Credit markets: Paper weight
By Aline van Duyn, Michael Mackenzie andRichard Milne
Published: October 31 2010 19:49
Gary Lieb can barely stand it. The broker at Apple Mortgage in Manhattan has never seen such cheap borrowing rates on housing loans. Yet he cannot take advantage of them to reduce his own monthly payments. After years of home price falls, the loan on his Long Island property is too large relative to the house’s value. “It is driving me completely crazy that I can’t snap up these incredibly low rates for myself,” he says.
The position Mr Lieb finds himself in is a small-scale example of the forces at work in the economy and the financial markets.
On the one hand, interest rates have plunged to historic lows, allowing companies, countries and some individuals to borrow at a cost lower than ever. On the other hand, households and the wider economy still struggle in the wake of a credit bust.
The interplay between these two forces – the stimulating effect on economic activity of low borrowing costs and the damping effect of a debt squeeze – has severe implications for investors around the world, from individual savers to the world’s biggest insurance companies.
In the past two years, after the 2008 crash in equity markets and in a frantic search for “safe” investments, more money has poured into bonds than ever before. Bonds – from US Treasury debt to emerging market corporate bonds – have performed remarkably well, ranking among the assets around the world to have generated the biggest returns in both 2009 and 2010.
But if the downward trend in rates were to end, the rally in bonds would also come to an abrupt halt. Just as falling interest rates increase the prices of bonds paying fixed rates of interest, rising rates erode their value and push prices lower.
“When rates have fallen this much, it’s right to question if there’s a bubble in bonds,” says Bob Michele, who as chief investment officer at JPMorgan Asset Management oversees $100bn in holdings. “We’re very concerned about what to do. One thing we know is that when the bond rally ends, it will not end well. When interest rates go up, holders of bonds and bonds funds will face losses.”
In the near future, borrowing rates are likely to fall even lower still. This week, the Federal Reserve is expected to start buying government bonds with the sole intent of pushing interest rates lower.
The problem is that, even after more than two years of near-zero official rates and huge amounts of stimulus spending, economies such as the US have failed to grow as strongly as hoped. This is why the Fed is getting ready to crank up its “quantitative easing”, even though there are plenty of economists and investors who do not think it will have a strong impact on economic growth.
One of the reasons is the hangover effect of the debt-fuelled house-buying and consumption binge that started to unravel three years ago. People are no longer able to borrow unless they have a good credit history. In any event, many people do not want to borrow. They are focused instead on reducing the debts they have taken on – a process called deleveraging – either by choice or because they cannot roll over debts with new loans.
“When economies accumulate too much debt, there is a risk that they stop responding to monetary policy in the usual way,” says Matt King, head of credit products strategy at Citigroup. “It is this which has dogged Japan for the past 20 years, and it is this which we fear now risks affecting other countries too.”
Under such a scenario, until debt is reduced to a more sustainable level, economic activity may remain subdued. “We are, even as some Fed governors now publicly admit, in a liquidity trap,” says Bill Gross, managing director at Pimco, which runs the world’s biggest bond fund, adding in a letter to investors last week: “Interest rates or trillions in quantitative easing asset purchases may not stimulate borrowing or lending because consumer demand is just not there.”
But is there a bubble in bonds? There are three main questions to consider.
First, are bond prices related to economic fundamentals? The value of government bonds is driven by interest rate and inflation expectations but investors still expect to get back the sum they invested. Johan Jooste, strategist at Merrill Lynch Wealth Management, says: “The term ‘bubble’ evokes something along the lines of the tech crash, where you lost all or nearly all your capital. It is very difficult to lose your capital in a bond unless there is an outright default.”
Corporate bonds are similarly affected by the interest rate outlook, but are also subject to credit risks. If companies are doing well, and their balance sheets are in good shape, credit risks can fall and corporate bonds can do well. If, however, economic conditions are poor and defaults rise, the value of corporate bonds will fall.
