Bulls, bonds and brain damage

There’s a dangerous impulsivity evident in both private equity markets and parts of the bond market that suggests a boom has morphed into a definable bubble. Whether it is from these markets that the next black swan or contagion emerges remains to be seen but bubbles they are, without doubt. In the first instance investors could do worse than rebalancing portfolios by reducing weights to these classes.

When the unthinkable become routine

Persistent negative yields on a growing quantum of sovereign bonds has captured the financial media’s attention. Today, US$17 trillion of sovereign bonds, or about 20% of global GDP, are trading with negative yields. Bonds issued by countries including Switzerland, Japan, Germany and the Netherlands now have negative yields and even dodgier credits such as Italy have negative shorter-term rates.

It has been enough to cause the central banks’ banker, the Bank of International Settlements, in the context of observing that monetary policy will become ineffective “should a downturn materialize” to note, “there is something vaguely troubling when the unthinkable becomes routine”.

Vaguely troubling is putting it lightly when one looks at junk-rated corporate bonds trading at negative yields. Yes, you read that correctly. A bond buyer who holds to maturity can only receive the face value of the bond and the coupon or interest payments. If the premium they pay above face value is greater than the sum of the remaining interest payments, they are locking in a loss.

Of course, if the issued bond is CCC-rated, there is the real prospect that the issuer defaults on their obligation to repay the face value. Typically, this not insubstantial risk is compensated for through a higher yield.

So the buyer of a negative-yielding corporate bond will lose money by holding to maturity and could also lose money if the company defaults. Investors surely cannot be that irrational.

Something else is going on

What is going on is pure unadulterated speculation. The buyer of a negative-yielding bond is simply hoping that rates head even more negative. The only way that can happen is if a bigger ‘fool’ pays a higher price for the bond and accepts an even greater negative yield.

Nobody wants to hold these bonds to maturity, and the buyer is obviously not expecting the company to default while they own the bond. Everyone trading these securities must therefore be expecting to have one last dance before the barn burns down. They’re expecting to be able to get out safely before they’re consumed.

Of course, now that these bonds are already negative yielding, someone has to lose, therefore some will. Whether or not it's brain malfunctioning, consensual hallucination or an intellectual short-circuit, it is rebadging speculation as investing.

So far of course, everyone who bought these bonds at higher yields has done well. In Europe, for example, according to the ICE BofAML Euro High Yield Index, the average yield on junk bonds is less than 2.90%. Anyone who purchased corporate high yield junk bonds back in 2012 when the index yield was at over 11% or in 2016 when the yield was above 6% has made a fortune.

To crystalise the profit, however, the owner has to sell and the new buyer must clearly believe yields will even be lower and more negative in the future so they can, in turn, sell to a similarly brain-dead or testosterone-fueled individual or institution.

European corporate bonds trading at negative yields this year include those issued by Ardagh Packaging Finance plc, Altice Luxembourg SA, Altice France SA, Axalta Coating Systems LLC, Constellium NV, Arena Luxembourg Finance Sarl, EC Finance Plc, Nexi Capital SpA, Nokia Corp., LSF10 Wolverine Investments SCA, Smurfit Kappa Acquisitions ULC, OI European Group BV, Becton Dickinson Euro Finance Sarl and WMG Acquisition Corp.

Elsewhere, it’s the terms of the bond that produces a negative expectancy. By way of example, earlier this month, the owner of the Tinder dating website, Match Group Inc. saw its 6.375% unsecured note trading at 105.35 cents on the dollar.

If these bonds were held to maturity in 2024, they would yield approximately 5% but the yield achieved on these bonds could be much lower because the bonds became callable in June of this year. In other words, at any time, Match can redeem the bonds by paying investors a modest premium over face value. If Match took advantage of today’s speculative frenzy to refinance the bonds, the actual yield would be minus 0.20%. For an online dating site!

Private equity values will come back to bite

The insanity being displayed among negative-yielding, high-yield bond traders is also evident among private equity and venture capital punters.

That Uber even exists is a function of equally brain-damaged altruists. Evidence that its model is broken is the popularity being driven by an underpricing its main service. There is a negative return on its investment in technology and a negative return to its owners. Uber won’t exist in its current form in a decade.

You can predict a similar outcome for Tesla thanks to Porsche, Mercedes, Audi and VW’s announcement of production-ready electric vehicles at this year’s international motor shows. Tesla will be forced to cut prices in an attempt to maintain volume and losses will accelerate.

Then there’s Peloton, a company selling US$3,000 stationary training bikes with a US$39 monthly subscription to an app that links you to your favourite spin class. Think Ab Blaster or thigh master meets Jane Fonda on roller blades with a Nintendo Wii Fit in her hand. It’s a fitness fad whose offer will be on the council collection heap in years to come, seeking a US$8 billion valuation.

Fortunately, the more recent cancellation of the WeWork IPO – US$5 million paid to the founder for the right to use the word ‘We’ anyone (?) – is evidence that the bubble may have been popped.

History is replete with examples of investors losing their minds and believing the unsustainable is permanent. How it plays out is anyone’s guess but serious investors should look elsewhere. Cash may only offer a percent or two but that’s better than minus 50%. It all reminds me of Herb Stein’s quote: “If something cannot go on forever, it must stop.”

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.