Investing after easy money

Good morning. The Securities and Exchange Commission, as anticipated, approved spot bitcoin ETFs yesterday. We won’t add our view to the absolute bonfire of takes that will be available to readers today, other than to reiterate our view that bitcoin has failed every test that defines a worthwhile asset, currency or commodity. And as a purely speculative instrument, it was just fine before it was placed in a low-cost, more highly regulated wrapper. Email us about something else: robert.armstrong@ft.com and ethan.wu@ft.com.

The end of easy money, revisited

A few days ago our colleague John Plender argued in the FT that, however short-term prices and policy play out, in the long term the era of ultra-low rates and inflation is over. Central banks are shrinking their balance sheets; the global labour force is shrinking, too; globalisation is wobbling; and higher government spending on defence and the green transition will fuel demand for, and the price of, capital. 

In his latest memo to investors (and in an FT column), Howard Marks of Oaktree made a broadly similar argument. The memo catalogues bad behaviour and bad outcomes that very low rates lead to: excessive leverage, excessive risk-seeking, malinvestment, asset-liability mismatches, and inequality. Those perverse outcomes might not cause the central bank to reconsider its interventionist policies of the past several decades, Marks acknowledges. But higher inflation risks, driven by the sorts of pressures Plender refers to, might mean they have little choice but to keep rates closer to 3 per cent than 0.5 per cent.

At Unhedged, we have thought about this a lot, and are not quite as confident as Plender or Marks that we have entered a new era for rates. It may be that we slide back towards the low rates regimes of 2011-21 once the last echo of the pandemic subsides. But let us grant for now the view that higher rates are here to stay. How will that change the way we invest? How will it change return expectations, and rational portfolio construction?

It’s not a simple question. Plender makes one relevant point: in a higher rate environment, growth in corporate profits will probably slow. Interest expense will be higher, for obvious reasons, and further reductions in corporate tax rates will be less likely, because governments will be working under harsher fiscal constraints. Plender cites a paper by Fed economist Michael Smolyansky that shows how lower taxes and interest rates account for 40 per cent of the profit growth at S&P 500 companies in the three decades ending in 2019.

This very likely means equity returns in the coming years will be lower. This should change planning assumptions but not, by itself, optimal portfolio structure. Equities still might return more than fixed income, and the benefits of imperfect correlation of stocks and bonds will remain.

I put the question of portfolio allocation to Marks. His response was quite straightforward: when the market offers higher interest rates, investors can and should move down the risk curve. Fixed income becomes more attractive, relative to equities, and many investors should probably hold more of it. Yes, equities might still return more, but:

One of the concepts I always argue for is the “higher-enough” return. People unthinkingly assume you want as much as you can get. But thinking rationally, isn’t there some point that you have enough, and you shouldn’t take more risk than what you need to get there? And in a higher rate environment, that point comes sooner.

So an institution that needs a 6 per cent return might be happy with a corporate bond portfolio that yields 8 per cent, rather than reaching into equities. Of course, Oaktree is a fixed income fund. Marks could be accused of talking his book. In fact I did accuse him of it. He noted in response that he had only started banging the drum for reallocation when the rates on high yield went from 4 per cent to 8 per cent: “Shouldn’t you own more of it at 8 per cent than at 4?” A fair point.

Are leveraged loans securities, Supreme Court edition

Half a year ago, we told you about a court case, Kirschner vs JPMorgan, that could upend the market for US syndicated bank loans. The market is big, about $1tn to $3tn depending on your measure. It’s also important, providing capital for leveraged buyouts and offering investors a floating-rate, higher credit risk asset class. But, unlike its cousin high-yield bonds, syndicated bank loans are not considered securities. Rather, they are treated like old-fashioned loan participation agreements, private deals between banks to share exposure to a loan. The disclosure requirements are lighter.

Disclosure is key to the Kirschner case. In the case, hundreds of institutional investors sued a group of banks including JPMorgan over a 2014 leveraged loan deal that went sour. US officials accused the deal’s borrower, Millennium Labs, of ordering unneeded urine tests to bill insurers and giving kickbacks to doctors, ultimately driving the company into bankruptcy. Marc Kirschner, the bankruptcy trustee, argues that these legal risks were not disclosed to investors because loans, wrongly, aren’t considered securities.

For investors, Kirschner’s case has an intuitive appeal. Syndicated bank loans sure look like securities. Generally, banks originate them to distribute to institutional investors, rather than for their own books. They trade with securities-like standardised ID numbers. Retail investors can buy bank loan ETFs on the open market. Analysts who cover the bank-loan market even use language reminiscent of high-yield bonds such as “building par” (buying loans at a discount on secondary markets to get a capital gain), notes Andrew Park of Americans for Financial Reform. Why wouldn’t a widely distributed investment product enjoy the protections of the securities laws?

And yet Kirschner has lost twice, first in district court and again at the Second Circuit appeals court. The problem is that today’s market is built on legal precedents set 30 years ago, when the bank loan market was far smaller and less sophisticated.

Little litigation has happened in the meantime. “No one’s ever argued [what Kirschner is arguing] because everyone knows loans aren’t securities, and the market has developed on that basis,” says Elliot Ganz of the LSTA, a loan industry body. Changing the legal foundations now would throw the market into disarray, at least temporarily. In August, the Securities and Exchange Commission reportedly shelved a legal opinion supporting Kirschner, because the Fed and Treasury feared financial instability.

Kirschner is now petitioning the case to the US Supreme Court, which in February will consider whether to hear it. The plaintiffs want the justices to toss the “Reves test”, a four-part rubric the Supreme Court created in 1990 to tell securities from non-securities. They argue the test is so hyper-broad that an unambiguous security can be technically deemed a non-security, perhaps because a court feels it would be inconvenient to change the classification. A person familiar with the case told us:

The Reves test is not tied to the statute and is highly malleable. It’s precisely the kind of test that textualists [the legal philosophy emphasising a law’s plain-text meaning, as opposed to legislative intent] abhor. I believe that the Court is likely to look at this and say this test is untethered to the statute and unworkable, and needs to be replaced with a ruling that is faithful to the text of the statute that Congress passed.

The case faces steep odds, though. It lacks the “hooks” that often draw in the Supreme Court: government pressure; split decisions in the lower courts; poorly argued judicial opinions. Even if a strong academic argument can be made that bank loans are securities, or that the Reves test is dubious, the Supreme Court might take a pass this time. As Ann Lipton, law professor at Tulane, told us:

The [Reves] test definitely raises all kinds of questions. That said, the industry and investors have mostly reached a detente; scholars will often argue that loans like these should be treated as securities, but the fact that this case is just coming up now shows how unusual it is for anyone to be upset with the status quo.

Meanwhile, the SEC reportedly backed down on arguing for securities treatment, I gather because of the potential knock-on effects in the economy, which means I assume they won’t support the petition either. I think it’s unlikely that the Court would be interested in a technical financial issue with no circuit split [disagreements between different appeals courts], little litigation, and no urging from the government.

If, on the other hand, the Supreme Court does take up Kirschner’s case, it will be a very big deal indeed. (Ethan Wu)

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