Market volatility has increased since the Federal Reserve ended quantitative easing, but the unintended consequences of the Dodd/Frank bill have heightened the risk in the bond market. Many people have forgotten that the 2008 financial crisis started in the bond market, not the stock market. Most of us have heard of certain financial firms referred to as Broker/Dealers. And the title is very telling. The Broker moniker refers to the part of the firm that executes trades for its clients. The Dealer side of the firm provides liquidity to the bond market by holding bonds in inventory so that the bonds are available for purchase by the firms’ clients. The Dealer part of the business is what has been adversely impacted by Dodd/Frank. Due to the stringent rules in Dodd/Frank, banks no longer want to own large bond inventories because it hurts the high capital reserve ratios they must keep.

As one high yield bond manager said to us – “We don’t have a liquidity problem, we have a pricing problem.” His point was that you can sell any bond, but if you have to sell it immediately, you might have to accept a price well below what the bond is worth – in some cases 5%-10% below the “real” price of the bond. Primary dealer inventory of investment grade and high yield corporate bonds is currently 20% of what it was in 2007. However, on the flip side, corporations have issued a massive amount of bonds since 2007 to buy back their stock. The amount of outstanding corporate bonds has risen from about $2.5 trillion in 2007 to approximately $4.5 trillion today. More importantly, in 2007, dealers’ inventory consisted of almost 12% of all outstanding corporate bonds whereas today they hold just about 1% of outstanding bonds.

So, what does this all mean? One of the primary functions of dealers is to provide liquidity and stability to the bond market. With the disincentive the Dodd/Frank bill has imposed on dealers, that liquidity no longer exists, at least to the much larger extent it did prior to the Great Recession and hence volatility has dramatically increased. The Federal Government’s fix, via the Dodd/Frank bill, to stabilize the markets is actually having the opposite affect by destroying primary dealers.

What does this mean for portfolios?

We continue to believe that high yield bonds will remain under pressure over the next several months. For that reason, we have the lowest exposure in that area in THOR’s history. The mispricing of corporate bonds also is causing price distortion in other investments like MLP’s and Business Development Corporations (“BDC”). In our opinion, these investments have fallen well below what they are worth and in many cases have higher yields than junk bonds. Investing can be difficult at times like this, but we see it as an opportunity to add to higher quality investments, like MLPs and BDCs, at cheap prices.

Book of the Month – Every Nation for Itself – Winners and Losers in a G-Zero World, Ian Bremmer

I want to thank Todd for suggesting I look at Ian’s work. Ian is the President of Eurasia Group which specializes in global political risk consulting. Many of you may have seen him on TV the past few days talking about what the Russian bombing in Syria means for the United States. This book was published in 2012 and talks about what it means to the world when we are leaderless. Back when many of us were growing up, the United States had allies that shared the same value system with most of the countries in the G-7. As the world changed, so did the G-7. It soon became the G-20 with countries that have very different values and is, in Ian’s opinion, ineffective.   Today, each country is on its own. Because of this, chaos will continue to exist around the world. It is a thought provoking book that brings some clarity to current world events and what may occur in the future.

Sincerely,

Your THOR Team