Bonds and Fixed Income

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It sounds like the Fed's plan for eventually tapering QE (which is currently running at $120 bil/month) may be aided by the arrival of the free spending Dems and their MMT fiscal spending plans. This will take up the slack in stimulus as the Fed tapers QE. So that's another reason for the Feds to favor a Dem sweep in this election.

Using fiscal policy (increasing deficit spending and decreasing taxes)
would be similar to the 2014-15 period when the Fed was fairly desperate to start tapering down QE and reduce its own bloated balance sheet. They got House Speaker Paul Ryan to reverse course and end the 'Sequester', and begin running much bigger deficits. Then a few years later came Trump's big tax cuts.

The stimulating effect from these bigger budget deficits and the tax cuts provided cover for the Fed's attempt to normalize interest rates and reduce its balance sheet. Nice try, and it almost worked, but the economy began weakening, made worse by Trump's trade war with China, so the Fed had to throw in the towel on rate normalization. Then the 'repo' problem appeared in the Fall of 2019, and the Fed had to restart QE. Of course then came Covid and mega QE.

Using the spendthrift Dems and MMT while the Fed tapers QE might work for a while, but how long can the US run deficits of 2-3 trillion/year before faith is lost in the dollar? Clearly the system is circling the drain, but they can probably keep it circling for a number of years before there is a final crisis. All the trillions in liquidity may keep the stock market buoyant, but looking longer term it seems best to start transitioning to hard assets like gold, land, rural real estate, etc.

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>>> Fed looks to 2013 for future strategies in tapering asset purchases


Yahoo Finance

by Brian Cheung

January 7, 2021


https://finance.yahoo.com/news/fed-looks-to-2013-for-future-strategies-in-tapering-asset-purchases-120448382.html


The Federal Reserve may dust off its playbook from 2013 if it shifts to tapering its aggressive asset purchase program.

Currently, the central bank is snatching up $80 billion in U.S. Treasury bonds and $40 billion in agency mortgage-backed securities per month.

The Fed’s latest guidance, from Dec. 16, noted that the so-called quantitative easing program would continue at least at that pace until the economy looks like it has made “substantial further progress” in the recovery.

But minutes from that December meeting note that a “number” of Fed officials are already thinking about how to wind down those purchases once that “progress” is made.

Those unnamed Fed officials said they would like to “follow a sequence similar to the one implemented during the large-scale purchase program in 2013 and 2014.”

At the time, then-Fed Chairman Ben Bernanke announced in December 2013 that it would be notching down its monthly pace of purchases from $85 billion per month to $75 billion per month. The Federal Open Market Committee (FOMC) clarified that the program was not on a “preset course,” and that further slowing those purchases would only happen if the economy was ready for it.

JPMorgan’s Michael Feroli noted that the FOMC minutes for December 2020 show that the Jerome Powell-led Fed would similarly like to have its purchases “set on cruise control.” Feroli wrote Wednesday that the 2013 and 2014 reference also means the tapering process could go on for about 10 months. Analysts at Evercore ISI project a 12-month taper.

“Guidance on asset purchases remains pretty vague at this point and it appears future decisions will remain discretionary,” Feroli said in a note.

A cautionary tale

But the 2013 experience is also a cautionary tale of the perils of Fed communication.

The Fed had been debating its approach to tapering for months leading up to the December announcement, and Bernanke in May 2013 let it slip that a “step down” in quantitative easing could happen. The remark triggered a spike in bond yields and falling stock prices in an episode now known as the “taper tantrum.”

“A taper tantrum is now a real risk,” Jefferies economist Aneta Markowska told Yahoo Finance on Wednesday, forecasting a U.S. 10-year Treasury bond reaching 2% by the end of 2021.

The 10-year broke through the 1% mark on Wednesday morning, on the heels of the Georgia runoff election results that resulted in Democratic control of the Senate.

For the Fed’s part, policymakers are not yet on the same page about the timing for when to kick off any tapering. The minutes noted that two Fed policymakers favored a more stimulative quantitative easing program that would tilt its purchases toward longer-dated bonds.

