the biggest Japanese Banks and financial firms are buying massive amounts of junk credit. Us corporate junk credit. The federal reserve's rate hikes have distorted the marketplace so much these Japanese firms have found out they can no longer afford not to take huge risks. And the results have been bubble type of defamations all across the system. Like any other bubble everyone participating in it tells themselves there are no risks or that they're totally manageable. In the same way we're finding out with commercial real estate that can be a dangerous assumption. This corporate credit bubble goes beyond commercial real estate. And in many ways is a response to that one beginning to fall apart. Now Narin Chen bank's announcement last week wasn't some outlier. Japanese Banks and financial firms have increasingly been moving down the risk curve in all types of corporate debt trying desperately to generate enough return reach for yield. The consequence of that is an enormous appetite for a whole whole lot of lower quality credit right when that debt is about to be challenged by real world circumstances.

that don't match the usual optimistic rationalizations. And at the center of this junk bond buying spree is the clo Japanese banks used to understand the downside potential and never strayed away from the top tiers, the most senior stuff. Times have apparently changed thanks to the Federal Reserve non-economic Distortion. But why clo and why riskier Clos? Well, one reason is because the spreads are typically wider than other debt, because Clos can feature greater complexity, sometimes lower levels of liquidity, and there are some regulatory requirements in it too compared with other investment-grade corporate options, even high-yield stuff and leverage loans that makes Clos a pretty compelling investment choice for a lot of investors who are increasingly forced to seek more and higher return. As Venc put it just recently, single A Clos outperform AAA Clos by 130 basis points per year over the past decade, and that was with volatility, which was lower than investment-grade corporate bonds. Triple B Clos provided a yield pickup over triple A of 219 basis points.

provide a yield pickup over high-yield bonds with higher credit quality. Of course, all of that assumes that these CLOs can manage risks in the way in which they purport to manage risks in all of their forms: credit risk as well as liquidity risk. If we learned anything from the last credit bubble in 2007 and 2008, it is that these untested financialization structures don't always perform as they're meant to. And while we learn something from each time we go through this, it doesn't necessarily mean that we've dialed in the risk tolerance or the risk calculations or that we have a good handle on how all of these things might behave under stressful circumstances. That's something that the Bank of Japan actually raised back in October 2019 because at that time, with interest rates falling in the Treasury market and the Federal Reserve, at least back in 2018 in the early part of 2019, making it seem like it was going to hold funding cost higher, Japanese firms were head over heels into

Clos at that time, too, the Bank of Japan. In October 2019, issued its Financial System Report, and it focused first and foremost on Japanese Banks buying of US credit Clos. It said, First, this issue provides an analysis and assessment of potential risks and vulnerabilities associated with the overseas exposure of Japanese Banks. The motivation is that financial institutions, particularly major banks, have increased overseas lending and overseas credit investment, such as leverage loans and collateralized loan obligations or Clos, since the global financial crisis. Global, not financial crisis, and have accordingly have increased connectedness with overseas, notably in recent years, especially 2019. Japanese Banks, particularly major banks, have increased their investment in leverage loans to borrowers who have low creditworthiness, as well as in collateralized loan obligations backed by those loans. The overall credit quality of the overseas loan portfolio has remained high, and most of the Clos that the bank hold hold are AAA rated tranches. So, even though became riskier and reach for yield, they at least

realized that they wanted credit prot protection, and stayed primarily with the top-tier seniors, the class A, the AAA-rated stuff. However, the bank continued attention should be paid to a risk of a decline in ratings and market prices of Clos in the case of a sudden change in economic and market conditions, since borrowers of Leverage loans are vulnerable to deterioration of business conditions, and an easing in lending standard for these loans has continued in recent years. Most estimates suggested that pre-2020 Japanese Banks were about 99% of their Holdings were in the AAA-rated Clos, but what the Bank of Japan was saying is that even though they were in AAA-rated, again, experience in the 2008 crisis showed that some of the performance characteristics of the top tiers, the senior pieces, were not even close to what most people were expecting. And the truth of the matter is the Clos that had been developed, many of them were developed in the post-crisis era, which sounds better, sounds like an

improvement because we've learned our lesson, or supposedly have, but what they were really saying, the Bank of Japan, was that the CLO market, as it existed to that point, to the size that it had attained, had never actually been tested, certainly not by a full-blown US recession, and we wouldn't see that in 2019 or 2020 because the pandemic came and erased everything. But essentially the warnings that the Bank of Japan were issuing back in 2019 still stand, and then some today. Concerns over all of this reach-for-yield behavior in corporate credit, the wider corporate credit space, are one reason why interest rates are going lower, and that's something we're going to talk about this coming Friday, June 28th, 6:30 p.m. Eastern, Eurodollar University's webinar. With rates moving toward recent lows, it's important, it's critical to understand where they're actually coming from. There's economic concerns, there's global concerns, and in this case, financial concerns that are global as well. And the webinar is just a glimpse.

