Is it time to have a spring clean of the junk in clients’ portfolios?
US investment legend Warren Buffett once commented: “We have a lot of fun as the bubble blows up and we all think we are going to get out five minutes before midnight – but there are no clocks on the wall.”
Thankfully, advisers do not need to rely on missing clocks when it comes to protecting clients’ wealth from the dangers that lurk in markets, and that are frequently at their most dangerous when making money looks easiest.
They can trust their own experience and their instinct. Those with long memories may have an advantage here, but in many cases the application of common sense will do.
Last summer this column, without wishing to sound like a terrible Cassandra, warned of the possible implications for sovereign debt markets, especially in Emerging Markets, of June 2017’s 100-year Argentine Government bond issue. The $2.75 billion slug of paper came with a coupon of 8%.
Enthused by President Macri’s reforms package and seduced by the yield, buyers either wilfully ignored or could not be bothered to research Argentina’s dismal record when it came to both debt defaults (just the five in the last 100 years) and inflation.
Roll on barely 12 months and Argentine inflation has galloped to 26%, the peso has lost 30% of its value against the dollar and the central bank has jacked interest rates up to 33.25% amid a gathering sense of crisis.
The net result is the (dollar-priced) ‘Century’ bonds are already trading at just 88 cents on the dollar, a loss which, if crystallised, would already wipe out 18 months’ worth of coupons.
Moreover, advisers and clients can see what has happened to sovereign bond prices and yields since that Argentine issue on a global basis ...
Global government sovereign bond prices have fallen ever since the Argentina ‘Century bond’ issue ...
Source: Thomson Reuters Datastream. (Based on Bank of America Merrill Lynch Global Government Bond Total Return Index)
... and also specifically in an Emerging Markets context.
... as has the price for Emerging Market sovereign paper
Source: Thomson Reuters Datastream. (Based on Barclays Emerging Market Local Currency Government Bond Index (priced in dollars)).
In sum, bond prices have fallen (and yields have risen) relentlessly.
It was as if someone had just rung a bell, to warn the unwary that perhaps the Argentinian seller was getting the better half of the deal and that trouble lay ahead for the buyers, despite the 8% coupon which lured in so many income-seekers. While the specifics of one particular bond issue will have been of little direct interest to advisers and clients, the wider implications may have been.
Now another bell may be ringing, this time in the field of corporate, sub-investment grade debt, also known as high-yield or ‘junk’ debt.
This is because two recent deals in particular stand out.
- The first came from Netflix. No sooner had the American media giant published first-quarter earnings which showed bumper growth in sales, subscribers and stated profits than the company issued $1.9 billion in 10.5-year bonds. They came with a coupon of 5.875%, a premium of less than 300 basis points (3.0%) over 10-year US Government bonds for a borrower rated B+ by Standard & Poor’s.
Whether it proves a good deal for the bond buyers remains to be seen, especially as that was Netflix’s third bond issue in barely a year, after a $1.6 billion, 10.5-year deal priced at 4.875% and a €1.3 billion, 10-year issue priced at 3.625%.
And if Netflix is so profitable, why does it need the money?
The company is registering profits but it is also burning cash, as it acquires and develops more content in a subscriber land-grab, hoping to monetise them in the future. This is a high-risk, if potentially high-reward strategy, not least as Netflix now has more than $16 billion of debt and content purchase commitments to fund.
Netflix’s cash burn explains why it continues to issue (junk-rated) bonds
Source: Netflix accounts
- The second deal came from WeWork, a so-called ‘unicorn’ (with an estimated value of $20 billion) which leases large office spaces and then prepares them to package them up and lease them out in small chunks to start-up firms or individuals.
The firm is reportedly heavily-loss making and presumably eating through the $4.4 billion investment from Japan’s SoftBank last year, which may be why it rushed out a seven-year, $700 million bond, also rated B+ by Standard & Poors.
The coupon was 7.875% but the bonds have already dropped to barely 95 cents on the dollar, according to the Financial Times newspaper. In both cases, just as with Argentina, advisers and clients need to think about why these bonds were issued now and for whose benefit. It may be that the sellers think the terms for any future issuance will be worse for them (higher yields as US interest rates in particular keep rising).
Risk and reward
This is not to say that advisers and clients should abandon bonds, developed or Emerging Market, government or corporate, investment grade or junk.
But they do need to ensure that fixed income offers returns which sufficiently compensate for the risks involved (while perhaps performing another function within a portfolio, such as diversification).
Research from Fidelity’s fixed-income team and Bank of America Merrill Lynch suggests that the spreads on offer from investment grade and junk bonds relative to Government issues are a lot nearer their lows than their highs.
Credit spreads are nearer their historic lows than their historic highs
Source: Fidelity International, Bloomberg, Bank of America Merrill Lynch as of 31 March 2018. (Based on data from Bank of America Merrill Lynch indices. Based on spread to worst versus Government bonds).
The data suggests to this column that investment grade (just) offers enough compensation relative to default but advisers and clients must be mindful of weighing the need for income and portfolio diversification relative to the capital risks involved – especially if they think they can hear a bell ringing.