The unprecedented worldwide surge in the market for bonds that are certain to lose money if held to maturity regained strength last month.
The total face value of negative-yielding corporate and sovereign debt in the Bloomberg Barclays Global Aggregate Index of investment-grade bonds jumped to $11.6 trillion as of Sept. 30, up 6.1 percent from a month earlier. That sum had fallen for two months in a row from June’s $11.9 trillion peak.
Demand for the safety of high-quality bonds pushed up the totals in all but two of the 13 countries with more than $100 billion in negative-yielding debt. Italy’s tally shrank by 9 percent to $361 million and Denmark’s expanded more than a third to $104 million.
Japan, where policy makers moved in last month to coax yields up, remains ground sub-zero with almost $6 trillion, about half of the global total. Western Europe accounts for 47 percent, the bulk from France, Germany, the Netherlands, Spain and Italy.
Less than a seventh of the world’s negative-yielding debt is owed by businesses. Finance companies issued the bulk of those corporate bonds, almost 80 percent, with original face values totaling $1.3 trillion.
Sovereign and corporate debt totals include both new negative-yielding issues and bonds with prices that rose enough to push their yields into the money-losing zone. The Bloomberg Barclays Global Aggregate Index has a market capitalization of $48 trillion and includes investment-grade debt from 24 developed- and emerging-economy markets.
The benchmark gauge does not include maturities of less than a year, which tend to have lower yields, so the value of many short-term less-than-zero bonds aren’t counted in this story. Because the totals are based on as-issued amounts, they also don’t take into account a small amount of buybacks.
* Billionaire’s first-quarter bet on gold miners among winners
* He’s been wary of China’s debt-fueled growth for several years
George Soros, the 85-year-old billionaire who broke the Bank of England in 1992, is becoming more involved in day-to-day trading at his family office, taking a series of big, bearish bets.
Soros is best known for netting $1 billion as a hedge fund manager decades ago when he and his then-chief strategist Stan Druckenmiller wagered that the U.K. would be forced to devalue the pound. His predictions haven’t always played out so well.
Anticipating weakness in various global markets, his Soros Fund Management cut its publicly disclosed U.S. stock holdings by 37 percent in the first quarter while buying shares of gold miners and an exchange-traded fund tracking the price of the precious metal.
Since then, the S&P 500 Index has returned 3.1 percent. Barrick Gold Corp., his largest new position disclosed in the quarter, fared better, jumping 44 percent.
Here’s a look at some recent calls by Soros, whose personal fortune is estimated at $24.7 billion, and some of the other trades made by his family office in the past few years:
Soros has been worrying about China since at least 2013, expressing increasing concern that the country’s leaders might not be able to manage an economic slowdown.
Earlier this year, he compared China’s economy to the U.S. in 2007-08, pointing to debt-fueled growth that’s produced uncertainty and instability in the country’s banking system.
“Most of the money that banks are supplying is needed to keep bad debts and
loss-making enterprises alive,” Soros said on April 20 at an Asia Society event in New York.
More defaults may be looming in the nation’s corporate bond market. Bloomberg Intelligence estimated in May that 15.6 trillion yuan ($2.4 trillion) of corporate borrowing can be classified as “at risk loans” — those where the borrower doesn’t have sufficient earnings to cover interest payments. That’s equal to 23 percent of the country’s gross domestic product in 2015.
China’s Hang Seng Index has returned 10 percent over the past three years, not great, but nothing like the 37 percent slump in U.S. stocks in 2008. The index is down 22 percent from a post-financial crisis peak in April 2015, when including dividends.
At a panel discussion on Sept. 24, 2011, Soros said the Greece-born European debt crunch was “more serious than the crisis of 2008.” Last year, he said the chances of Greece leaving the euro area were 50-50.
“You can keep on pushing it back indefinitely” by making interest payments without writing down debt, Soros said in a Bloomberg Television interview that aired March 24, 2015. “But in the meantime there will be no primary surplus because Greece is going down the drain.”
There are signs that nervousness about the euro area economy is ebbing as investors increasingly focus on China. Greece and its creditors in the currency bloc may be nearing an agreement to disburse a new tranche of bailout aid that would allow it to meet debt payments this summer and also pave the way for restoring access to the European Central Bank’s regular refinancing operations.
Since Soros’s 2011 comments, the Bloomberg European 500 Index has returned 82 percent. European sovereign debt has returned about 14 percent in dollar terms.
Soros took a personal interest in Argentina — where he’s been invested for decades — and most recently wagered successfully on the country’s defaulted bonds. From time to time, he’d meet personally with former President Cristina Fernandez de Kirchner to discuss Argentina’s economic prospects. After a U.S. court blocked payments on the nation’s bonds, his Quantum Partners fund in 2014 joined an investor group that sued bond trustee Bank of New York Mellon Corp. in London for failing to distribute interest payments on securities, claiming the ruling shouldn’t apply to notes governed by laws outside of the U.S.
