Big friends needed for ‘bottom fishing’

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In the US markets at least, there’s now been just enough of a pause in the sell-off of riskier assets for the more courageous, or more foolish, investor to wonder whether it’s time to do some “bottom fishing”. That is, looking to buy securities with good intrinsic value that have been liquidated by forced sellers. In my experience, the first wave of value buyers that come after a market crash tend to be sacrificed so that others’ portfolios liquidity may be saved.

It’s not that there aren’t cheap assets to be had, even this early in such an “adjustment” or “new paradigm” process. There are, but the really deep value, as in ready-cash-with-in-the-money-options-attached, hasn’t appeared yet, and probably won’t for many months, if not years. If you wait that long, your limited partners will have redeemed every last cent, and you will be writing your last cheque to the divorce lawyers. So if you can’t wait to be Benjamin Graham with 1932 prices and a pristine current account, what do you do in the meantime?

First, recognise that while there may be such a thing as “intrinsic value”, some intrinsic values have more friends than others. For example, emerging market equities may well represent modern machinery, set in countries with plentiful resources, good demographics and improving governance. So what? If they can’t earn enough dollars from the sale of weakly priced commodity exports, that value is not going to be priced very well for a long time, particularly given that those companies have a limited access, directly or indirectly, to the Federal Reserve.

The same problem of realising value in a reasonable period of time is even true for a lot of emerging market debt. The issuers of EM debt are far more systematic and professional than they were at the time of the Latin American crises of the 1980s and the Asian crisis of the late 1990s, and their central bank reserve positions are, collectively, much stronger. Offsetting those creditor-friendly improvements, though, is the greater democratisation of emerging market politics. We will see, for example, just how much austerity the Turkish government can impose on excessive domestic credit creation, when it seems to have difficulty clearing the land for one unpopular development. And Turkey is, relatively speaking, a good story.

Yes, it’s at times like these that you have to look for friends. Big friends, such as the Federal Reserve. About a month ago, I recommended Governor Jeremy Stein’s February paper, “Overheating in Credit Markets: Origins, Measurement, and Policy Response”. It’s turning out to be more than just an interesting advance in the academic debate, and I would again suggest a close read of it would be useful for market practitioners.

In it, Mr Stein discusses the potential risks of “collateral transformation”, in which, briefly, holders of, say, junk bonds who need high-quality collateral to secure derivatives transactions swap the junk for Treasury bonds. Then, if junk bond spreads increase, and there is a margin call on the collateral, this could lead to what he calls “unwind risks”, ie a self-reinforcing spiral. He then goes on to discuss how the response to this sort of problem could involve the use of supervisory and regulatory tools alongside monetary policy.

In light of what’s gone on in the risk markets in the past month, that probably means doing something to relieve the shortage of high-grade collateral, mostly Treasury paper, that’s been created by the Fed’s quantitative easing and the reduction in the federal government deficit.

A recent IMF paper estimates, based on recent experience, that “at this rate, the Fed could silo over $1tn additional good collateral in 2013 . . . This is likely to have first-order implications for collateral velocity and global demand/supply of collateral.”

But if the Fed decides either to loosen collateral rules, buy lower-grade paper, or in some other way support the market for risky assets, who will be the first beneficiaries? After all, you, the portfolio manager or speculative investor, don’t want to wait around for all of this to percolate down into the real economy.

You can’t be a bottom fisher if you’ve already sunk to the ocean floor yourself.

So what one needs at this point is a pool of relatively short-maturity, high-value assets that could attract some sympathy from the Federal Reserve if needed, and which have been liquidated recently by forced sellers. I say “short maturity”, because we can’t necessarily count on yet another set of bubble buyers to take us out of our positions. Look how short the first Abenomics rally turned out to be.

This describes a lot of the US junk bonds that have been sold, of necessity, by high-yield credit exchange traded fund managers in the recent panic. Usually there are better values to be found in the smaller, “off-the-run” junk issues that are too illiquid for the ETFs, but the managers have had to raise a lot of cash quickly to meet redemptions.

Maybe there has been too much covenant-lite junk bond issuance of late, but the easy money of the past couple of years has enabled leveraged companies to push out their “wall” of bond maturities by several years.

This means that even with a stagnant economy, they are likely to be able to repay bonds maturing over the next three or even four years. That’s much longer than even well-financed emerging market issuers.

It’s pretty easy to screen the holdings of ETFs or managed mutual funds to identify their recent dumpings of junk issues. Then screen again to find the junk bonds with maturities short of the individual companies’ big refinancing requirements. Even if the market for risky paper remains choppy, you can hold these to maturity with relatively low risk.

You can’t just wait for the central banks to blow a new bubble.

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