Why it pays to ignore the market
At the end of 2008, the loan market was in stunningly bad shape. There was almost no bid for loans in general, and cov-lite leveraged loans in particular were treated like they were radioactive. If you looked at the prices they were trading at, the market was clearly expecting a huge wave of defaults in the very near future, along with very low recoveries.
Two years later, the picture could hardly be any different. High-yield bonds are being issued within 40bp of the state of Illinois. Cov-lite loans are being churned out at bubble-era pace: the $8.8 billion so far this year is 25% of all loans year-to-date, already tops the 2010 total, and works out to an annualized pace of something in the region of $65 billion. The defaults that everybody was expecting generally failed to occur, and the few defaults that did happen had surprisingly high recoveries.
The WSJ‘s Mike Spector is at pains to point out that “creditors aren’t guaranteed to lock in these better recoveries. Distressed-debt exchanges, while giving good recoveries in the short-term, could later prove a mirage should firms falter again.” This is true broadly, but false narrowly: if creditors want to lock in their recoveries they can do so very easily by selling their shiny new bonds and loans in this frothy market at very high prices.
When I started blogging full-time in 2006, I formulated a principle — that the market is the best pundit. Sometimes the market is wrong and some specific pundit is right, as I’m sure my boss at the time, Nouriel Roubini, would love to remind you. But the expectations priced in to the market are a more reliable base case than any other forecast you might use.
That principle didn’t work out well for me in the case of mortgage bonds. Or just about anything else: the market took it upon itself to go completely bonkers, with a level of volatility bespeaking zero reliability whatsoever when it came to priced-in expectations. Even so, in the midst of a massive recession it did seem reasonable that crazy cov-lite loans would start defaulting en masse — no matter what the Fed did in terms of monetary policy.
But something interesting happened: it turned out that these bonds and loans were big enough to concentrate the minds of the creditors. Banks and investors worked hard to avoid realizing losses, in a manner which has most emphatically never happened in the mortgage market or with small business loans. You can call it “extend and pretend” or “delay and pray” if you like, but it seems to have worked, with a lot of help from the Fed. That was unexpected, and because it was unexpected it had a huge effect on prices, which outperformed massively in 2009 and 2010.
So when the market seemed unreasonably sanguine, in early 2007, it was wrong. And when the market seemed reasonable in its pessimism, in late 2008, it was also wrong. Right now we’re back to unreasonably sanguine again — Bethany McLean says, sensibly enough, that the recent uptick in cov-lite issuance is “a sign that some kind of reckoning is in store.” But the one thing I’ve learned over the past three years is that the market just isn’t a sensible or rational place.
If you’re being logical about such things, stocks look incredibly frothy right now, just as bonds do, both in terms of valuation and in terms of psychology. But this market has a way of making everybody look foolish, no matter how logical they are. Which is ultimately just another reason to spend as little time as possible paying any attention at all to the market. It’ll just drive you mad.