What gets stuffed into the Wall-Street sausage maker on the American side are dollar-denominated risky “leveraged loans” – loans issued without collateral by over-indebted junk-rated companies. Banks slice and dice these leveraged loans, lumped them together into Collateralized Loan Obligations, and sell them to other financial institutions. These CLOs are then repackaged and peppered with derivatives to hedge against currency fluctuations.That’s what goes into the sausage maker.
What comes out of the sausage maker on the Japanese side are plump-looking, yen-denominated, highly rated bonds.
Blame the Bank of Japan. Where there’s enough demand, there will be supply. The BOJ, as part of its mega-QE program, is buying every Japanese Government Bond that hasn’t been nailed down. It has been telling banks, insurance companies, and pension funds to dump their vast holdings of JGBs. It pushed 10-year yields to 0.33%. And it’s strangling the JGB market.
Conservative Japanese pension funds, and even the Government Pension Investment Fund with ¥137 trillion ($1.14 trillion) in assets, long reliant on these JGBs, are dumping them into the lap of the central bank to replace them with a variety of goodies that provide some visible yield, including the latest Wall Street sausage.
It’s logical in our absurd world. Corporate America is already racing to sell euro-denominated junk bonds in Europe where the epidemic of negative yields in government bonds has suppressed yields across the corporate spectrum as well, to where junk bonds yield about 200 basis points (2 percentage points!) less than in the US. Low-cost money for high-risk US issuers, the new nirvana [read… Dumping American Junk in Europe, Draghi Asked for it].
But the deal with Japan is vastly more glamorous. These aren’t junk-rated US corporations going to Japan to sell yen-denominated bonds directly. This is Wall Street offloading murky, risky products at a high price.
These leveraged loans that form the base for the CLOs have long worried US banking regulators. Yellen personally warned about them. So they’ve fallen out of favor with banks. Issuance in the first quarter dropped 52% from a year ago. Retail investors have soured on them too, and they’ve been yanking their money out of leveraged-loan mutual funds for 12 months in a row.
The other option for banks to offload their leveraged loans is to slice and dice them and repackage them into highly rated CLOs. That too worries regulators because banks retain some risks. But never mind. Investors are clamoring for CLOs. So year-to-date, US issuance jumped 22% from a year ago, to $30.4 billion, with March issuance setting a new all-time record – though investors suffered “dismal” returns.
Where does this demand for CLOs come from? From all kinds of directions, including from across the Pacific. Now it’s time to turn these dollar-denominated CLOs into yen-denominated bonds for desperate Japanese pension funds – and thereby retirees. “To make it easier for Japanese investors to get to this US debt,” as Bloomberg put it. And it’s in the true spirit of sausage:
The Repackaged CLO Series GG-A1 Ltd., for example, “consists of a special-purpose entity that will issue Japanese yen-denominated notes and is backed by the U.S. dollar-denominated notes” issued by Kitty Hawk CLO 2015-1 LLC, according to a Standard & Poor’s March 24 pre-sale report.
Essentially, it transforms $249 million worth of a $331 million U.S. CLO managed by Guggenheim Partners Investment Management into highly-rated Japanese-yen denominated bonds, according to an April 15 Moody’s Investors Service report.
The deal was finagled by Mitsubishi UFJ Financial Group, which, as Bloomberg reported – I had to hold my nose as I was writing this – “is also the counterparty on the currency swap that mitigates the risk of losses from changes in the yen-dollar exchange rate.”
Japanese institutions that turned their JGBs over to the BOJ have other options to use their freshly printed cash and obtain a visible yield. They can buy US Treasuries, for example. And they’re doing that. They can buy US corporate bonds directly which are a lot less murky than the sausages they’re buying from Mitsubishi. And they’re doing that too. They’re buying everything in sight that has a measurable yield. Right now, there isn’t much in Europe to fit that strategy, outside of Greek bonds. As far as a large market is concerned, the US is it.
The bitter irony of QE in Europe and Japan? The ECB and the BOJ are repressing yields to absurdly low levels, to levels where borrowers make money on their liabilities while lenders are losing money on their assets – by design! They’re doing this even while the cacophony emanating from the Fed has been evoking interest rate increases in the US.
The ECB and the BOJ are encouraging Wall Street and Corporate America to head to their shores and dump even the riskiest US securities for the juiciest price. And they’re motivating their hapless folks to buy even inscrutable and potentially toxic American securities at ludicrously low yields to obtain a feeble illusion of income.
But it’s great for America. We get to export breath-taking risks, nicely packaged and relabeled as “safe,” to other countries and let them take the losses when they come due. By the looks of it, this risk-dumping is going to be a huge trend. Until it blows up. But this time, it’ll blow up in their faces, rather than in our faces. And they can thank their central bank.
These junk-rated US corporations are already showing what material their debts are made of. Read… Bankruptcies Suddenly Soar Across Corporate America, Worst First Quarter Since 2009