In remarks this week, Fed officials sent mixed messages on whether or not the next steps on asset purchases would be a ramping up or a winding down of the program.

“These comments created an unhelpful mini-cacophony that is more than usually problematic given subsequent political and fiscal developments,” Evercore’s Krishna Guha and Ernie Tedeschi wrote Wednesday.

The analysts advocated for Fed leadership to more clearly signal its intention on where quantitative easing is headed, marking now as a “sensitive moment” for the Fed.

The next scheduled policy-setting meeting will be Jan. 26 and 27.

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>>> Fed policy in 2021: Three things to watch


Yahoo Finance

Brian Cheung

December 28, 2020


https://finance.yahoo.com/news/federal-reserve-policy-in-2021-3-things-to-watch-113851008.html


It has been a long year for the Federal Reserve.

Since the first cases of COVID-19 in the United States, the central bank has slashed interest rates to zero, restarted its quantitative easing program, and opened up a slew of emergency loan facilities to backstop markets ranging from corporate debt to municipal bonds.

The beginning of the new year will be a critical inflection point for the U.S. economy. With case counts surging across the country, the Fed will attempt to bridge the next few months until widespread vaccination and herd immunity are achieved.

With interest rates near-zero and likely to stay there through the end of 2023, that means a need for other, unconventional monetary policy tools.

“There is more that we can do, certainly,” Fed Chairman Jerome Powell said December 16, adding that the second half of 2021 should see the economy “performing strongly.”

So what should markets be watching for from the Federal Reserve next year?

Emergency loan facilities

As COVID-19 began ripping through the country in March, the Fed moved to backstop several financial markets and stand up new programs offering credit to business borrowers.

Several of the programs will expire on December 31, at the order of U.S. Treasury Secretary Steven Mnuchin. But if economic conditions worsen next year, the Fed will face a difficult question: whether or not to re-open the facilities.

Three programs in particular will pose legal and political challenges to the Fed: the Municipal Liquidity Facility (loans to state and local governments), the Main Street Lending Program (loans to small- and medium-sized businesses), and the Corporate Credit Facilities (liquidity for corporate debt markets).

Language buried in the over 5,000-page government spending bill, which includes COVID-19 relief, would bar the Fed from either resurrecting those three programs or anything the “same as” those programs.

But current and former Fed officials have been vocal about their desire to keep those emergency programs available into 2021.

A Treasury Secretary Janet Yellen, pending Senate confirmation, could work with the Fed on other programs in the future. But the new statutory limitations may entangle the Fed in political backlash if it attempts to toe the line on re-opening something close to the three facilities in question.

"How effective that narrowing will be, in terms of freeing up the Fed to do what it most wants to do? It depends on how aggressive the Fed's lawyers want to be,” said Columbia Law professor Kathryn Judge.

Quantitative easing

The Fed’s massive pile of assets totals more than $7 trillion, the consequence of an aggressive pace of quantitative easing in the face of the crisis. The latest guidance from the Federal Open Market Committee makes it clear that its balance sheet will only get bigger until “substantial further progress” is made on the recovery.

More specifically, that means at least $120 billion in monthly purchases ($40 billion in agency mortgage-backed securities and $80 billion in U.S. Treasuries).

“Any time we feel like the economy could use stronger accommodation, we would be prepared to provide it,” Powell said on December 16.

But the Fed has not clarified exactly how it could adjust those purchases. Powell entertained the idea of, for example, targeting longer-dated purchases to push down longer-term borrowing costs.

Similarly, the Fed has not spelled out what a better-than-expected 2021 may mean for its asset purchases. “Substantial further progress” may mean a tapering of its asset purchases would come before the Fed lifts off from zero-interest rates.

The imprecise language, however, will keep Fed watchers and investors guessing on where inflation and unemployment will have to land before quantitative easing is pared back.

“It’s hard to infer when tapering will begin, but we would still pin that sometime around the end of next year,” JPMorgan’s Michael Feroli wrote on December 16.

Reflation may be around the bend

For both interest rate policy and quantitative easing, the Fed will be using inflation as its guiding star to get to the destination of an economy at maximum employment.

