Zombies, bombs and vigilantes

The financial news looks like my Netflix account after watching the wrong movie. The recommended viewing section has been invaded by zombies, bombs and vigilantes.

The Bank of International Settlements is warning about “The rise of zombie firms”, which are companies that can’t repay their debts out of earnings.

Legendary fund manager Stanley Druckenmiller is warning about bombs:

… but with the monetary tightening, we’re kind of at that stage of the cycle where bombs are going off. And until the bombs go off in the developed markets, you would think the tightening will continue.

And if the tightening continues, the bombs will keep going off…

The Financial Times went all out with this headline: “Market Forces: The Italian Job — The bond vigilantes flex their muscles”.

These three warnings have something in common. They’re about bonds – a loan you can buy and sell on financial markets.

I always wanted to be a bond vigilante. The idea of profiting from the predictably disastrous consequences of political promises is right up my alley. That’s something Zero Hour Alert readers know first-hand.
As we covered in Capital & Conflict on Wednesday and Thursday, wilful delusion gets you into trouble eventually. And there’s no more wilful delusion than the idea that government can solve your problems. Whether it’s drinking or economic growth, the cure is always worse than the disease once you ask a politician to fix it.

Unfortunately for me, it hasn’t been a good season for the bond vigilantes. In fact, they went into hibernation 35 years ago.

Each time they woke up, it proved to be a false spring. Even when they’ve been temporarily right and interest rates spiked, the consequences played out in the stockmarket, currency market and elsewhere, but rarely in bond markets. In fact, people flooded back into bonds as a safe haven in each crisis…

And thanks to central banks and government bailouts, bond vigilantes didn’t get much of a payoff on their successful bets either. Because central bankers use the bond market as the window through which they manipulate the economy, bond prices haven’t exactly been free to crash.

Today we ask, is all this about to change? Is the next bubble to pop…

The bond bubble

After 35 years in the making, the bond bubble would be the biggest ever. Companies, governments and even mortgages via securitisation are all financing themselves via bonds.

The trouble is, interest rates can’t really go much lower. They can go higher though. And that spells trouble in bond markets and elsewhere.

The Australian Financial Review (AFR) reported on what the consequences look like in Australia in terms you can understand:

PIMCO warns that rising mortgage costs will increase mortgage payments from 38 per cent of pre-tax income to close to 48 per cent, near its worst level over the past two decades.

Interest rate shocks are a shocker, as Aussies might say.

Further AFR articles have the headlines “Developers squeal over apartment price slump” and “6700 apartment projects blacklisted for loans”.

But it’s not just Australian debt markets that are tightening. Bloomberg reports “European Bond Market Falls Victim to Volatility as Third Sale in a Week Pulled”. An Austrian, a German and a Bahraini firm all pulled their bond sales.

Bond yields around the world spiked recently thanks to Italy, the Federal Reserve chairman saying he wants to hike rates much further, and the Bank of Japan winding down its stimulus.

If bonds are in a bubble, it may have just popped.

They all rolled over and one fell out

The trouble with bonds is that you never have to repay them. Sort of.

That sounds like a benefit. But it isn’t.

Let me explain…

Instead of repaying their debt, firms and governments roll over their bonds continuously. They borrow money by issuing new bonds to repay the bonds coming due. In effect, they’re not really repaying them at all.

Investors tend to mimic the behaviour on the other end, rolling over their investments from one bond to the next too.

It all looks peaceful and serene. As if you don’t have to actually repay your debts.

Compare this to a mortgage.

When a bank lends you money, it’s a multi-decade punt on your liquidity. And you eventually repay the debt.

When you finance your business in the bond market, it’s a constant, never-ending process of re-evaluation and analysis. You’re constantly being tested. And the whole market can express an opinion of you.

Would you have been able to refinance your mortgage at any point in your life? Was there no month where you changed jobs or had a health scare bad enough to worry potential lenders?

The bond market is far more fragile than it looks. And the pressure is rising in the US corporate bond market especially according to Goldman Sachs. More than $1.3 trillion of US non-financial firms’ bonds mature between now and 2020. By 2023, US non-financial firms will have to roll over half their debt – $3 trillion.

They all want to roll over. But remember, many in the bed are zombies. And interest rates are rising.

Who will fall out?

I think I know. And it’ll be the biggest default in history.
Until next time,

Nick Hubble
Capital & Conflict

Category: Central Banks

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