of what I write every day. In our Deep dive analysis, the daily updates, and my daily briefing. And behind both of those, we've got memberships with all the background material. You can sign up right now for our webinar. There's a link in the description, and I'll let you know more about your doll University's anniversary sale as we get a little bit closer to it. So, I hope to see you on Friday, June 28th, 6:30 p.m. Eastern time. Link in the description to sign up. One of the reasons why, in addition to the extra spread. I mean the extra spread is the primary motivation, but there are also these sanguine assumptions and what Deutsche Bank called at the end of May a flywheel effect, which is a nice way of saying bubble type of behavior rationalizations that become a self-reinforcing loop. What Deutsche Bank wrote about Clos was the same underlying drivers of clll deal volume tight spreads high all-in yields constructive loan prices are producing positive knock

on effects improving market value in credit portfolio metrics an acceleration in refi reset activity, and an uptick in Deal liquidations. These, in turn, are further boosting investors' sentiment for the market and ultimately driving more demand when combined with a constructive macro backdrop in which GDP remains relatively robust and unemployment relatively low. Amid a broadening of investor base as US domestic Banks return as active buyers. So essentially, because people believe the economy is good, and because there's a whole class of investors out there who are reaching for yield, making credit spreads start to narrow. You put those two things together, the more people assume the US economy is doing well, the more credit spreads narrow. Those two things are assumed to be part of the same thing, and that leads more people into the space, which means more narrow spreads, which means the market seems to be more sanguine about economic risk, leading to more interest in the space and more narrow spreads. And it's just like the stock market all over again. Essentially, we're building assumptions on top of assumptions on top.

of this financial need to reach for yield, and as we've seen throughout history, not just the 21st century, reach for yield is never a good thing to build anything on, let alone a massive system which is relying upon all of these things to go just absolutely right and perfect, not just a soft landing but better than a soft landing in the US. But one of the problems with all of that is that we have a bunch of the same participants in the marketplace for the same reasons, which means you create the ingredients for procyclical behavior. In other words, when one part of the system or one category of these reach for yield investors begins to sell, it usually leads other parts of the investing community to sell as well, and it creates this self-reinforcing doom loop. That's one of the things that the Bank of Japan's report in 2019 really emphasized. What it wrote was regarding this point, granular data on the underwriting of syndicated loans indicated that the connectedness with overseas financial institutions has

risen. This is 2019. An analysis shows that this is mainly due to the increase in common exposure, i.e., the degree of overlap in borrower categories between Japanese major Banks and overseas globally systemic important Banks or GBS for leverage loans, which have a higher credit risk and thus raise concerns regarding vulnerabilities in a recession period. And you often have leverage loans as the collateral in these clo loan pools. So what the Bank of Japan was cautioning was, as more Japanese reached free yield even in the AAA-rated Clos, that raised the risk of a recession leading to a stampede out of those CLOs at a time when other Banks who normally make a market in them, who might provide a price backstop or liquidity backstop, in whatever the case may be, they're likely to be doing the same thing as Japanese Banks, and suddenly the entire Marketplace dries up, and we don't have any price discovery whatsoever, sort of like what we're seeing in commercial real estate. So the Bank of Japan was saying even though Japanese Banks were stuck

were sticking primarily to AAA-rated CLOs. They still had to factor in some substantial systemic risks because of the way the marketplace is actually structured. And it's structured in the same way, many of the same ways as we saw in commercial and residential real estate a generation ago. Now, it's not the same degree, it's not the same problems. There have been lessons learned. It's not to the same scope and scale as the residential bubble in the 2000s. But there are too many similarities to simply just dismiss and ignore. Now, what we've seen over the last really couple years since October of 2022, since the worst of the energy crisis in Europe, everything that happened in 2022, ever since then, we've seen spread compression in a whole bunch of places, including government bond spreads, too. The Italy to Germany spread, which is a key collateral indicator, that's come down. But corporate bond spreads in the US, high-yield corporate bond spreads, CLO spreads, everything have come down really since.

October 2022, as many investors have been taking Van X's advice to look for an additional bit of yield, thinking that if the United States economy continues to perform relatively well, as everyone says it will, then there's extra yield to be had in those higher spreads coming out of 2022. And Japanese banks, in particular, don't have a whole lot of options here because as funding costs have gone way up, producing the negative carry that we talked about with Noring Chicken Bank, what that means is they have to reach for yield. And as they have to reach for yield just to try to have any possibility of generating a positive return or a positive carry, they are overlooking tons of risk because they don't really have any choice. That's another bubble rationalization. When you're forced into reaching for yield, you downplay the risk that might even be significant and that you might otherwise appreciate is significant in order to try to stay in business and just ride the whole thing out with your fingers crossed, hoping.