In the face of the downside risk of rising COVID-19 cases, the Fed hopes that widespread vaccination and a return to normal will spur consumption that could bring some modest price increases.

A new policy adopted by the Fed in August articulates that the Fed would tolerate inflation “moderately” above its 2% target, meaning that reflation in a possible second half recovery would not trigger an interest rate hike.

Core personal consumption expenditures, the Fed’s preferred measure of inflation, clocked in at just 1.4% in November.

The end game is to keep policy accommodative and give the economy ample time to pull the unemployed back into jobs. As of November, the economy remained 9.8 million jobs short of its pre-pandemic level in February.

“We are committed to allowing the economy to run until we find out what maximum employment means experientially,” San Francisco Fed President Mary Daly said in September.

Constance Hunter, chief economist at KPMG, told Yahoo Finance that she would not expect a rate hike for another year or year and a half.

“A lot of this depends on how broad-based the recovery is, but assuming we can get some reflation going then that would mean they might start changing their language and changing their asset purchases so that we can have slightly tighter monetary conditions going into 2022,” Hunter said.

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>>> Bets on World of Negative Interest Rates End With Capitulation


Bloomberg

by Ruth Carson and Greg Ritchie

December 15, 2020


https://finance.yahoo.com/news/bets-world-negative-interest-rates-084540722.html


(Bloomberg) -- At the height of the pandemic, it seemed only a matter of time before negative interest rates -- the last resort of central banks -- ruled global markets.

A controversial strategy that’s yielded mixed results in the euro-area and Japan, traders still piled on bets earlier this year that central banks from New Zealand to the U.K., and even the U.S., were destined to follow suit. The three were among those that most aggressively cut rates through the worst of the virus-induced lockdowns. Yet all ultimately stopped short of going negative.

Traders now see a sub-zero move as increasingly unlikely, with policy makers largely favoring a “new conventional” mix of bond purchases and sector-specific aid programs. Of course, trillions of dollars of debt continue to trade with negative yields, effectively guaranteeing a loss for those who hold them to maturity. But with optimism returning about global growth, bond investors are shifting their attention to bets that yields will go higher, not lower.

“Central banks who don’t already have negative interest rates are going to be very cautious about crossing that rubicon,” said James Ashley, head of international market strategy at Goldman Sachs Asset Management. If policy makers need to prop up growth, “would it not be more prudent simply to rely on the unconventional tools like large scale asset purchases.”

Bold Experiment

Considered one of the boldest monetary experiments of the 21st century, negative rates were adopted in the wake of the financial crisis to drive borrowing costs lower and penalize banks that hoard cash rather than lending it out. The consequences for bond markets were far-reaching and long-lasting as trading was stymied and yields tumbled. The world’s stockpile of negative-yielding debt climbed above $18 trillion this month, a record, with rates on Spanish 10-year bonds sliding below 0% for the first time.

But despite the sub-zero strategy, both Europe and Japan have seen muted growth and failed to boost inflation to central banks’ targets. In fact, negative rates may have eaten into bank profits and hurt savers. As Federal Reserve Chairman Jerome Powell put it in May, “the evidence on negative rates is mixed.”

“The Fed has investigated a lot of BOJ and ECB policies,” said Kenta Inoue, senior market economist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo. “At this point in time, there is no evidence suggesting that negative rates policy has a positive impact on the economy as well as markets.”

In a way, the holdout central bankers were saved from having to make the decision to go negative by both the success of alternative policies and an improvement in the global economic backdrop. The flood of liquidity to the financial system -- spearheaded by the Fed -- pushed borrowing costs lower, and rapid progress on vaccine development brought forward expectations of a return to normal.

Positive Shift

In money markets, traders have erased bets on negative rates next year in both the U.S. and New Zealand. And while their U.K. counterparts still expect rate cuts to combat the economic blow dealt by the coronavirus and Brexit, the Bank of England is seen stopping at zero.

Indeed, higher bond yields are now seen in the U.S. and New Zealand, with some strategists from Bank of America to Societe Generale looking for 10-year Treasuries to advance toward 1.5% by the end of 2021.

