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The Coming Private Equity Bubble and Increased Default Rates

Private Equity Debt Bubble

A Warning on Risk in Commercial Mortgages - New York Times

Apparently, there is so much money in the fixed-income market, that yields are declining significantly more than the risk, which could be creating a private equity debt bubble.

Debt markets for private equity have become riskier because:

Why are lenders loosening underwriting standards to make more loans? Because the loans can be securitized, and the risks can be passed onto investors. Commercial mortgages are securitized into commercial mortgage-backed securities (CMBS), and divided into tranches of varying risk, which are then sold to investors. This is how the subprime mortgage market ballooned into the leviathan that it is today—banks securitized the debt and sold it to investors, thereby transferring the risk as well, which freed up more capital to lend even more. With so much money to lend, lenders marketed to borrowers with greater credit risk or lent money to pay bubble-inflated real estate prices, thus creating the current real estate bubble, with the inevitable decline in home prices, and, of course, greatly increased foreclosure rates.

CMBS issues in the last quarter of 2006 were nearly double the previous quarter, and continues to grow. Because of increased competition, underwriting standards have deteriorated, and riskier deals are being made, including interest-only loans, and even negative amortization loans. Although default rates have been low recently, this is bound to change. Thus, buyers of junk-grade bonds should beware.

Bond Trading at the NYSE — NYSE Bonds

NYSE Is Cleared To Expand System For Bond Trading - WSJ.com

The New York Stock Exchange Group, Inc. has received approval to list bond issues of all NYSE-listed companies on its exchange. The SEC has granted the NYSE an exemption to the rule that required that each bond be registered before it could be listed on an exchange. Exchange-listed bonds would have the more competitive bid/ask pricing system over the usual best-efforts approach where a bond broker would call 3 dealers to get the best price among them, even when there could be thousands of other dealers in the bonds—at least a few of whom would almost certainly have better prices. An exchange-listed bond price would aggregate all prices available for the bond into the best ask/bid price in the same way that stocks and options are listed.

The NYSE Group is also currently seeking SEC approval for a new fixed-income trading exchange that will be called NYSE Bonds.

Catastrophe Bonds

Catastrophe-Bond Supply Builds Up - WSJ.com

Catastrophe bonds (frequently shortened to cats), first marketed in the 1990’s in response to Hurricane Andrew and the earthquake in Northridge, California, are issued by insurance companies to cover catastrophes such as windstorms in Europe and earthquakes in Japan, but the majority cover hurricanes in the United States. It is a means by which insurance companies can transfer their risk. Reinsurance is not readily available for such disasters, and, in the event of a disaster, insurance companies get their money faster from catastrophe bonds than they do from reinsurance. Another advantage of bonds over reinsurance is that the issuer can get coverage over several years.

The risks of catastrophe bonds are hard to assess because their ratings are often based on a model portfolio rather than actual risks, which, in any case, is very difficult to forecast.

Catastrophe bonds are attractive to investors because, since it is possible to lose the entire principal from a disaster, they pay very high yields, and they don’t correlate with stocks or even with other bonds, thereby providing diversification.

T-Bills, Rising Rate CDs

I just received an email advertisement from my bank today for rising rate CDs. Right now, my bank is paying 3.42% up to 4% ($50,000 to $99,999 investment required for top rates) for a 12-month CD. The interest rate will be adjusted once during the 12-month term if rates continue to rise.

But why buy a rising rate CD when you can buy 4-week T-Bills that are paying about 4.5%? With the Treasury's new website http://treasurydirect.gov, you can open an account on their website, and buy a 4-week T-Bill with money drawn directly from your checking account. When the T-Bill matures 4 weeks later, the money is directly deposited back into your checking account. How easy is that? Furthermore, 4-week T-Bills are auctioned every Tuesday, and issued 2 days later, on Thursday—that's when your checking account will actually be debited for the purchase. That means that while interest rates are rising, you can could be earning the latest high interest rate available. Note that although T-Bills are auctioned, as a small investor who isn't buying more than $5,000,000 worth of T-Bills, you will get an average of the auction price, which right now is about 4.5%. And since the government has recently just increased the debt ceiling to $9 trillion, Uncle Sam is going to continue to need your money. Furthermore, unlike most CDs, you don't have to tie up your money for a whole year. In fact, a good strategy would be to stagger your T-Bill purchases, buying some every week, which means that some will mature every week, so if you need the money, you won't have to wait too long. This is a good way to save the money for emergencies, like if you lose your job, for instance. In most cases, you won't need all of the money right way, so the serial maturation of T-Bills is an excellent way to receive income right when you need it.

Now for a few basic facts.

