Normalizing the Abnormal
By Adrian Ash
June 15, 2007
Will a half-per-cent hike in
US bond yields really undo all the mischief of cheap money?
"TOO MANY PEOPLE think risk is dead,"
says Tom Metzold, a US fund manager. "They think that they
can't lose money anymore."
Metzold runs the Eaton Vance Municipals Fund. He
was speaking at the Reuters Investment Outlook Summit in New
York earlier this week after buying higher-rated bonds and
selling junk to raise the credit quality of his portfolio.
"We're selling stuff that others continue to
buy," he told the Reuters delegates. But selling risk amid
this bubble in credit is already costing him money. Anyone not
sat right on the leading edge of credit excess will underperform
his peers during a credit bubble.
Still, "the spread [between junk-bond yields
and US Treasury yields] can't go to zero," Metzold reasons.
"There has to be some spread between a triple-A and
single-B security."
From here to zero, however, leaves plenty of room
for leveraged bond buyers to buy more junk, thinking they're
getting a bargain high-risk or not even as US Treasuries
sell off. Relative to US government bonds, in fact, the yield
paid by higher-risk debt has actually shrunk this past month.
So while bond investors have been marking down the
credit worthiness of Washington's debt, the Baa rated
investment-grade bonds of USA Inc. haven't suffered so badly
not yet, at least. The half-a-per-cent leap in 10-year US
Treasury bond yields has not been matched by a similar leap in
the returns offered by corporate paper. Hence the squeezing of
Baa yield spreads even tighter still.
The price of junk bonds has performed better yet,
if by "better" you're happy to take a loss that isn't
quite as bad as the next guy's. Martin Fridson of Leverage
World, the high-yield research service whose name just about
says it all, notes that junk bonds have "a comparatively
low interest-rate sensitivity. So in a rising-rate environment
[junk] would actually be a relatively good place to be."
Relatively is the right word yet again, however.
During the last four weeks, according to data from Merrill
Lynch, high-yield bonds lost 1.18% of their price on average,
but lacking the mark of "investment-grade" actually
stemmed their losses. The best-rated US corporate debt sank by
1.87% over that time.
"The 50 basis point back-up in 10-year US
Treasury yields over the past month is a major step on the road
to bond-market normalization," says Stephen Roach, chief
economist and former όber-bear at Morgan Stanley. He calls the
current shake-out in long-dated US Treasuries Act II of the
normalization process that's followed the Fed's deflation scare
of 2002-2004.
Falling prices and a contracting US money supply
never showed up. Perhaps we have the Fed to thank for that. But
deflation would have been truly unusual in our post-Gold
Standard world. Abnormal times called for abnormal interest
rates and so Greenspan and Bernanke matched their panic with
an emergency 1% price for Dollars.
After raising rates 17 times to last summer, the
Fed then went on hold. It's been waiting for the interest rate
on 10- and 30-year US bonds to catch up ever since. Now, at
last, long-dated US Treasuries offer to pay more to investors
than short-dated notes and Act II might reach its end
without too much bloodshshed, says Roach.
"A third act is likely in the great
normalization saga," he goes on, "this one starring
the spread markets. So far, credit spreads remain abnormally
tight, as do those on emerging markets debt instruments. There
is no inherent reason why these assets deserve special exemption
from a financial market normalization scenario."
'Credit markets' is a broad term, however and
it's come to represent an ever fatter and taller pile of notes
and promises each day, too. Right in line with Economics 101, as
those record-tight credit spreads show, this flood of supply
hasn't pushed down the price. Because demand for credit-based
investments buying the debt that somebody else lent has
never been so popular.
The Swiss-based Bank for International Settlements
says in its latest report that dealing in exchange-traded
derivatives rose 24% during the first three months of this year
from the same period in 2006. Turnover in leveraged
interest-rate, currency and stock index contracts hit $533
trillion.
Sales of collateralized debt obligations also shot
higher. Trading in these credit notes, based this time based on
the credit-default swaps used to insure corporate-bond
portfolios, grew by very nearly one-third from the end of 2006
alone, hitting $121 billion.
And standing atop this mountain of monetized
promises, spending on mergers and acquisitions in the stock
markets rose to a record total of $1.1 trillion in the United
States between January and May. In Europe M&A hit $1
trillion, too. Only $1 in every $8 spent to fund this bonanza
came in the form of equity, says the BIS. The rest of the money
fully 78% of all corporate deal-making was paid for in
debt, most typically corporate debt sold onto the bond market.
To put that into perspective," says Greg Peel
for FN Arena, "the last merger boom amongst tech stocks
in 1998-00 averaged 50% equity."
And so it was that, at least until May of this
year, private equity continued to buy shares almost regardless
of value. Hedge funds bid up junk bonds to earn just a few pips
above official bank rates; the sell-off in Treasuries has only
narrowed that spread further. The total volume of outstanding
derivatives contracts outweighed the entire global economy more
than eight times over.
Will the re-pricing of money a.k.a. 10-year US
Treasury bond yields stuff the cork back in the vodka
bottle? It would be a strangely quiet end to this party if so.
No drunks crying on the stairs, no fisticuffs amongst the last
stragglers. The newswires today fail to mention any one plunging
from the Gherkin in London or No.60 Wall Street.
Might this bubble in debt really have grown so huge
that it ends as never before without bursting?
"I continue to fear that central banks are far
too smug about the effectiveness of their inflation-targeting
tactics," Stephen Roach goes on "especially in an
era when the combination of low inflation and low interest rates
is biased toward a steady string of asset bubbles. Normalization
with respect to the narrow CPI [inflation] target hardly
guarantees a normalization of broader macro risks that might
stem from boom-bust outcomes in major asset markets."
In short, the super-low interest rates of the last
five years may have reached their end. But the bubble in debt
most especially leveraged debt, born of a promise to pay
sold to a buyer who in turn has to borrow to raise the cash for
the purchase still remains.
We're a long way from "normal" in short.
Getting straight might prove harder than simply enduring a 0.5%
hike in the base cost of money.