The vocal pushback from U.S. policy makers on the likelihood of negative rates and economic optimism have seen investors switch to bets on a steeper yield curve, albeit with limits. The benchmark Treasury yield has about tripled from its March low to 0.90% Tuesday.

“Since the Federal Reserve has signaled that it would not cut interest rates below zero, Treasuries have a floor at 0%,” said Saxo Bank strategist Althea Spinozzi. “2021 is going to be all about a yield-curve steepener.”

New Zealand Story

The situation is similar in New Zealand. China’s economic rebound, the Reserve Bank of New Zealand’s more favorable outlook on the economy and a new lending program have slashed expectations for even one more rate move in Wellington, let alone a reduction below zero. The RBNZ has a record-low rate of 0.25%.

Swap markets are pricing just a 30% chance of a 25 basis point cut by the end of 2021, after pricing in almost 50 basis points of cuts in November. And the 10-year government bond yield was trading around 0.87% on Tuesday, about double the September low of 0.44%.

“The hurdle for doing negative rates is going to be very high,” said Bank of New Zealand strategist Nick Smyth. New Zealand bonds are losing their premium to peers and there’s the potential for 10-year yields to climb to 1.5% if Treasuries retreat, he added.

Brexit Blues

Still, the risk of a no-deal Brexit could revive bets on negative rates in the U.K. Although the BOE is currently seen lowering rates by 10 basis points in early 2022, pricing has see-sawed with Brexit headlines, with traders betting on a cut as soon as May last week.

The move comes after Monetary Policy Committee member Michael Saunders flagged room for more cuts, and colleague Silvana Tenreyro said evidence is “supportive” of a sub-zero rates policy.

“We see the BOE taking the bank rate negative next year,” said Peter Schaffrik, a global strategist at RBC Europe Ltd. “Even a Brexit deal is a huge disruption from the status quo, so the odds of negative rates will be lower but not by a lot.”

To be sure, BOE Governor Andrew Bailey has made a point that doesn’t chime with the market movements: that sub-zero rates might be more effective during an economic recovery rather than a slump. Ranko Berich, head of market analysis at Monex Europe Ltd., finds bets on negative rates rising in tandem with expectations of a no-deal Brexit puzzling for this reason.

“The BOE’s own communication has made clear the MPC views negative rates as a tool best used at a time when banks are less worried about balance sheet risks, ideally the initial upswing phases of a recovery,” he said. “This suggests they would be highly unlikely to take rates negative as a knee-jerk reaction to a no-deal Brexit, which is precisely the kind of shock that would get banks worries about balance sheet risks.”

For now, though, the market is being driven by Brexit talks. Concern about the impact of no-deal on the U.K. economy has kept a lid on the nation’s bond yields, with gilts’ performance regularly out of step with peers. The 10-year benchmark yield traded at around 0.24% Tuesday, having fallen as low as 0.15% last week, and investors see more downside as a distinct possibility.

“Gilts offer limited protection, given yields are already low, but they’ll still fall further in a bad Brexit outcome as negative rates becomes the base case,” said John Roe, head of multi-asset funds at Legal & General Investment Management. “We don’t see negative interest rates as a problem per se. We just see it as an outcome that’s positive for gilts, which means it’s dangerous to be short.”

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>>> The Bull Market That Won’t Die


BY JAMES RICKARDS

OCTOBER 28, 2020


https://dailyreckoning.com/the-bull-market-that-wont-die/


The Bull Market That Won’t Die

Investors have been hearing for years that “interest rates are near all-time lows,” and “rates have nowhere to go but up,” and finally, that “the bond bear market is right around the corner.”

These warnings have come from notable bond gurus including Bill Gross, Jeff Gundlach and PIMCO’s Chief Investment Officer Dan Ivascyn.

Investors are told that the time has come to dump bonds, short them if you can, and brace for much higher interest rates.

There’s only one problem with these warnings. The bond gurus have been dead wrong for years, and they’re wrong again now. Rates are going lower, and the bond market rally that began in 1981 has further to run. The bull market still has legs.

To paraphrase Mark Twain, reports of the death of the bond market rally have been “greatly exaggerated.”

The key is to spot the inflection points in each bear move and buy the bonds in time to reap huge gains in the next rally.

