.

To contact the author of this story: Danielle DiMartino Booth at Danielle@dimartinobooth.com.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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