that nothing goes wrong. And so, as early as last year in the aftermath of last year's banking crisis, there were reports that Japanese banks were already reaching for yield. And the one thing here, though, is that they weren't just buying CLOs like they had in 2018 and 2019. Now they were buying tons of CLOs or interested in buying CLOs or announcing that they were going to be buying CLOs further down the credit, the risk spectrum, further down the stack as they call it. In other words, instead of just triple-A rated seniors, we're now talking about double-A and maybe even single-A, searching for yield by also thinking there's much less risk in doing so, much more return, not a whole lot of extra risk, which is, again, a rationalization. Bloomberg reported last April that Japan's investors are long-standing players in the CLO market. We know that Naren Chaen, a cooperative that invests for farmers and fishermen that we just got all over the news last week, was the

world's second biggest buyer at the end of September 2022, at least according to SMBC Securities. And then quoting a manager at Sumitomo Life Insurance, they said, Floating rate CLOs are a beneficial investment for our profit stability and growth, so we are thinking of increasing our holdings in the new fiscal year, which started last year. And then it continues, This search for yield or reach for yield means the Osaka-based insurer is buying double A and single A tranches of CLOs when it had previously only purchased top-rated portions. So, he was confirming already that last year Japanese Banks were moving down the risk spectrum. They were interested in moving beyond the AAA rated to maybe double A and single A, maybe even further beyond that because it wasn't just Sumitomo Life Insurance Company nor Norinchukin Bank. All of Japanese Financial companies are facing the same pressures. They have to go overseas to generate yield as funding costs have gone up over the last couple.

years producing the same same shape and position that Narin chin bank is in. They're finding they can't just hold on to the US treasuries. They have to go into corporate credit is the only way the only sizable way in which they could possibly generate positive returns. And the more they all go into corporate credit, the more they all reach for yield then more they're going to have to reach for junkier corporate credit along the way. And the statistics from the Japanese government, the Ministry of Finance show exactly what's happening here. They show exactly what we've been talking about. The Japanese banks in uh in particular for the most part have been heavily into buying foreign longer-term debt securities over the last couple years. And from what we've got what we pieced together from all of these reports and anecdotes and things that come up like noring chin bank, they have been buying US treasuries to an extent but primarily they're more reaching for yield and buying longer-term Clos and corporate

debt junkier, the better, because if you believe the US economy is going to be just fine, then why not take a little bit, you think it's a little bit of extra risk for a whole lot more return. What the Ministry of Finance, uh, statistics show is that Japanese Banks bought on net 14.7 trillion yen in the calendar year of 2023, which was by the by far the highest in any single year, completely reversed Japanese Banks selling out of foreign longer-term debt in 2022. They sold a net 13.5 trillion yen. You go back to 2019, it was a net positive but only 8 and a half trillion yen back then, and there have been net selling in 2017 and 2018, so you can see what happens here. Japanese banks in particular and insurance companies to an extent, though a much lesser extent especially recently, but Japanese Banks when treasury yields start to go down, when the yield curve flattens out and inverts, that's when Japanese Banks were buying. Clos in 2019.

it's when they're what they're doing again 2023 and 2024 because lower bond yields on treasuries mean they can't cover the cost of carry. The funding cost that they have to pay and so it forces them to reach for yield and that inverted curve. The situation where the treasury curve is flattening that's the Distortion of the fed. The FED screwing around in the front end where the marketplace says we don't agree with the Fed so longer-term rates go down and it creates all of these difficulties across the financial system. Ironically the fed's rate hikes are leading to these corporate credit bubbles this reach for yield Behavior so there is and has been a whole lot of reach for yield not just in Japan but a lot of Japan this year last year too and and it's done at maybe what is the worst possible time as the US economy proves weaker than many people are anticipating more questionable as we move forward and in reality we can see the recession signals all over the US as

well, as in particular, the labor market. This demand for lower quality assets is being driven by this reach for yield, which means many participants are focused exclusively on the return and downplaying the risks associated with classic bubble rationalizations and behavior. Japanese banks, in particular, they used to stick to AAA because they didn't necessarily trust what they were getting. They realized, as the Bank of Japan said in its report in October 2019, that there were substantial risks in high yield and junk types of corporate credit, even if they're in the best quality parts of a CLO. But the circumstances of the last couple years have caused Japanese firms to look beyond those into the less quality asset because they don't have any choice. They have to focus exclusively on return and crossing their fingers that everything will just work out just fine. And all of this because the FED sees inflation that the market doesn't. That's why the FED is raising short-term borrowing costs at the same time treasury yields are going lower. And the irony here, the other irony

here the bigger irony here is that the more the FED distorts the marketplace, the more it's going to lead to the reach for yield type of behavior, bubble type of behavior that increases the chances of deflationary outcomes that are being priced in US treasuries. Narin chin bank is one of the more extreme examples of everything we're talking here and I went over the details of that one in the video link below. As always, thank you very much for joining me, huge thank you to your doity members and subscribers. Check out our webinar this coming Friday. Link in the description below, and until next time, take care.

Japan is buying MASSIVE Amounts of Junk Credit

Monetary science reborn. Rediscovering the principles of currency. Putting central banks where they belong. Welcome to Eurodollar University, your place for all things modern money and monetary science. The YouTube channel for Jeff Snider, from here you can begin to investigate all the ways in which the global monetary system impacts you: economy, politics, investments and more.

Japan is buying MASSIVE Amounts of Junk Credit

Japan is buying MASSIVE Amounts of Junk Credit

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