That’s where the market is now, at an inflection point. Investors who ignore the bear market mantra and buy bonds at these levels stand to make enormous gains in the coming rally.

“The Much Feared Bond Bear Market Never Materializes”

Let’s look at the record. The 10-year U.S. Treasury Note had a yield-to-maturity of 3.64% on February 11, 2011. That soon fell to 1.83% by September 23, 2011. Then the yield spiked to 2.23% on March 16, 2012. It fell back again to 1.46% on June 1, 2012.

Yields spiked again to 3.0% on December 27, 2013. Then yields fell back to 1.68% by January 30, 2015. And, so it continued through 2016 and 2017. Yields staged one last major back-up reaching 3.22% on October 5, 2018, before crashing once again to 0.54% on July 31, 2020.

Notice the pattern? Yes, yields are back up with some regularity. But they have never broken through the 3.25% level in nine years. The much feared bond bear market never materializes.

When yields get above 3%, the economy stalls out, disinflation takes over, the Fed panics and either “pauses” rate hikes or cuts rates resulting in yields coming back down to earth. Every time yields fall, bond investors make huge capital gains.

That’s exactly why the opportunity to go long Treasuries is so attractive. With all of the big players (hedge funds, banks, wealth managers) leaning on one side of the boat, it only takes a small perturbation causing lower yields and higher prices to trigger a massive short-covering rally, where these short investors scramble to exit their positions and buy bonds to cut their losses.

That’s not all. This technical history exhibits a pattern called “lower lows.” The rate spikes run out of steam around 3%, but each rate collapse goes lower than the one before. The history of rate bottoms is 1.46% on June 1, 2012, 1.36% on July 8, 2016, and the recent low of 0.54% on July 31, 2020.

Every time the bears say yields are going to the moon, they crash to a new low. That means bigger gains for investors.

Basic Bond Math

A bit of bond math is always helpful in these discussions since it’s counterintuitive for many investors. Yields and prices move in opposite directions. When bond yields go up, bond prices go down. When bond yields go down, bond prices go up.

Investors hoping for higher yields may not realize that the bond prices in their portfolio go down when that happens.

The best trading strategy is to buy a bond just when yields spike, and then hold it as yields fall back down to earth. That way, you keep the high yield on your bond and accrue huge capital gains as market yields decline. You can hold the bond to maturity, of course, but you can also sell it for a gain, move to the sidelines with cash and buy a new bond when yields get toppy again. Wash, rinse and repeat.

There’s another bit of bond math that is not intuitive to most investors. It’s called convexity or duration. In plain English, it means that as interest rates get lower, the capital gains get larger for each basis point decline in rates.

As an example, rates can decline from 3.50% to 3.25%. They can also decline from 1.00% to 0.75%. In each case, interest rates dropped by the same 0.25%. And, in each case, an outstanding bond would realize a capital gain.

But, the capital gain is larger in the second case than the first. Not all interest rate declines are created equal. Gains are bigger when rates are lower. Right now, rates are quite low, so the potential for capital gains is spectacular.

But, with rates so low already, what is the potential for rates to fall even more?

Rates on 10-year Treasuries rose from 0.513% on August 4 to 0.848% on October 22. Rates are 0.768% as of today. Right now, my models are telling me that bond yields will continue to fall, which means that bond prices will continue to rise.

Don’t Buy Into the Consensus

What’s been driving this increase in rates? The answer is simple. Markets expect a new deficit spending stimulus package from Congress. The package is still under negotiation, but the expectation is that it will be around $2 trillion, comparable to the $3 trillion of spending packages passed between March and June, during the worst stages of the pandemic.

Markets expect that this much new debt will flood the markets with new Treasury borrowings, which will drive bond prices lower. Markets also expect that this much stimulus will be inflationary because the Fed may have to monetize the new debt. The combination of more supply with a higher risk premium for inflation will result in much higher yields.

Both assumptions are probably wrong. The spending package depends on the election.

Democrats are confident that Joe Biden will win, so they are holding out, both to avoid giving Republicans a pre-election win and to get a better deal under President Biden.