Assuming low growth and low inflation in the US, bond yields appear grounded in reality. Phil Maisano, chief investment strategist at BNY Mellon Asset Management, points to Japan, where yields have long been low: “Is there a bond bubble in Japan? Because if there is, it has somehow lasted for 20 years. If you don’t get legitimate economic growth, then there isn’t a bond bubble.”
So far in 2010, the average monthly real rate of return on the 10-year Treasury bond is 2.22 per cent, which is only barely above the historic average of 2.18 per cent dating back to 1920, says Scott Minerd, chief investment officer at Guggenheim Securities. “For the majority of investment professionals, an extended period of low rates is outside of their life experience,” he goes on. “It is not, however, outside of historical context.”
Indeed, it is the historical reference points that many investors think need to be adjusted – especially those who believe growth will be very slow and inflation will be low. Paul Colonna, chief investment officer for fixed income at GE Asset Management, which oversees $117bn in assets, says the economic environment is not one that most investors have seen before. Yet investors have been trained to see cycles and, by the standards of recent decades, the current low interest rates cannot last.
“Everyone’s talking about whether or not we are in a bond bubble,” Mr Colonna says. “In the short term, meaning the next couple of years, I do not think that we are.” Relative to recent decades, interest rates may seem low, he says. But on a longer-term horizon, very low rates are not that unusual.
The second question revolves around supply and demand factors that can pump up prices or cause them to fall.
Demand for bonds is increasing, as evidenced by the record inflows into bond funds by individual investors. Regulators are meanwhile pushing insurance companies and banks to hold more bonds to bring stability to their balance sheets. Pension funds are buying bonds in order to ensure they have cash at specific dates to match money they need to pay out. Indeed, low interest rates increase the size of pension funding gaps by reducing the rate at which future payments are discounted. This creates even more demand for bonds and pushes rates lower still.
Some of this is deliberately fuelled by the Fed, as it seeks to encourage investors to take on more risks by making yields in government debt too low to be attractive, and by buying up much of the supply of US Treasuries. Yet overall, the supply of new debt is shrinking, as the securitisation and structured finance that fuelled the credit boom peters out. “Amplifying bubbles is unfortunately one of the ways we have been regulated. We are forced to buy equities and bonds at the wrong time,” says the finance director of one of the world’s largest insurance companies.
A third question is whether the Fed’s policy, in fuelling demand for higher-yielding alternatives to low-yield government bonds, is building up trouble in the riskiest parts of the debt markets. Mr Gross thinks the outlook for many bondholders is grim. “The [quantitative easing] is temporarily, but not ultimately, a bondholder’s friend. It raises bond prices to create the illusion of high annual returns, but ultimately it reaches a dead end where those prices can no longer go up.”
This yield-chasing has already led veteran market experts to worry that junk bonds and emerging market bonds are too “hot”. “Historically low bond yields are making both pension funds and insurance companies thirsty for yield,” says Jan Loeys, chief global strategist at JPMorgan. “This raises the risk that these institutional investors will move towards corporate bonds in a search for yield.”
The risk premium paid by less creditworthy companies on their so-called junk bonds is still higher than historical averages, but it is shrinking. The lower that yields go, the less wiggle room there is for investors once interest rates do turn. Martin Fridson, credit strategist at BNP Paribas Asset Management, says spreads are pricing in a 15 per cent chance of another recession soon – a “double dip”.
That is down from 35 per cent in August. Yet if the economy fails to recover, government bond yields will stay low but corporate defaults could go up. The healthy state of corporate balance sheets is one reason why this is not such a concern at the moment, but this could change.
“The risk is that the economy gets weaker, not stronger,” says Joe Balestrino, strategist at Federated Investors. “Credit markets would get under pressure from a fundamental perspective. Default risk could become a headline issue again.”
One problem is that it is impossible to predict when the tide will change. Mr Loeys runs around 20-30 different models that try to predict price moves and market direction across different asset classes. Most provide him some visibility over the next few months. But government bonds are, to him, much closer to “random walks” and he thinks he can predict their direction over only a few weeks.
