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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 458958  
Subject: Bubble in Junk Bonds Date: 8/16/2012 2:27 AM
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Dear METARites, I am seeing signs IMO that we are in a bubble for high yield, aka junk bonds. One recent deal pegged the bubble meter to the red for me.

First a bit of history. The largest leveraged buyout in history was Texas Utilities (TXU). TXU was a large, boring public utility serving a large part of Texas. It stated in 1927 and had built up over the years into a tens of billions dollar business. TXU had also expanded outside the US making a $7 billion acquisition of England based Energy Group in 1998.

In 2007, a consortium of Kolberg Kravis Roberts, Texas Pacific Group and Goldman Sachs took TXU private in a $45 billion buyout. It has turned out to be in the running for “worst leveraged buyout ever” which is surprising because normally those buyout firms do NOT place losing bets. They renamed the company Energy Future Holdings (EFH).

Two things primarily hurt EFH’s business:

1) The global recession reduced demand
2) EFH’s profit model planned for high $6 to $8 natural gas. Fracking has caused gas prices to do down, NOT up.

Those two factors going the wrong way have caused EFH to have a string of yearly losses. EFH lost $696 million in Q2 2012 and $1 billion year to date. [1] For the full year 2011, losses were $1,913 million, we will call it an even $ 2 billion. [2]

We can stipulate that Kolberg Kravis Roberts, Texas Pacific Group and Goldman Sachs had a bad hair day when they did the buyout. Guess who also participated? Warren Buffet purchased $2 billion of bonds during the buyout for Berkshire Hathaway. In 2010, the bonds were written down to $1 billion in value. In 2011, they were further written down to $610 million for a paper loss of 70%. WEB says that the bonds might be end up with a 100% loss. [3]

By January 2012, the market was pricing EFH bonds with a 91% chance of default with an assumption that investors would receive 14.5 cents on the dollar for each bond. [4]

Pretty grim outlook, right?

Ah yes, but PT Barnum has been proven correct yet again.

Last week, EFH issued $250 million of 6.875% notes maturing due 2017 and $500 million of 11.75% due in 2022. [5] With US treasury 10 year paper yielding ~ 1.75%, the EFH offers a sure fire, can’t miss, extra ~ 10% of yield!

Apparently, there are enough investors desperate for yield that bought out the whole $750 million offering. It also proves that at the right price, you call sell anything.

I have a great idea. Why don’t we get 11.75% bonds from about 100 different companies and put them together. We could make a great, sure fire, high return bond fund. We can choose them from different industries and localities. That would guarantee they would be uncorrelated to each other. So if one or two or five or ten go bad, the remaining ones would be money good!


If this isn’t the early stages of bubblicious high yield bond behavior, I don’t know what is. As always, bubbles have a tendency to last a lot longer than most people expect. My guess is that we are in the 2nd or 3rd inning of this game and it will take many more years before the bubble bursts.

In the meantime, Yoda will NOT be adding any EFH bonds to the widows and orphans funds.

BOTTOM LINE for conservative investors is to make SURE you know what you are buying if you invest in mutual funds or ETFs. Bottom line for higher risk investors is to break out the Dom Perignon and drink away because times are good! (You can serve Yoda a Château d'Yquem, preferably 1959, if you like.)


Thanks,

Yodaorange




[1] Energy Future Holdings Q2 2012 report
http://www.energyfutureholdings.com/pdf/Q212EFHEarnings.pdf

[2] Energy Future Holdings Full Year 2011 report
http://www.energyfutureholdings.com/pdf/Q411EFHEarnings.pdf

[3] Berkshire Hathaway write downs in Energy Future Holding bonds
http://www.bloomberg.com/news/2012-02-27/buffett-says-energy...

[4] January 2012 assessment of EFH bonds
http://www.bloomberg.com/news/2012-01-19/kkr-s-txu-buyout-fa...

[5] EFH issues $750 in new debt August 2012
http://services.corporate-ir.net/SEC/Document.Service?id=P3V...
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Author: qazulight Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401260 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 9:57 AM
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Easy and simple for the less educated.

"If the guys in the expensive suit arrive in nice jets to sell something, if you want an expensive suit and a nice jet, you should do the same."

