The Rules, Part V

Tonight’s rule:  Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

If you are a bond manager, it pays to do what is difficult.  Buy proportionately less or none of the sector that is the heavy issuer.  Even  more, sell into it, and try to create a balanced portfolio without the hot sector.

When a sector as a whole borrows far more than in the past, it is often a mania, and the management teams are expanding capacity all at once, because conditions are so favorable.  I experienced this twice as a bond manager.  When I came on the scene in 2001, I tossed out all of my investment grade telecom bonds (aside from some of the Baby Bells), and auto bonds.  I could not see how they would make money over the long haul.

Those were two sectors heading for capacity gluts.  Yet there was a bigger capacity glut growing — that of the banks.  As 2005-2007 progressed, it was difficult to keep a balanced corporate bond portfolio, because almost half of all issuance was from financials.

Debt issuance is the option of optimists, and in an era where your competitors are issuing debt, it is hard to not imitate them.  But when everyone is optimistic in a sector, and levering up, that is often a time where subpar performance resides.

There is more than a hint of seeming success as a sector adds progressively more debt.  Pass on too many deals, and you begin to feel like a stick-in-the-mud.  There is a lot of pressure to change your strategy when things are running so hot.  Rather than change strategies in mid-stream, a good manager will sit down with colleagues and discuss:

  • What companies are misunderstood, and are safe to invest in.
  • What companies are misunderstood, and are definitely not safe to invest in.
  • Are there safe industries in the sector that aren’t adding so much debt?
  • On the scale from historic widest spreads over Treasuries, to historic lowest, where are we?  What inning of the tightening game are we in?
  • Stop looking at companies, and let’s create a model of the sector on the whole.  Is there enough business to justify all of the expansion that is going on?  What is happening to product pricing?
  • Who is the marginal buyer of the hot sector, and of yieldy paper generally?  Do they have strong or weak balance sheets?  How fast will they sell if things go wrong?
  • How fast are new deals completing?  Are the syndicates testing the waters to price deals too tight, in order to restore normalcy to bidding?
  • Are fools making money?  Have they been making money for a little while or a long time?  Are ordinarily risk-averse investors beginning to imitate them?
  • Where is the Fed?  Perhaps today it would be “What is the Fed?”  Are they getting ready to jerk the rug out from under the markets?  How complacent are expectations?
  • How long can we suffer underperformance before money begins to get pulled from us?  Are our clients educable or not?  Do they appreciate the risks in the market?  Why do we always get the dumb clients?  (Wait, don’t answer that, you get the clients that you deserve…)
  • And more, but you get the picture…

By the time you are done, you have a roadmap toward how you will add and subtract exposure in areas of the hot sector that you like and don’t like.  You will know your limits, and will maximize performance given those limits.  Finally, you will have an estimate of how long the hot sector will do well, and a trading strategy for the short run.

Capacity gluts are tough.  They have such an air of inevitable success as companies compete to dominate a promising area.  But ideas that are great if one company pursues the opportunity are only good when two do so, and average when three or four join the party.  But when a half dozen to a dozen join in, results will be poor.

This goes double for equity investors.  Avoid sectors that have high debt issuance.  At minimum, if you are a momentum investor, follow the mo, and decide in advance what sort of decline will cause you to make an exit.

Impractical Application for Today

This is all very nice, you might ask, but where are the debts building up today?  Need you ask?  We have just seen some of the biggest transfers of debt from the banking system and consumers to the government.  Government debt is the hot sector.

Wait, you might say.  How can this principle apply to governments?  They don’t go broke, at least, that what Walter Wriston told us.  Sorry, but Reinhart and Rogoff’s book says differently.  Government defaults are not unusual.  Also, banking crises are often followed by sovereign crises.

Wait, you might say again.  I have to limit my risks.  Governments will always be the safest credit in a currency because that can tax the other credits.  Maybe, but there are limits.  As tax rates get very high, they don’t produce incremental revenue.  Yes, I know this sounds like supply side economics, but there is a difference here — I believe higher tax rates would produce greater revenues at present.  But there is a tax level that governments cannot exceed before tax revenue goes down.  A sound business in a country with an unsound taxation policy might survive even if the government refused to pay on their debts.