“Government bonds are the most likely to switch direction with very little notice,” he says. “For corporate bond spreads, there is a little more time to become wise to likely moves.”
In the meantime, investors remain worried. If the interest rate cycle does revert to more recent patterns, there will be losses on bonds across the world. At the centre of the debate is whether investors believe the Fed, or fear that inflation may come back much sooner than anticipated.
Thomas Atteberry at First Pacific Advisors says a chart of bond yields going back 200 years shows that buying at the current low yields represents an “asymmetrical bet” on deflation – there are a lot more periods when interest rates and inflation rise than when they stay low for long.
“The Fed is making these rates artificially low,” he says. “The Fed wants higher inflation and lower bond yields: it seems like a bubble.”
Prospects for treasuries
QE2 ready to set sail towards historic lows
Investors expect that some $1,200bn in new US Treasury paper will be sold in the coming year, and that could be matched by purchases from the Federal Reserve and other central banks looking to keep their currencies lower against the dollar.
Consensus in the bond market about the size of this second round of “quantitative easing” to stimulate the economy is for the Fed to buy $100bn a month of Treasuries until core inflation starts rising and/or unemployment is falling. Whether this includes current Fed purchases of $30bn a month from reinvesting proceeds from its holdings of expiring mortgages remains to be seen, say traders.
The yield on 10-year Treasury notes sits at 2.65 per cent and is down from a high of 4 per cent in April. The benchmark yield is seen as falling towards 2 per cent once QE2 starts. That would eclipse its modern low of 2.04 per cent, set in December 2008 at the height of the financial crisis.
Prospects for corporate bonds
Rather an issuer than a buyer be
Walmart and Microsoft have both issued three-year bonds in recent weeks at an interest rate of less than 1 per cent, historic lows for companies. Few therefore doubt that pricing for investment-grade businesses is frothy at the moment.
A senior Wall Street banker says: “Would I rather be a buyer or issuer of bonds right now? An issuer, without a doubt.”
In the absence of an increase in corporate defaults, however, bondholders would expect to get their initial investment back – unlike shareholders – even if prices could move against them.
But an interesting twist to the debate is that the dividend yield for many companies is higher than their bond yield, often for the first time in decades. That gives groups such as IBM the chance to issue cheap debt and buy back expensive equity.
A big government bond trader says: “If you’re looking for a bubble, that looks pretty exuberant to me.”
Prospects for high-yield
Junk gains lustre as defaults decline
When even bankers in a sector become worried, it has to be at least a potential sign that trouble might be on the way.
In high-yield bonds – often called junk bonds as they are issued to the lowest-rated companies – some are now priced to yield just 6 per cent, a level some joke is more like “medium-yield”.
The head of leveraged finance at a large US bank frets: “It is an incredibly hot and aggressive market. What I worry about is: is it too far, too fast? I would rather things be a little less white-hot. You can’t help but worry. You can’t help but think: we are creating some kind of financial bubble.”
But others are more relaxed. Jan Loeys of JPMorgan Chase points out that the default rate for this year is set to fall to a record low of 0.3 per cent. And while yields may be low, spreads – the difference between high-yield levels and those of US Treasuries – are fairly high historically.
Prospects for emerging markets
Comfort in the quality and size of inflows
Emerging markets have known plenty of bubbles before. But investors are pouring into them not just in their search for higher yields but also from a belief that those economies may be stronger than much of the developed world. For some seasoned observers that makes some things similar to previous bubbles, but for others it looks different. Richard Luddington, deputy head of capital markets at UBS, says: “There is always a risk that over-bullish views on emerging markets create a bubble which can burst painfully. But the feeling this time is that the size and quality of the inflows will limit the downside.”
Some countries from emerging markets now have bonds trading at yields below the level of some developed nations. That partly reflects the sudden realisation that countries such as Spain and Greece are not as safe as previously thought. But some worry that investors are forgetting political risk in emerging markets too.
