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Equities and the Corporate Bond Market: How the Alphabet Soup Monsters Play Into Today's Market

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Don't assume a one-to-one correlation between rising stock prices and POMO.

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Deutsche Bank sells CDOs representing $8.7 billion worth of risk…Buyers will receive a payment of 8% to 14.6% depending on how much risk they take on.
-- Bloomberg, January 24, 2013.

Carlyle plans 300MM Euro CLO (Collaterized Loan Obligation). Investors have dumped a weekly record $1.5b in leveraged loans last week
-- Bloomberg News, April 12, 2013

A lack of net new US loan issuance is expected to limit CLO growth for the rest of the year, according to delegates at IMN's Annual Investors' Conference on CLOs and Leveraged Loans this week in New York.
-- Bloomberg Brief, Leveraged Finance, April 12, 2013.

US junk bonds may set a new high for issuance in 2013, beating last year's $360 billion after a record $89.7 billion in junk bonds was sold during the first quarter. The main barriers to this are a slowdown in refinancing and less-than expected M&A.
-- Bloomberg Brief, Leveraged Finance, April 5, 2013.

Pearl Diver Capital, a London-based money manager, is raising its fourth fund to invest in CLOs as deal volume grows in the U.S. and Europe. PDC Opportunities IV will raise about $250 million before first closing by early May, said Chandrajit Chakraborty, managing partner and co-founder of Pearl Diver. The firm, which closed its third fund of similar size in August, plans to deliver annual returns of 20 percent with 15 percent cash payments every year. . . . Pearl Diver closed its first fund to buy CLOs at about $200 million on Sept. 15, 2008. It generated an annual return of about 90 percent. . . . Pearl Diver's second fund raised $200 million in 2011 and recorded an annual return of about 35 percent.
-- Bloomberg Brief, Leveraged Finance, April 5, 2013 (emphasis mine)

Sometimes no real analysis is needed to understand what is going in the markets, or to paraphrase one of Todd Harrison's favorite sayings, "One can learn a lot just by reading." The above snippets present one of those times. A lot is being made every week of the Fed's Permanent Open Market Operations (POMO) and how the Fed's purchases of bonds and mortgage backed securities (MBSs) through the POMO supposedly provide the cash for the never-ending levitation of the equity markets.

While of course money is fungible, and therefore if the Fed throws more liquidity at the system that added money may ultimately free up cash earmarked for riskier investments, I would caution against presuming a 1:1 correlation between POMO and rising stock prices. As Rosenblatt's Brian Reynolds taught me through the years, and as is borne out by the Fed's Quarterly Fund Flows reports, the transmission mechanism between excess cash and rising stocks runs through the corporate bond market, where companies can flood their coffers with bonds sales, and then use that cash to bid on their own stocks.

Which brings me back to a couple of the above quotes. As long as junk bond sales continue at record pace, as long as the awakening of the "alphabet soup" monsters is only limited by a lack of underlying loans, and as long as buyers heed the siren song of 20%, 35%, and 90% returns by buying "sausages" of loans, companies will have an unending stream of money available to manipulate their equities.

You do not have to agree with it (and I don't); it doesn't have anything to do with the fundamentals of the companies, and it certainly is no indication of the health of our economy. What we must respect, however, is that it is a transfer of risk from equity holders to debt holders which pushes up equity prices.

Does it mean that the S&P 500 (INDEXSP:.INX) will never again go down for more than two hours and 2%? Of course not. But when you have the likes of Nike (NYSE:NKE), Coca-Cola (NYSE:KO), IBM (NYSE:IBM), and hundreds of other companies sitting on the bid of buyback programs totaling nearly $1 trillion, it does mean that, when those programs kick in, they can pretty much overrun any selling scenarios we can muster. And we can learn a lot just by looking at that.

Twitter: @FZucchi
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Position in SPX.
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