Republicans take the opposite view and are holding out for a more conservative package under a reelected President Trump. The result is a stalemate.

My forecast is that Trump will win, and markets will be disappointed at the size (and spending priorities) of any package that results. This will cause rates to crash again.

Too Much Debt for Stimulus to Work

Even if a large spending package passes in the next few days or shortly after the election, it will not have the inflationary impact markets expect. Congress knows how to spend, but they do not know how to provide stimulus.

In fact, stimulus in the Keynesian sense is impossible when government debt levels are 130% of GDP. Research shows that any stimulus effect goes into reverse when debt-to-GDP levels pass 90%.

What you end up with is more spending, higher debt, but lower growth. Everyday Americans respond not by spending more but by saving more in anticipation of higher taxes or inflation down the road.

The short-term impact of that is not inflation, but disinflation or outright deflation. That means lower rates and bigger capital gains for Treasury bond investors.

As for rates being “low,” they’re not. It’s true that nominal interest rates (the kind you see on screens and TV) are near all-time lows. But real interest rates (nominal rates minus inflation) are quite high by historical standards. Real rates have to go much lower to help growth.

With inflation dropping, that means nominal rates have to go deeply negative in order to get real rates low enough to help. My forecast is for 10-year Treasury note rates to go to negative 0.50% or lower over the next year. That means large capital gains for investors in Treasury bonds.

Don’t go along with the crowd on this one. If you’re on the wrong side of this overcrowded trade, you could get trampled.

Regards,

Jim Rickards

for The Daily Reckoning

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>>> Bond Defaults Deliver 99% Losses in New Era of U.S. Bankruptcies


Bloomberg

By Jeremy Hill and Max Reyes

October 26, 2020


https://www.bloomberg.com/news/articles/2020-10-26/bond-defaults-deliver-99-losses-in-new-era-of-u-s-bankruptcies


Market prices, derivative auctions imply debt may be worthless

High borrowings, weak protections leading to low recoveries

Three cents. Two cents. Even a mere 0.125 cents on the dollar.

More and more, these are the kinds of scraps that bondholders are fighting over as companies go belly up.

Bankruptcy filings are surging due to the economic fallout of Covid-19, and many lenders are coming to the realization that their claims are almost completely worthless. Instead of recouping, say, 40 cents for every dollar owed, as has been the norm for years, unsecured creditors now face the unenviable prospect of walking away with just pennies -- if that.

While few could have foreseen the pandemic’s toll on the economy, the depth of investors’ pain from corporate distress was all too predictable. Desperate to generate higher returns during a decade of rock-bottom interest rates, money managers bargained away legal protections, accepted ever-widening loopholes, and turned a blind eye to questionable earnings projections. Corporations, for their part, took full advantage and gorged on astronomical amounts of debt that many now cannot repay or refinance.

It’s a stark reminder of the long-lasting repercussions of the Federal Reserve’s unprecedented easy-money policies. Ultralow rates helped risky companies sell bonds with fewer safeguards, which creditors seeking higher returns were happy to accept. Now, amid a new bout of economic pain, the effects of those policies are coming to bear.

Debt issued by the owner of Men’s Wearhouse, which filed for court protection in August, traded this month for less than 2 cents on the dollar. When J.C. Penney Co. went bankrupt, an auction held for holders of default protection found the retailer’s lowest-priced debt was worth just 0.125 cents on the dollar. For Neiman Marcus Group Inc., that figure was 3 cents.

CDS Sadness

Credit default swap auctions portend steeper-than-usual losses

The loose lending terms that investors have agreed to mean that by the time corporations file for bankruptcy now, they’ve often exhausted their options for fixing their debt loads out of court. They’ve swapped their old notes for new ones, often borrowing against even more of their assets in the process. Some have taken brand names, trademarks, and even whole businesses out of the reach of existing creditors and borrowed against those too. While creditors always do worse in economic downturns than in better times, in previous downturns, lenders had more power to press companies into bankruptcy sooner, stemming some of their losses.

The pandemic is upending industries like retail and energy, making it unclear how much assets like stores and oil wells will be worth in the future. The underlying problem for many companies, though, is that they have astronomical levels of debt after borrowing with abandon over the previous decade, then topping up with more to get them through the pandemic.

