Interpreting Middle East Economic News and Analyzing Market Trends

Junk bond issuance hits new record, time for sukuk issuers to stay clear of this bubble

Junk bond issuance hit a record in 2012 and is on track to hit another record in 2013.  Much like the sukuk market, junk bonds have been the hot product on Wall Street ever since the Fed and ECB pushed interest rates near zero and promised to keep them there for years to come.  Investors searching for higher yields had to look outside of these markets for better returns.  This ushered in the new era for the junk bond market.  Here’s a recent article on the junk bond market:

Wall Street banks are selling junk bonds at a record pace — raising concerns they are selling debt that may be poised to lose value.

 The banks spent more than $93 billion dealing with costs from the 2008 credit crisis, including lawsuits and fines for allegedly misleading investors about mortgage-backed products.

This time is different, bankers say.

  

  For anyone who believes in “this time is different,” I suggest reading This Time Is Different: Eight Centuries of Financial Folly, by Kenneth Rogoff.  This time is not different; markets inflate and deflate all the time.  The trick is knowing when to spot an inflated market…. The junk bond market is displaying some of the key signs right now.  Here’s more…  

Wall Street banks have underwritten $89.6 billion of high-yield debt so far this year, up 36 percent from the same period in 2012, according to data compiled by Bloomberg.

 Last year’s $433 billion of sales was an all-time high for the asset class and produced about $6 billion in fees, the data show.

 JPMorgan Chase, Deutsche Bank Citigroup and Bank of America are leading firms benefiting from growth in a market where the average underwriting fee is almost three times as big as for selling more creditworthy bonds.

  Please read the above sentence again! Does this smell like a bubble?

Meanwhile, investors poured $33 billion into mutual funds and exchange-traded funds dedicated to junk bonds last year, 55 percent more than in 2011, according to Morningstar Inc.

 The risks to investors are less about the bonds’ creditworthiness and more about benchmark government borrowing rates that eventually must rise after falling to a three-decade low, bankers say. The pace of leveraged buyouts, which issue junk bonds to fund acquisitions, is nowhere near the levels in 2006 and 2007, bankers say. Much of the new debt has been issued by companies refinancing at lower rates instead.

 “Investors and underwriters in this market are showing credit discipline,” said Marc Warm, New York-based head of U.S. high-yield capital markets at Credit Suisse Group, which ranks sixth among high-yield bond underwriters globally, according to data compiled by Bloomberg. “The rate environment is probably more of a risk today.”

  Another sign of a market peak, believing all is under control, especially when underwriters are getting 3 times the fees to underwrite junk, what could go wrong?  Investment bankers are an honest, self-regulating bunch.

To stoke economic growth, the Fed has kept short-term borrowing rates close to zero for more than four years and purchased U.S. Treasuries and mortgage-backed bonds to drive long-term borrowing rates to a record low.

 Falling interest rates have increased demand for higher-yielding debt, boosting prices on dollar-denominated junk bonds to a record 105.9 cents on the dollar last month, according to Bank of America Merrill Lynch data. As yields have collapsed to 6.54 percent from a peak of 22.7 percent in late 2008, junk bonds have become more sensitive to the risk that underlying government bond yields could increase.

 The extra yield that investors demand to own junk bonds over government debt, known as the spread or risk premium, has contracted by 16.69 percentage points since 2008 to 5.24 percentage points, according to the Bank of America Merrill Lynch Global High-Yield Index.

 While economists surveyed by Bloomberg expect 10-year Treasury yields to rise by less than a percentage point through the first half of 2014, some investors already are preparing for higher rates by funneling record amounts of cash this month into leveraged loans, which are tied to floating-rate benchmarks. The world’s biggest corporate-bond buyers also are seeking refuge in shorter-maturity notes. So are some banks.

 PNC Financial Services Group president William Demchak, a former JPMorgan executive, said the Pittsburgh-based bank is sticking to short-term investments in its fixed-income portfolio to avoid losses when interest rates climb. He said he expects long-term rates to swing higher before the Fed starts raising rates.

 “The long end of the curve could get out of their control,” Demchak, who will become PNC’s CEO in April, said in a telephone interview. “That’s everybody’s fear. I think that’ll happen sooner than people expect.”