Cheers
Qazulight

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Author: hockeypop Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401265 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 10:30 AM
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Last week, EFH issued $250 million of 6.875% notes maturing due 2017 and $500 million of 11.75% due in 2022. [5] With US treasury 10 year paper yielding ~ 1.75%, the EFH offers a sure fire, can’t miss, extra ~ 10% of yield!

Apparently, there are enough investors desperate for yield that bought out the whole $750 million offering. It also proves that at the right price, you call sell anything.


Rest easy ... Calpers and GM pensions funds bought them. Now their projections are correct.

Seriously, the question for a high yield bond index fund is NOT whether some will fail, but what percentage will fail. Compared to the "experts" on whole, with costs lower you often do better in the index. Failure, duration, the economy AND interest rates are all factors.

ZIRP is horrible (I hit 66 this month). But I've been wrong about inflation and interest rates for 4 years now, so why admit defeat now. If there is inflation and IF GNP rises by about 1.5% then there probably isn't a bubble, IMO. Now whether EFH fails ... that's a different question.

Hockeypop

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Author: sailrmac Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401272 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 12:00 PM
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As always, bubbles have a tendency to last a lot longer than most people expect. My guess is that we are in the 2nd or 3rd inning of this game and it will take many more years before the bubble bursts.



You got that right, this one has a ways to go. 1.) The Fed is keeping interest rates low for at least the next year and a half, forcing people into higher risk / hihger yield products. 2.) Baby boomers retiring have created above previous average demand for yield. This demand is likely to exist for decades.

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Author: Windchasers Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401273 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 12:28 PM
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2.) Baby boomers retiring have created above previous average demand for yield. This demand is likely to exist for decades.

I see it the other way: Retiring baby boomers means a drawdown of retirement accounts. It's deflationary for investments, inflationary for consumption (particularly healthcare).

Likewise, retiring boomers means more SS payments going out, which probably means a bigger government deficit, which is also inflationary.

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401274 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 12:45 PM
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<If this isn’t the early stages of bubblicious high yield bond behavior, I don’t know what is. As always, bubbles have a tendency to last a lot longer than most people expect. My guess is that we are in the 2nd or 3rd inning of this game and it will take many more years before the bubble bursts.>

Here is some data from the Federal Reserve. Unfortunately, the data for junk bonds (CCC and below) only starts in 1997. Fifteen years is a pretty skimpy data set. I don't know why the Fed didn't collect information before that, because the market for junk bonds was active in the early 1980's (remember the movie "Wall Street," about leveraged buyouts?).

The BofA Merrill Lynch US High Yield CCC or Below Total Return Index Value is currently at a high, so it certainly looks like a bubble.
http://research.stlouisfed.org/fred2/series/BAMLHYH0A3CMTRIV...

The BofA Merrill Lynch US High Yield CCC or Below Effective Yield is low, similar to 2005 but not quite as low as 2007.
http://research.stlouisfed.org/fred2/series/BAMLH0A3HYCEY

The BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread is low (10.78%), but not as ridiculously low as in the 2000s boom years, when it was less than 10%.
http://research.stlouisfed.org/fred2/series/BAMLH0A3HYC

Junk bonds behave more like stocks than they do like higher-grade bonds. Higher-grade bonds are issued by companies that are unlikely to go bankrupt during recessions. High-grade bond prices increase during recessions, when interest rates fall. Junk bonds are issued by companies that are more or less likely to go bankrupt during recessions. Their prices drop during recessions. Junk bond investors expect a certain failure rate but hope that the profits exceed the losses. (I'm just reiterating what you probably already know.)

As a conservative investor, I get bent out of shape when my investments fail. During early 2009, I bought several AA rated corporate bonds but avoided junk bonds, even thought the latter were offering astounding yields.

Since the panic ended, you can see two small spikes in junk bond yields, which correlate to the almost-crises in Europe in 2010, 2011 and early 2012. Currently the risk markets (stock and junk bonds) are complacent.

What would happen if the U.S. fell into a classic (non-panic) recession? The answer is in the behavior of junk bonds during the 2001 recession, which was relatively mild. The risk markets were closely correlated. It doesn't take a crisis to cause junk bonds to spike in price and plunge in value. I bought corporate bonds (but not junk bonds) in 2002. During the next recession, I might buy a junk bond index fund and let the manager spread the risk.

http://research.stlouisfed.org/fred2/series/SP500

The Federal Reserve has hooked our economy on low interest rates like crack cocaine. Trying to wean the addict off the addiction will have predictable results. The Japanese have been doing this for over 20 years.

