Be Prepared for the Worst: CLO High-Yield Bonds Face Heightened Risks

Humans 99% are animals 1% are humans

That 1% causes problems

You probably think it’s the opposite, right?


"The Last Four Days of Lehman Brothers"
(Director Michael Sandules)
Quoted from

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Hello, this is Shimoyama.



“Both day and night, customer intake is about half of what it used to be.

Things are gradually returning, but,

if this lasts another month, we may have to close up….”



Around mid-March,

an American restaurant owner in Akasaka, Tokyo, joked,

but with a serious gaze,

I overheard him saying this.



As I listened, my heart ached,

and I think many are facing hardship.



I only wish that the world will be free from the burden of COVID-19

as soon as possible.



But, even when the coronavirus subsides,

will we be able to feel relieved?



I don’t think so.



Whether the coronavirus exists or not,

the financial industry will still have bombs lurking in it.

That won’t change.



In the not-too-distant future, a financial crisis could arrive that surpasses Lehman,

and we should assume this and

prepare accordingly.



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The Last Four Days of Lehman Brothers

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Recently, I watched a drama on Amazon

called

“The Last Four Days of Lehman Brothers.”



Just before Lehman Brothers’ collapse,

the sense of urgency and tension come through vividly,

and if I had to summarize what underlies it in a single character,

it would be

“greed.”



“I want my own home.”

“I want to earn money endlessly.”

“I don’t want Lehman Brothers to be sold off cheap.”

… etc

The endless greed of the characters collides

and leads to the worst outcomes.



I’m not saying greed is bad.

Greed is part of being human.



However, greed that can trigger a financial crisis

cannot help but be called evil.





And,

even more than 10 years after Lehman’s collapse,

the financial industry remains full of greed.



Even now, a situation reminiscent of Lehman’s collapse is being created,

and it’s getting more powerful…



Humans are creatures who repeatedly err,

so there’s no helping it.





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CLO—the magic product

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Right now, the financial industry is holding a bomb called “CLO.”



As I mentioned in a previous newsletter, about CLO,

I’ll explain briefly again.



First, the story of “Leveraged loans.”



For companies, financing is a lifeline.

If cash flow stops, it literally means ruin.



Especially for companies with low creditworthiness

that struggle to borrow money,

there exists financing that even those with low credit can access.





That is the “Leveraged loan.”



In English, it is written as Leveraged loan.



Sometimes people ask, “A drone?”

But it’s not Drone with leverage

—it isn’t“leverage drone.”



It is “Leveraged”



Leverage means

“a fulcrum.”

To move a large power with a small force,

like the old school days.



If you’re an experienced trader, you’ve probably heard the term “Leverage ○○ times.”

It’s a system that allows you to trade with funds multiple times the amount you hold,



and is very much like a “fulcrum.”Whether you’re trading or financing,

it’s a matter of using more money than you have.

In that sense,







and can be viewed as a form of “fulcrum.”



Anyway, in either case

“borrowing” is the core, so in the financial industry, a common concept is

“Leverage = borrowing.”

So, on to the main topic,

that leveraged loan is securitized together as

“CLO.”



A product that securitizes the loans to

low-credit companies,

so CLO is, no matter who you are,

an inherently high-risk product.



However, there exist CLOs with AAA ratings.



“Even if the companies can’t repay, the money will be returned first”



is the reason for the AAA rating, but…

the underlying leveraged loans were loans to low-credit companies, after all.





Does becoming a CLO reduce the risk?

The answer is obvious.







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High-yield bonds as well

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There is one more bomb.



“High-yield bonds.”



Just hearing the term may seem difficult or off-putting to some,

but it isn’t something to be afraid of.





This is also a method of funding for companies with low credit, called “bonds.”





In English, yield is written as “yield

,”



meaning “return or yield.”In other words,

“high-yield bonds” = “bonds with high yields.”

And that means



they carry high risk.



Since these are bonds issued by low-credit companies,

the risk is naturally high.



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Particularly dangerous are shale-related companies

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and right now

leverage loans, CLOs, and high-yield bonds are

causing concern in the financial industry.



Due to COVID-19, the economy has stagnated,

and many companies have been severely damaged, clearly.



Low-credit companies lack resilience, so the negative impact of leverage loans and high-yield bonds



is unavoidable.



What’s especially scary is that the U.S. shale-related sector is in dire straits

due to declines in crude oil prices.



American shale-related companies can reportedly break even

at around $40–50 per barrel,

and if prices stay below that,

bankruptcy risk could rise sharply.



And

there are whispers that

“the low-rated American shale-related bonds are dangerous.”

It’s not my intention to sensationalize, but





facing reality and preparing is important.



Thank you for watching until the end today as well.





Keizo Shimoyama