I know, that government would likely try to inflate their way out, but indexing of benefits and political outcry might hinder them.  I don’t believe that it would be easy to inflate out of a debt crisis.  Too many economists derive simplified models of reality, and don’t consider how ugly the politics will be in the situation.  Sorry, men aren’t rational, particularly not as groups, and there would be a lot of sturm und drang, and delay.  Who could tell what foreign nations might do in response?

Still, I would underweight Treasuries relative to high quality bonds in other sectors.  Issuance is high as far as the eye can see — and beyond 2050, given all of the difficulties with entitlement programs.  Many high quality corporates won’t have much issuance over that same period; they will be scarce versus the massive amount of government debt to pay.  Beyond that, when the Fed tightens, debt costs for the government will rise dramatically.  Perverse, huh?  When you have so much to refinance, everything fights against you.

So, avoid the hot sector.  Suffer underperformance for a while, but decide in advance what mitigating actios you will take, lest you be a buyer out of insecurity near the peak, when losers capitulate prior to the bear market.

5 Comments

  • CP says:

    David,
    This is one of your best posts ever. I’d like to see you write about your answers to the rhetorical questions you posed.

  • Very useful, thanks!

    Making the jump from corporate sectors to sovereigns presents some interesting challenges. Almost all analysis I see about demand for sovereigns is about the history and future within a particular nation. But I think the crowding effect mentioned (“But ideas that are great if one company pursues the opportunity are only good when two do so, and average when three or four join the party. But when a half dozen to a dozen join in, results will be poor.”) applies in some sense. Many nations are increasing issuance simultaneously, and not much analysis seems to have been devoted to how the competition for savings will work out.

    Many are making the argument that “government would likely try to inflate their way out, but indexing of benefits and political outcry might hinder them.” It is certainly true that inflation quickly becomes self-defeating in the bond market, and obviously has little or no value (depending on your views of the CPI) with respect to indexed pensions. But I would counter that on three fronts.

    First, public opinion might go both ways. Younger people might well be convinced that inflating away older, unrealistic promises (where that is possible) might be the best way forward.

    Second, inflation provides many back-door ways to increase revenue (e.g. the tax on inflation-based interest is wealth transfer pure and simple) and decrease benefits (e.g. index a schedule of acceptable medicare charges to average market rates over the last three years).

    Finally, even on the assumption that inflation is irrational and fails to significantly reduce obligations, that hardly guarantees that governments will not attempt to print money as a last resort to pay the bills. Yes, I know we have an independent central bank. But as a worst-case scenario.

    Jim Fickett
    ClearOnMoney.com

  • Hondo the Bondo says:

    David Merkel, how do you reconcile the bearish sentiment toward Treasuries seen in the CFTC reports, surveys like Barron’s and Investors’ Intelligence, and reported anecdotally by the likes of David Rosenberg, ex-Merrill strategist now with Gluskin Sheff.

    How can the “hot sector” have negative sentiment toward it? Is there really that much index-chasing bond money? Banks (both foreign central and US commercial) don’t care about how much Tsy is in the Barclays Aggregate, either.

    With inflation, MZM and M2 growth so close to zero, and commercial loan demand still contracting at YOY double digit rates, rates could be rangebound for longer than most expect.

  • RedSt8r says:

    Very good post, thoughtful read. For some strange reason I was actually surprised to read that sovereign debt was the “hot” sector. Wow, I must be tired.

    @JimFickett makes two great points: (1) about how many nations are simultaneously issuing debt (and I dare say, printing money to buy it with); and (2) that young people might prefer inflation as the answer (as opposed to deflation which I, being cash rich prefer).

    @CP: I too would like to see some answers to your questions or at least ideas of how to answer for those of us unlucky enough to never have been a bond trader.

    I’m not ready (yet) to see inflation looming. There is simply too much idle capacity to enable the requisite velocity of money necessary to create the inflation. What I ponder is how much longer that idle capacity remains viable?

  • @RedSt8r: Right, I don’t see inflation being a threat any time soon. But markets are anticipatory. So if there are any adjustments to make to the portfolio, I don’t want to wait too long.