The further the quality of the bonds sinks below the highest grade, the less the bond yield is influenced by the Fed and the more it is influenced by the economy.

If the U.S. economy continues its slow but steady growth, I agree with you that it will take many more years before the bubble bursts. However, if there is a new recession approaching (ECRI says it is already starting), junk bonds will react strongly because lenders will back away.

Thank you for your detailed analysis of EFH. Each company that issues bonds should be analyzed the same way, but I fear that many bond buyers do not do this level of due diligence.

I can't reach your level of expertise. I intend to watch the chart of the BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread and buy a junk bond fund when this chart hits 25%, as it did in 2001-2002.

Wendy

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Author: notehound Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401275 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 1:01 PM
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I intend to watch the chart of the BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread

Here's the link for the chart:

http://research.stlouisfed.org/fred2/series/BAMLH0A3HYC/

We're a long way from a 25% level.

;-)

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Author: VUCommodore Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401291 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 4:30 PM
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From your bloomberg news story (citation #4):
"Three-year credit-default swaps tied to Texas Competitive Electric Holdings, the company’s unregulated merchant power unit known as TCEH..."

Bonds and CDS reference specific legal entities. In this case, the CDS in question are not with reference to Energy Futures Holdings Corp, they are with reference to Texas Competitive Electric Holdings.

Berkshire's writedown is also with reference to TCEH bonds:
http://www.sec.gov/Archives/edgar/data/1067983/0001193125111...
"Substantially all of Berkshire’s other-than-temporary impairment losses recognized in the fourth quarter of 2010 on fixed maturity investments related to investments in a single issuer, Texas Competitive Energy Holdings Company (“TCEH”). "

The bond issuance that priced at 11.75% yesterday is NOT with reference to TCEH, it is with reference to Energy Future Holdings Corp. TCEH appears likely to be put into bankruptcy. The proceeds from this debt deal allow TXU to fully seperate its financial ties with its unregulated TCEH unit.
http://www.bloomberg.com/news/2012-08-16/energy-future-paves...

So the bonds that were priced at a 20% yield, 91% chance of default, and written down by Berkshire, are likely going to be bankruptcy losses within the next few months. They are not being issued! The new issue 11.75% bonds are obligations of the "parent" company, which includes a regulated utility, and has a substantially different credit profile.

It is still a high yield bond, and thus likely never appropriate for highly risk-averse accounts, but the narrative you put together does not reflect reality. Is a 10% annual risk premium appropriate for TXU as a CCC+ rated utility? Not sure. Are we in a high yield bond bubble? Nope. The average spread-to-Treasuries of Wells Fargo's high yield index is currently 4.50%. When we actually DID have a credit bubble, in 2003-2006, that average spread went as low as 1.48% (on 12/31/04). There is three times the risk premium in high yield bonds today than there was eight years ago, despite the fact that yield is so hard to come by in today's market.

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Author: VUCommodore Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401292 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 4:33 PM
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"I see it the other way: Retiring baby boomers means a drawdown of retirement accounts. It's deflationary for investments"

True for investments as a whole, especially true for riskier equity investments which receive declining allocations with age, but the impact is ambiguous for fixed income. Retirement accounts get drawn down, but the share of retirement accounts invested in fixed income increases.

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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401311 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/16/2012 11:28 PM
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Apparently, there are enough investors desperate for yield that bought out the whole $750 million offering. It also proves that at the right price, you call sell anything.

Especially when those investors aren't investing their own money. Dollars to donuts, these bonds were gobbled up by pension funds or some other kind of fund that holds other peoples money.

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Author: flyerboys Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 401333 of 458958
Subject: Re: Bubble in Junk Bonds Date: 8/17/2012 7:41 AM
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Thanks to all, especially yoda, notes, and Wendy -- recs all round. This is very very useful and valuable data and analysis outside my areas of concentration and knowledge. Cutting and pasting the thread onto my desktop.

Threads like this make METAR the best of the best. I am truly grateful on many similar threads, but this time I thought I should stop and gush.

david fb

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