 Wall Street’s biggest banks have benefited most from fees tied to junk-bond sales, with the top 10 underwriters capturing 45 percent of assignments last year, according to data compiled by Bloomberg. JPMorgan, first every year starting in 2009, is leading 70 firms in the global market this year, the data show. Frankfurt-based Deutsche Bank and New York-based Citigroup are ranked second and third.

 Debt underwriters and investors say they don’t know what might happen if Treasury yields climb by more than a percentage point or two.

   

Rates on 10-year Treasuries are already on the rise; rising from a record low of  1.5% in 2012 to 2% recently.  If rates keep rising, investors will bring some of their money home for safekeeping, causing the junk bond market to fall apart.

 There are risks that are not being considered, another sign of a market about to pop.  However, we are not experts so here’s what one expert had to say:

 “I’ve been in the business for 40 years, and the reality is that we’ve never had a situation like this because this is totally manufactured by the Fed,” said Michael Holland, chairman of New York-based Holland & Co., which oversees more than $4 billion. “You have the prices of bonds acting like dot-com prices.”

There you have it, we are in uncharted territory and have no idea what will happen, but looking back at history, we can see that these situations tend to end badly.

 

The craze for so-called dot-com Internet stocks caused the Nasdaq Composite Index to more than triple between the end of 1997 and its peak in March 2000, only to plunge 77 percent by the end of September 2002. More recently, the home-loan bubble more than doubled the size of the mortgage-backed bond market from the end of 2004 to mid-2007, according to Fed data, only to collapse when housing prices fell.

 In both cases, banks that profited by bringing the securities to market were later accused of misrepresenting the risks and contributing to losses.

 Crisis emerging?

 Rising demand has meant more lenient terms for some debt. Borrowers are selling speculative-grade bonds that have the weakest covenants in at least two years, according to Moody’s Investors Service. Downgrades of the least-creditworthy companies outpaced upgrades last year for the first time since 2009 at both Moody’s and Standard & Poor’s.

 Legal & General Group, which oversees about $3.5 billion in junk bonds globally, has shied away from about three-quarters of the high-yield deals brought to market this year amid concern that some companies borrowed too much and debts may lose their value, said Stanley Martinez, who runs high-yield credit research for a U.S. subsidiary of the London-based firm.

 Legal & General has declined to buy debt sold by companies including Caesars Entertainment Corp., the biggest U.S. owner of casinos, Lennar Corp., the largest U.S. homebuilder by market value, and WEX Inc., a payments processor, he said.

 “Some of the originations of high-yield loans and term bonds that you’ll see in 2013 and 2014 will be the raw material for the default cycle of 2015 and 2016,” said Martinez, who’s based in Chicago. “I’m very confident of that. But we’re not there yet.”

 Read the full article from The Commercial Appeal.

    What does the junk bond market have to do with the sukuk market?

First, read our earliest post titled Emerging Market Debt Issuance Hits Record and Spills Over into Sukuk Market as Investors Worldwide Hunt for Yield. Much of the sukuk issuance comes from emerging markets.  In fact, the largest sukuk market is Malaysia, which is also a leading emerging market.  Indonesia and Turkey have also become active in the sukuk market.  The GCC, which is seeing the largest growth in sukuk, has steered clear of junk issuance, mainly because they can afford to do so and have investment grade credit ratings.  However, international investors hungry for yield have been searching all over the world for higher returns.  This is why yields on junk bonds have come down, but it’s also the main reason for the falling yields on sukuk.  The yield on Dubai government sukuk, for example, have dropped by more than half from 5.13% to 2.23% in one year according to Bloomberg.

The dramatic drop in sukuk yields are also leading to a rush to issue sukuk.  This year is expected to be another record year for the sukuk market.  Whether sukuk investors like it or not, their fate is linked to the junk bond market.  While sukuk are a completely different instrument, little has been done to highlight their differences.  One key difference is that sukuk are not bonds at all.  In fact, there is no such thing as an Islamic bond.  Sukuk might behave like bonds and share some characteristics, but they are securities backed or based on assets.  They are not loans, secured or unsecured.  Therefore, the risks of a sukuk are not the same as bonds.

Sukuk issuers need to differentiate themselves from bonds, not only because they are a different asset class, but also because they need to remove any doubt that they are emerging market debt or worse, junk bonds.