Stocks fell for the fifth time in six days overnight, continuing a broad flight from risk to whatever is perceived as a safe haven, mostly cash and long-term Treasuries.
By Vikram Rangala
Monday, December 14, 2015
The latter is intriguing because of the historic response of long-term Treasury returns following Fed rate increases. While the stock market may well respond favorably to a rate hike as well, funds looking to diversify need new choices. The old choices, which included energy producers, commodity funds, and risky high-yield corporate bonds, are all looking less attractive this week, if not downright scary.
Oil prices continued to fall, dropping below the critical price of $35 a barrel in the WTI (West Texas Intermediate) market and $37 for Brent crude. The price reality behind these publicly-traded benchmarks is more complicated and dismal. Many producers receive an actual price below $30, such as Mexico and Venezuela, which have seen prices below $28. Producers of heavy, sulfurous crude oil and Bitumen, a tar-sand sludge, get even lower returns, below $20 a barrel, because “dirty” oils are more expensive to refine and therefore less in demand.
When oil prices were $100 a barrel, the expense of extracting and refining dirty oils and shale oil was worth it because of the net profit. But now, countries are looking at other options. That interest in alternative energy got an unprecedented boost with the signing of the landmark climate accord in Paris. Already analysts are speculating about the end of Big Oil and the rise of Big Solar.
The biggest flight from risk has been the dumping of shares in high-yield bond funds. These bonds, which detractors call “junk” bonds, offer high returns to “sophisticated” investors willing to take on more risk. As of this week, three major bond funds with over $2 billion under management are either liquidating and returning, or worse, suspending all payouts, leading to a growing anxiety about the asset class.
The SPDR Barclays High Yield Bond ETF, which reflects the junk bond market as a whole, fell the most in four years on Friday and is dropping today. If my use of the term “junk bond” to describe the ETF seems biased, you should know that its stock symbol is JNK. So no one should say they didn’t know what they were getting into.
So what could be riskier than oil funds or junk bond funds? How about oil junk bonds? According to BloombergGadfly, energy and basic industries like mining account for 28% of the $1.35 trillion face value of debt in the BofA Merrill Lynch U.S. High Yield Index. Much of that 28% is leveraged with debt it took on to pay for more and deeper drilling and extraction. Remember “Drill, baby, drill”? Well, it required a lot of debt, baby, debt.
Even in the tame world of ordinary equities, funds are pulling back their exposure as they usually do before a Fed meeting, especially one so heavily expected to result in a rate hike. This meeting, at the end of the year, comes just before a little-known but important market event, the end-of-quarter rebalance.
The rebalance happens because funds and other large investors want to show the best possible end-of-quarter profit/loss numbers. So they ditch the losing stocks and use the proceeds to buy more of the winners. They also buy “hot” stocks which they may not have had in their portfolios but which they want to tell clients they do have.
Sometimes it’s smart investing, but other times it’s just a bit of theater. When a client calls and asks, “Hey, are you invested in solar? I hear solar is big now,” brokers can say, “Of course, we reduced our holdings in fossil fuels and diversified into solar and alternatives.” They may have just done it yesterday, but there’s no need to get into details like that.
The Fed’s decision, whatever it is, will face the additional challenge of restoring confidence in markets that are looking for places to put not only their money, but also their faith.
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