For bondholders, the kind of liabilities that companies have added makes the problem worse. Loans have been a particularly cheap form of debt for many companies over the last decade. Those borrowings are usually secured by assets, leaving many corporations with more secured debt than they’ve had historically. That means that unsecured bondholders end up with less when borrowers go broke.

“We’ll see companies gradually hitting the wall -- it’s just a question of when and how fast,” said Dan Zwirn, founder of Arena Investors, a $1.7 billion investment firm with an emphasis on credit. “There’s just going to be way more downside.”

Record Lows

The recent low values for bonds in credit derivatives auctions signal that in future bankruptcies owners of unsecured bonds, not to mention loans, may suffer a bigger hit than usual, according to research from Barclays Plc. The median value for companies’ cheapest debt in credit derivatives auctions this year is just 3.5 cents on the dollar, a record low and far below the 23.4 cent median for 2005 through 2019.

The value of a company’s bonds in an auction for credit derivatives payouts doesn’t necessarily equal how much money bondholders will actually recover when a bankruptcy is complete. But lower auction values do tend to correlate to lower recoveries, according to Barclays. Lower market values also reflect investor concerns.

The auctions represent the value of a company’s cheapest unsecured bond, although usually most of a borrower’s unsecured notes trade around the same price in bankruptcy, according to Barclays. When a company defaults or files for bankruptcy, an investor that bought a credit default swap receives a payout equal to 100 cents on the dollar minus the auction value of the cheapest-to-deliver security.

Loan Pain

It’s not just bond investors that will suffer from low recoveries. Amid the pandemic downturn, loan investors could find themselves losing 40 to 45 cents on the dollar, compared with historical averages of 30 to 35 cents, according to Barclays.

One factor that is hurting money managers is the erosion of investor protections known as covenants, as more and more high yield and leveraged loan deals are covenant-lite, meaning they feature minimal such safeguards. When corporations had more restrictive covenants, borrowers had less room to fix their debt outside of court, sending them into bankruptcy closer to the first sign of trouble.

Now companies have more leeway to seek extra financing when they’re in trouble, and to give lenders providing additional funds the right to jump to the front of the line if the company does go bankrupt.

“Covenant-lite paper usually means by the time you get back to the table with the borrower, the house is on fire,” said Sanjeev Khemlani, a senior managing director at FTI Consulting. “All of that extra time you had before, that’s just gone away.”

Oaktree Deal Crushed a Leveraged Loan and Exposed Market’s Woes

Investors that bought a J. Crew Group Inc. term loan at par back in 2014 may have thought they were making a relatively safe bet, since it was secured debt. When the company started struggling a few years later, it moved intellectual property including its brand name into a new entity, a move enabled by relatively loose covenants.

The company then exchanged some of its existing bonds for new notes secured by the intellectual property as well as preferred stock and equity in its parent company, as part of a broad restructuring. Loan investors ended up suffering: after the company filed for bankruptcy in May, the 2014 obligation was worth less than 50 cents on the dollar, according to Bloomberg loan valuation estimates. (J. Crew exited bankruptcy in September.)

FTI’s Khemlani, who advises lenders with senior claims on borrowers’ assets, said investors should make an effort to “put some teeth” into their agreements with borrowers now as they fall into distress, regaining some lost protection.

In addition to shifting assets, companies have also been doing more distressed exchanges in recent years, where troubled corporations offer creditors new, debt that often ranks higher in the repayment pecking order in exchange for relief like lower principal or later maturities or both. Creditors that participate can stem their losses in the event of a bankruptcy, but investors that sit the deal out can end up worse off.

The popularity of distressed exchanges has also contributed to a general rise in secured debt in companies’ capital structures. That means that more investors -- holders of loans and secured bonds -- are fighting for the same scraps when a company files for bankruptcy. Almost 20% of the debt in the U.S. high-yield bond market is now in some way secured, according to Barclays, versus just 6% in 2000. The number of businesses that had taken out just loans and no other form of debt almost doubled between 2013 and 2017, according to JPMorgan Chase & Co. data.

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