  1. T-Bills are as safe as any bank account because they are backed by the full faith and credit of the U.S. Government—yes, that same government that insures the money in your banking account.
  2. T-Bills are issued only in $1,000 denominations or a multiple of that, and you buy that at a discount. For instance, you would pay $996.52 for a single T-Bill and get $1,000 back 4 weeks later. Note, that because you don't know what the discount rate will be that week, you simply set up your Treasury account to buy, let's say, $5,000 worth of 4-week T-Bills. That would be 5 T-Bills, but your checking account will only be debited for what the actual cost is, which for this example, might be $996.52 x 5 = $4,982.60. Then you would get $5,000 back 4 weeks later when they mature. (To learn more about calculating the interest rate of a discount, see Time Value of Money, with Formulas and Examples.)
  3. Although you pay federal tax on the interest, you don't have to pay state or local tax, which is another advantage over the interest earned in banking accounts.
  4. You can easily set up the automatic re-purchase of the T-Bills as they mature, so that you don't have to do anything if you want to keep your money invested in T-Bills. When you want to get the money, simply stop the automatic re-purchase.
  5. There are other options, of course. For instance, you can buy 180-day T-Bills that mature in 6 months and pay a little more interest, or buy notes that mature in 1-10 years or bonds that mature in more than 10 years. However, considering the fact that interest rates are rising, its probably best to keep buying the 4-week T-Bill, because their rates rise every 4 weeks as long as interest rates continue to rise. Now, when interest rates start declining, then it would be time to lock in interest rates by buying longer-term notes or bonds.

It is easy to open an account at http://treasurydirect.gov, and everything is explained there—including a very good flash presentation.

The U.S. government debt is, to a large extent, financed by foreigners, so you can help your country by buying T-Bills, so that the interest, which is paid by the taxpayer, goes back to the taxpayer.

So, what is the amount of interest generated by a $9,000,000,000,000 debt. Well, here's an approximation:

4.5% x $9,000,000,000,000 = $405,000,000,000!

That's almost one-half of a TRILLION DOLLARS EVERY YEAR! Just in interest! Imagine the goods and services the government can provide with that much money.

In the past, mostly wealthy individuals, institutions, and foreign governments bought U.S. Treasuries. Now the rest of us can buy them, too. The fact is, the government can greatly increase the amount bought by U.S. citizens, thereby returning that interest to the people that pay it. Because U.S. Treasuries are now book entries—everything is electronically stored and transacted—there is no need to require a minimum purchase of $1,000 or in multiples of $1,000. Even maturity terms and dates can become more flexible. This would allow many more people to invest in U.S. Treasuries, and thereby, not only keeping the money in the country, but helping to lower the interest rate that the government pays by increasing the potential pool of investors.

Bond Defaults

How Default Rates for High Yield Bonds Varies by Economic Conditions and Age

Here's another article by the Federal Reserve Bank of New York about the variance of default rates for high yield bonds, and discusses how economic conditions and the age of bonds contribute to the observed default rates for bonds of a given credit rating.

Buying Bonds

4 Reasons to buy Bonds

MONEY Magazine: Sivy on bonds - Dec. 19, 2005

Here's an article on 4 reasons to own bonds.
  1. Buy a long-term bond when interest rates are high so that you lock in a good rate for the long term, or be able to sell the bond for more money than you paid for it.
  2. Take advantage of impending declines in interest rates by buying a bond before interest rates start declining, then selling it after the bond appreciates in price. The shorter the time period in owning the bond, and the greater the price appreciation of the bond, the higher the effective yield. This works because bond prices increase when interest rates decline (to see why: Complete Introduction to Bonds), but there is the problem of forecasting interest rates. Still, if the forecast turns out to be wrong, you still get the interest payments, and bonds are much less risky than stocks.
  3. To earn predictable current income, an obvious reason.
  4. To reduce in swings in the value of your portfolio. When stocks do well, bonds tend to do worse, and vice versa. Thus, declines in the value of 1 asset are partially offset by gains in the other.

Smartmoney.com: One Bond Strategy: Ten Things Your Broker Won't Tell You About Bonds

This is a good article about buying bonds. Some key facts:

Bond Ratings - Fitch, Moody's Investor Services, Standard & Poor's

Credit Rating Information

An excellent detailed, but concise, guide to bond rating codes provided by the credit rating services—Fitch, Moody's Investors Service, and Standard & Poor's. Also explains what steps a bond issuer must take to get a rating, and what factors these services consider to arrive at a credit rating for the issuer.

Bond Rates, Bond Screener

Bloomberg.com: Rates & Bonds

A good at-a-glance page for interest rates of bonds, mortgages, and U.S. Treasury securities.

Use Bond Screener to search for bond type, maturity, rating - Yahoo! Finance

An excellent bond screener. First select bond types: treasury, treasury zero coupon, corporate, and municipals for all states or a specific state. Additional bond criteria that can be specified are price, coupon range, current yield range, yield to maturity range, maturity range, debt rating range, and whether it is callable or not.

Yahoo! Help - Bond Center

This link gives detailed information about the criteria.

Bond Screener Results - Yahoo! Finance

This example of results from the bond screen show the type of bond, issuer, price, coupon percentage, maturity date, yield-to-maturity percentage, current yield percentage, rating (based on Moody's and Standard & Poor's), and if it is callable. Click on any of these column headings to sort by that column. Click it again to sort in reverse order.