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DITMo: The Biggest Risk – Question To Bill Gross

 

Just before the Brexit vote, Bloomberg invited fixed income subscribers to their sponsored Fixed Income Summit in Los Angeles where former PIMCO / current JANUS legendary bond magnate Bill Gross was interviewed on stage for about an hour.  Below is a link to the Q&A with Bill Gross.  None believed that Brexit posed a systematic risk and there were no comments nor questions on this subject.

The question at 49’ 30” is from me, answered by Bill Gross to 53’ 53”.  My question was to ask what the next shoe is to drop akin to the subprime MBS and fixed income derivatives debacle of late 2008 that caused the collapse of the most venerable banks.  His answer was the same cause that brought down the investment banks in 2008: LEVERAGE.  Gross points to the lure of carry trades but also to the risk of such trades in the face of negative interest rates overseas.

My question to Bill related the fact that issuance is unusually high due to the mispriced risk from contrived low interest rates.  Additionally, some municipalities in California are funding deficits with Capital Appreciation Bonds (CABS) that, unlike OID issues, do not accrete on the books that understates the municipality’s liability.  We have seen what happens when states within a super-state, i.e. the European Union, over-leverage.  In the United States, individual states and other municipalities are not capped in budgets, unlike EU members that technically are bounded by a multiple of their respective GDPs.

Corporations are at almost unprecedented issuance.  It makes sense to lower the cost of capital by issuing low-cost debt for buybacks, hence, raising EPS.  Also, raising financial leverage with increased interest also increases the “gear” of earnings to operating income.  Therefore, dovish monetary policy over an extended period misprices risk, both on fixed assets by those reaching for yield (accepting increased duration and credit risks) and on equity multiples through EPS growth without revenue growth.

The coming change of regulations relating to prime money market instruments would further cause a rush to treasuries to escape a possible break-the-buck NAV.  Though treasuries remain at low rates, corporate issuance, rising municipal budgets and Libor increases (reflecting growing risk) will eventually move toward normalizing rates to properly price risk.  Cost of equity will then begin to reflect repriced risk with a normalized risk premium forcing multiples to fall in my scenario.

http://www.bloomberg.com/news/videos/2016-05-26/bill-gross-on-monetary-policy-and-asset-prices Go to 49:30 minutes:seconds to 53:53

Pj de Marigny
DITMo
pj@DITMoAnalytics.com

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