While the dispute was resolved after Fernandez left office last year, Soros has still been showing interest in the country. Representatives for his fund participated in Argentina’s bond roadshow in April, according to a document obtained by Bloomberg, after which the government sold a record $16.5 billion in securities in its return to the global debt market.
Argentine bonds have returned 57 percent on average since Soros’s bet was revealed with the lawsuit in August 2014.
Soros’s family office made almost $1 billion from November 2012 to February 2013 betting that the Japanese yen would tumble with the election of Prime Minster Shinzo Abe, who pressed the Bank of Japan to introduce additional stimulus measures. A couple of months later, the billionaire warned that moves to expand monetary easing could trigger “an avalanche” in the yen as citizens shift their money abroad.
“What Japan is doing is actually quite dangerous because they’re doing it after 25 years of just simply accumulating deficits and not getting the economy going,” Soros said in an April 5, 2013, interview with CNBC. Central bank officials may not be able to stop the currency’s fall, he said.
The yen continued to fall in the wake of Soros’s comments.
Argentina is coming back to world markets after being shut out for 15 years.
And it’s gearing up for one of the biggest bond sales ever for a developing country.
On Wednesday, the U.S. Court of Appeals upheld an earlier decision that allows Argentina to issue bonds and payoff its creditors it has owed since the country defaulted in 2001.
The ruling is a major victory for Argentina, which slugged through a legal debt battle with American hedge funds known as “vultures” in Latin America.
This week, Argentina’s brass is on a “road show” in London, New York and elsewhere in the U.S. to pitch investors on $15 billion in governments bonds. That’s second only to Mexico, which holds the record with a $16 billion debt offering in 1996.
How much appetite investors have for Argentina’s bonds will depend in part on the interest rate, expected to be between 7% and 9%. Argentina could begin selling bonds as soon as next week, Argentina’s finance minister said earlier this week.
Argentina says it wants at least $12.5 billion, enough to pay the holdout creditors and have plenty left over for infrastructure projects that the country badly needs.
Argentina’s markets rallied on the news. Its stock market index, Merval, rose 4.7% on Wednesday, the biggest gain of any world market. The Merval is up nearly 14% so far this year as Argentina’s new government, led by President Mauricio Macri, seeks to resolve the country’s debt problems.
In February, Argentina finally reached an agreement with hedge funds, led by billionaire Paul Singer, to pay them a total of $4.65 billion. Since that agreement, Argentina has resolved debt deals with other holdouts worth billions.
Argentina is South America’s second-largest economy behind Brazil. It defaulted on $95 billion of debt in late 2001, which was a record at the time. Argentina’s populist presidents, the late Nestor Kirchner and his wife, Cristina Fernandez de Kirchner, ruled Argentina from 2003 to 2015. They refused to pay the holdout creditors as a sign of patriotism.
That decision had effectively shut Argentina out of foreign capital markets since 2001, and its economy has stagnated for the last four years.
“Today’s ruling is a huge triumph for Argentina,” says Edward Glossop, an emerging markets economist at Capital Economics, a research firm.
The Bank of Japan is running out of government bonds to buy.
The central bank’s would-be counterparties have become increasingly unwilling to sell the debt that monetary policymakers have pledged to buy, and the most recently issued 30-year Japanese bond didn’t record a single trade during a session last week as existing owners opted to hoard their holdings.
The central bank in the land of the rising prices sun has set a target of 80 trillion yen ($733 billion) in government bond purchases per year in its continued attempts to slay deflation, an amount that’s more than double the pace of new bond issuance planned by the Ministry of Finance and about 16 percent of gross domestic product.
But safe assets like government debt aren’t just attractive to central banks looking to force investors into riskier asset classes and push down the cost of borrowing or to pensioners looking for a reliable source of income—they’re also in high demand by financial institutions for use as collateral.
That’s because where there is a dearth of safe assets, there is also an incentive and tendency for them to be manufactured; that is, improperly labeled as such. Past results certainly haven’t been pretty.
As the Bank of Japan begins to rub up against the technical constraints of its asset purchase program, Jefferies Group LLC Chief Global Equity Strategist Sean Darby proposes a radical solution: consolidate some of the Bank of Japan’s existing holdings of debt into a perpetual bond—that is, one with no maturity and therefore no principal repayment—with a coupon of zero.
“There is a growing realization that there are effective limits to how much more Japanese government bonds can be acquired,” he writes. “The BoJ is approaching a shortage of Japanese government bonds for the central bank to buy, as commercial banks, pension and insurance funds have run down their holdings.”
Darby cited a working paper from the International Monetary Fund which concluded the collateral needs of financial institutions were such that the Bank of Japan might be forced to begin tapering its purchases of sovereign debt in 2017 or 2018, to bolster his case.
The thinking here is that as the Bank of Japan reaches the quantitative limits of quantitative easing, the issuance of such a perpetual bond that costs nothing to service would be a way to offer the government a blank cheque to proceed with fiscal stimulus such as boosting spending or cutting taxes.
The strategist believes the Bank of Japan will drop hints about its intention to pursue such a plan at its April meeting.
