View: The Bubble in Junk Bonds - Barrons.com

The Bubble in Junk Bonds - Barrons.com

You needn't be a climatologist to figure out why record high temperatures and fearsome droughts have enveloped most of the nation. Everything in creation has been blamed for this excruciating summer, from global warming to flatulent cows. Everything , that is, except the most obvious and likely cause -- the noxious exhalation of politicians.

Yes, yes, we're aware that politicians are always with us, but so, too, it follows, is atmospheric pollution. But in case you've forgotten (ah, if you only could, eh?), this is an election year. And the emissions from politicos' well-rounded tummies always rise during an election year. But this year, thanks in part to Supreme Court decisions as well as the staggering sums available to the loud mouths when they take to the stumps, the sheer volume of the discharges from their internal-combustion apparatus is sure to be unprecedented.

In the lucky days of yore, campaigns were limited to a few months, and even though speeches not infrequently ran on for hours, the cumulative emissions were something that the resilient atmospherics could handle. But now that campaigns invariably start immediately after the last one and go on nonstop until the next one, those emissions overwhelm any and all natural counterforces. Do you really think that the irrefutable facts that a) we're sweating through the most torrid summer ever and b) campaign spending has reached astronomic levels far above anything before are pure coincidence?

And the hot air, already at times bordering on the intolerable, is certain to get worse as the presidential race heats up. And heat up it inexorably will now that Mitt Romney has chosen Paul Ryan as his running mate. In fact, things are already heating up. In the few days since he became the GOP's presumptive veep nominee, Ryan already has shown a beguiling tendency to wiggle out of some of his more controversial stances as congressman. And the current incumbent, Joe Biden, has forgotten the one iron rule for vice presidents: Keep your yap shut

Sooner or later, we suppose, the candidates will get down to chattering about deficits, jobs, fiscal stimulus, and the rest of that boring stuff. For the moment, though, center stage is occupied by Mitt and his reluctance to release for public scrutiny all but one or two of his income-tax returns.

The mean-spirited Dems, led by Harry Reid, the senior senator from Nevada, insist that Mitt is ashamed to have earned who knows how many hundreds of millions and paid a mere pittance in taxes. Mitt stoutly contends he paid at least 13% of his income to Uncle Sam, which was far from a pittance, and avoided forking over more by means that were fair and square but anyway legal.

The consensus among the citizenry is that Mitt must be eager to hide just how successful he was at making money and keeping the government's greedy hand from grabbing a bigger chunk of his plush income. Still, if, as he insists, he has nothing to hide, why he is so unyielding about hiding it?

Our own take is a bit different from the popular one: We suspect he's bound and determined to shield his returns from public view because in truth he never was as big an earner as his tax returns affirm. And if the truth were out, he fears, it might diminish his reputation as a crackerjack businessman, in sharp contrast to Barack Obama, who never had to meet a payroll. Hey, man, it's far-fetched, but no more so than the notion that Mitt never paid any taxes whatsoever.

The stock market seemed to view the political follies benignly or at least a silliness not worth paying much heed to. What seems of greater moment to investors is what Ben Bernanke will have to say at the annual economic symposium at Jackson Hole, Wyo., come Aug 31. In the past, Ben has found the forum a congenial place to hint at changes in Fed policy. So the portfolio types will be all ears.

Meanwhile, the rather limp rally continues, buoyed by a smattering of decent economic news and pretty much ignoring the occasional negative reports like the Philly and Empire State surveys. All the while. the distance between us and the loathsome fiscal cliff becomes shorter and shorter, as the odds of Congress doing anything positive before Jan.1 rolls around and the budget butchery begins, grow ever longer.

IF YOU'RE ONE OF THOSE UNEASY INVESTORS on the lookout for the next bubble that may go splat -- which includes just about anyone who is reasonably compos mentis and has had even a passing acquaintance with the market these past dozen years or so -- a recent commentary by Stephanie Pomboy rates more than a quickie glance. Stephanie, whose engaging rants have appeared in this space many a time and oft, is of course the main maven of MacroMavens and a keen-eyed bubble spotter from way back.

That deceptively simple line drawing on this page tracing the yield on junk bonds from 1998 to the present is, in fact, a stark and telling depiction of the subject of her musings -- the bubble in junk bonds. It may not rate as a startling discovery -- we have droned on from time to time about the budding bubble in junk, as have numerous others, as well as Stephanie herself -- but her latest warnings are notably trenchant and all the more urgent in a world of incredibly low interest rates in which the hunt for yield has become an almost maniacal pursuit.

She cites the torrent of dollars pouring into high-yield-bond funds (junk bonds' proper moniker) a whopping $43 billion so far this year, some 130% more than the existing full-year record, spurred by a glaring lack of decent alternatives. That lack, Stephanie observes acidly, scarcely constitutes a sensible long-term investment strategy and, the perils of sublimating fundamental concerns to a desire for yield, she's firmly convinced, are sure to end in tears.

Stephanie shrewdly avoids pinpointing when the junk-bond bubble will burst; even Nostradamus in his prime likely would have found that degree of exactitude a daunting challenge. But she's adamant that the bubble will burst, and the likely dire consequences when it does are as clear as they are chilling. She's not, in case you're wondering, talking an eternity, but something relatively imminent. Enhancing that unpleasant prospect, she says, is that "nominal junk yields are already way below where they deserve to be."

Ominously, she avers, "The very folks driving the bubble's inflation -- those most desperate for yield -- pension funds, insurance companies, and retail investors, will be hit the hardest." Her big concern for insurance companies is the possible knock-on effect that a junk-bond blowout might have. More specifically, she worries that were the insurers to suffer severe portfolio losses, it could cause serious dislocations in the derivatives market, where "they are huge counterparties and participants." And, as we can ruefully attest, when things go bad for derivatives, the global financial system is destined to feel the pain.

As for pension funds, portfolio losses caused by fallout from a junk-bond collapse will accelerate efforts to renegotiate (a polite way of saying "reduce") pension obligations.

At the state and local level, Stephanie explains, that's possible only for municipalities in financial distress. For those who are "just hale enough not to meet that criterion," she says, "spending will have to be cut and/or taxes raised to make the necessary pension contributions." Which, in turn, she envisions, means that Washington's efforts to goose the economy will be partially offset by state and local drag, already evident in the recovery's lack of oomph.

State and local governments have some $3 trillion in unfunded pension liabilities and another trillion in unfunded health-care obligations. Stephanie cites a report by the Pew Center on the states putting their actuarial accrued liability at $766 billion -- a number, she notes, that would swell to $2.2 trillion were they to embrace a more realistic 5.5% return instead of what she dubs "the pie in the sky" 8% return assumptions currently in favor.

Stephanie grants that a $100 billion-a-year cut in state and local spending may seem like a drop in the bucket of a $15 trillion economy, but that's today, while the bubble is inflating. Imagine, she asks, what the drag will be when the bubble pops and the pension funds go from earning 5% to 6% returns to losing 10% to 20%.

The most important consequence of the coming bursting of the junk-bond bubble in Stephanie's reckoning is a shift in household saving behavior. In addition to the inevitable reduction of pension benefits, she predicts, "the direct hit borne by investors in high-yield bond funds will shatter whatever limited shreds of confidence households had left in the financial markets," which likely will translate into an increase in savings and a decrease in consumption. To say the least, not exactly a recipe for a vigorous economy. 

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