If unprecedented monetary easing has littered the landscape with zombies, companies that’ll never make a profit, then what could come next is a tsunami wave of illiquid investments.
The first early warning wave of illiquid investments has already made landfall with UK’s Metro Bank circling the drain
The bank’s stock has collapsed by 95% which has been exasperated by its recent bond sale failing despite 7.5% yields.
Illiquid investments are those that can not be easily sold in sufficient volumes, whenever needed unless the investors incur punitive transaction costs.
Russ Mould, investment director of AJ Bell explains the challenging corporate bond environment where even high yielding bonds have become illiquid investments.
“Failure to get enough support for a product that is yielding 7.5% is quite remarkable when you consider how investors are struggling to find generous levels of income in the current market,” he said and added, “It suggests that investors don’t trust the bank or they believe the 7.5% yield is simply not high enough to compensate for the risks of owning such a product”.
Selling unsecured bank bonds just a month before another Brexit deadline is a tall order, nevertheless, it is not the reason why Metro Bank’s bond issue failed and caused it’s a stock price to collapse.
Metro Bank isn’t the only bank struggling to sell an illiquid investment in tough market conditions
Indeed, Bank of Ireland was also forced to cancel a £300 million bond in early September due to the low level of demand. As I said previously, the banking sector is rich with shorting opportunities as it is hit with two headwinds namely a downturn in the economic cycle and the Fintech revolution, which is likely to be the greatest game-changer for banking and financial services industry in a generation.
Luxury makers could also find it challenging to sell illiquid investments
The luxury automaker Aston Martin had to offer interest rates as high as 12% to convince investors to buy $150 million of bonds due in 2022. S&P has recently downgraded the automaker to deep-junk CCC+ over concerns about its ability to service its big pile of debts.
The fixed income market has become so financialized since 2008 that it has distorted risk and forced conservative investors to chase higher yields in risky global bonds which could become illiquid investments in a downturn
The severity of these illiquid investments will depend on the extent of the market’s deterioration. But what we are already witnessing is that yield-hungry corporate investors are turning away high corporate bond yields in the teens.
Put simply corporate bond investors in certain segments no longer perceive high yields as an opportunity, a ladder to profits but as a snake, a toxic asset.
A no-bid scenario would trigger a price collapse in illiquid investment leaving investors holding worthless paper.
The proliferation of illiquid investments could mean investors keeping a wide-berth from the high-risk junk bond market and even risky sovereign debt
In good times corporate investment-grade bonds are liquid, but that assumption may not be true for a growing portion of the corporate bond sector (i.e. bonds issued by companies) when the market turns. Already we are seeing this with banks and a luxury auto.
The issue of corporate bonds becoming more illiquid investments has been underway for the last decade
A recent research paper by the Bank for International Settlements (BIS) notes the growing liquidity gap between government bonds (referred to as ‘sovereign’ bonds in the paper) and corporate bonds;
“Market liquidity in most sovereign bond markets has returned to levels comparable to those before the global financial crisis, as suggested by a variety of metrics and feedback from market participants.
There are, however, signs of increased liquidity bifurcation and fragility, with market activity concentrating in the most liquid instruments and deteriorating in the less liquid ones, such as corporate bonds,” said BIS Committee on the Global Financial System.
So with near $17 trillion of negative-yielding bonds across the world the scramble to “reach for yield” has meant that the higher returning bonds could become illiquid investments in adverse market environments.
What do these illiquid investments include?
Junk (high risk) corporate bonds, loans, Residential Mortgage-Backed Securities, emerging markets and structured products are at risk of becoming illiquid investments in a market panic.
“The big worry is that the now-troubled European funds that embraced such investments, only to stumble when investors asked for their money back, are just the tip of the iceberg.
Exposure to illiquid assets and poor-quality bonds has crept into funds as managers hunt for whatever returns they can find in today’s low-interest-rate world,” writes Bloomberg.
The Bank of England recently warned about illiquid investments, risky investments, have been incorporated into funds without fund managers fully appreciating the risks. Investors have been piling into a host of risky investments in some cases, without them fully understanding the dangers.
“Some $30 trillion is tied up in difficult-to- trade investments” said Mark Carney from the Bank of England. This poses a “systemic” risk said, Mark Carney. That is the central bank’s doublespeak for the kind of risks that can potentially cascade through markets, institutions, and economies.
But the proliferation of illiquid assets also means that corporates are going to find it challenging to raise finance irrespective of the yields that their bonds are offering
Take, for example, UK’s Metro Bank. Flagged up by regulators in January, the “error” left a gaping £900 million hole in its balance sheet which prompted managers to announce a £350 million rights issue. The cash call was successful at 500 pence a share. Hedge fund managers, the likes of Steven Cohen and Bloomberg-founder Michael Bloomberg claimed that the stock was a “bargain” at 500 pence. They are now trading at just above 190 pence. So with investors now losing confidence in Metro Bank how will the company raise finance without paying punitive interest rates?
Investors have already been stung with a rights issue and a bond issue has failed.