The Bank of Japan’s decision to shock investors and adopt a negative rate regime in January—one week after Governor Haruhiko Kuroda said such a move wasn’t needed at the time—was spurred by a desire to push yields at the longer end of the curve as low as possible in preparation for the consolidation of existing debt into a zero coupon bond, according to Darby.
“The authorities are attempting to push bond yields down below existing nominal GDP, so that the existing debt can be converted or ‘consolidated’ into a perpetual zero coupon bond presumably before any ‘tapering announcement,'” he writes.
Whether this extreme step will ever be taken—in particular on the timetable the strategist suggests (i.e. ahead of the elections scheduled for this summer)—is highly questionable.
But Darby’s suggestion does underscore that with Japan unable to declare ‘mission accomplished’ on its quest for reflation and a shortage of bonds looming, it’s time to consider Plan (perpetual) B.
When the next corporate default wave comes, it could hurt investors more than they expect.
Losses on bonds from defaulted companies are likely to be higher than in previous cycles, because U.S. issuers have more debt relative to their assets, according to Bank of America Corp. strategists. Those high levels of borrowings mean that if a company liquidates, the proceeds have to cover more liabilities.
“We’ve had more corporate debt than ever, and more leverage than ever, which increases the potential for greater pain,” said Edwin Tai, a senior portfolio manager for distressed investments at Newfleet Asset Management.
Loss rates have already been rising. The potential for them to climb further may mean that in general junk bonds are not compensating investors enough for the risk they are taking, said Michael Contopoulos, high yield credit strategist at Bank of America Merrill Lynch. The average yield on a U.S. junk bond is now around 8.45 percent, according to Bank of America Merrill Lynch indexes, about the mean of the last 10 years.
In bad times, corporate bond investors on average lose about 70 cents on the dollar when a borrower goes bust. In this cycle, that figure could be closer to the mid-80s, Bank of America strategists said. Those losses would be the worst in decades, according to UBS Group AG’s analysis of data from Moody’s Investors Service.
At least part of the pain that investors will experience in this downturn was deferred from the last credit crunch, which for corporate issuers was relatively short-lived. During the financial crisis, the Federal Reserve was quick to cut rates, and investors began diving back into junk bonds quickly, said Alan Holtz, a managing director in the turnaround and restructuring practice at AlixPartners, a consulting firm that focuses on companies in distress. Many companies were able to refinance debt instead of defaulting.
“A lot of the troubled companies that had become overleveraged were able to find more temporary solutions in the last credit cycle,” Holtz said. “Those Band-Aids are no longer available now, and a lot of companies are going to have to face distress,” he said.
Leverage levels have been rising as more companies use borrowings to refinance existing liabilities, buy back shares and take other steps that do not increase asset values, Holtz said. Capital expenditure, which does boost assets, has been relatively low during this cycle.
Junk-rated companies have debt equal to about 48 percent of their assets now, up 7.5 percentage points in the last 7 years, according to Bank of America Merrill Lynch data. The ratio of debt to assets is one of the main factors in how big losses will be when a borrower defaults, and it could be .
Another factor is the rate of default, because when more companies are defaulting, more are looking to sell assets or otherwise restructure, leaving investors with lower recoveries. Default rates currently stand around 4 percent, according to Moody’s. The ratings company forecasts that the measure will rise to 5.05 percent by the end of the year in the best-case scenario, and could jump as high as 14.9 percent under the most pessimistic projection.
Default rates and debt-to-asset ratios explain 75 percent of the variation in observed recoveries, Bank of America strategists said.
As debt-to-asset ratios and default rates have risen, recovery rates, or the percentage of principal that investors get back when a credit defaults, have already started falling. They stand at around 29 cents on the dollar, according to Bank of America Merrill Lynch data. Two years ago, that figure was closer to 44 cents. In other words, loss rates are already starting to rise.
The long-term average recovery rate for senior unsecured debt across the entire credit cycle is around 40 cents on the dollar, a level that falls to around 30 cents when times get bad. In downturns going back to the 1980’s, the lowest recovery rate was around 22 cents in 2001, according to UBS strategists’ analysis of Moody’s data.
Bank of America strategists see possible recovery rates in the mid-teens in this cycle. While holding a portfolio of speculative-grade bonds to maturity at current yields may still result in a positive return for investors, higher defaults and losses on the securities will likely weigh on prices in the coming months, Contopoulos said.
Taking steps including buying secured debt can help mitigate investors’ trouble, Newfleet’s Tai said. Newfleet had $11 billion under management as of December 31.
The low price of oil is another factor that will likely hamper recoveries. Crude now trades at around $36 a barrel, down about 65 percent from its level in mid-2014, a decline severe enough that a few drillers have started missing payments on their debt.
Some energy companies will be able to negotiate with their lenders to cut their debt loads. But a chunk of them have production costs that are too high even ignoring borrowing costs, giving their creditors few options apart from liquidating the company.
For many liquidated energy companies, “there’s not a whole lot to recover in terms of cash,” said Leonard Klingbaum, a partner at law firm Willkie Farr & Gallagher.