In his Dickensian tale of the 1980s Wall Street excess, The Bonfire of the Vanities, Tom Wolfe described his bond-trading protagonist Sherman McCoy as a master of the universe. The following decade, James Carville, Bill Clinton’s political advisor, said, ?When I come back, I want to come back as the bond market because then you can intimidate everybody.? People who have lost money in stocks are today lending to the US government for 30 years at a yield of 3.30%.
For a brief period on Wednesday,
December 9, 2008; investors bought three-month treasury bills from Mizuho Securities with negative yields of 0.01% to 0.02%.
These yields have turned negative for the first time since the US began selling the debt in 1929. Investors were willing to pay $100, while being assured by Uncle Sam that they would get $ 99.99 in return. They did not mind the small loss, as they were assured the rest of their capital would be intact. During the boom years, risk was ludicrously underpriced. In a process of ?reversion to the mean?, it should now become overpriced by a similar magnitude.
With the yield on the 10-year US Treasury note falling below 2.70% to its lowest level since 1955, it is obvious that the government bonds no longer reflect long-term fundamentals.
The yield has fallen by more than 100 basis points within just a month. It is obvious that it is only so many candidates that the governments around the world can bail out, as the global recession becomes more durable in 2009. According to Nouriel Roubini, professor of economics at the Stern School of Business, New York University and among the prescient few who could see the ongoing global credit crisis assume gigantic proportions, ?2009 will be a painful year of global recession, deflation and bankruptcies.?? Once the stimulus measures of world government begin to yield results, signs of stabilisation will begin to appear and corporate defaults will get contained. This will, in turn, result in investors spurning government securities and buying riskier corporate bonds. When this correction takes place, yields on government paper will rise. This will also result in a robust return to equities, since they look cheap as the S&P 500 dividend yield is above the 10-year note yield for the first time since 1958. In a major policy action to counter the risk of deflation and in a major boost for the government bond markets; Ben Bernanke, chairman of Federal Reserve, has said that the US apex bank could buy substantial amounts of long-term treasuries. The Fed’s move to buy up to $500 billion in mortgages, has boosted the valuations of treasuries, which are widely used in hedging mortgage rate risk. The Fed is all too keen to avoid a Japan-like ‘lost decade’, where Japan has witnessed deflation for much of the last 10 plus years and the yield on 10-year paper there stands below 1.4%.
The US, UK and Eurozone has seen government bond yields fall sharply in recent times, as investors have grown increasingly fearful of a prolonged period of weak economic growth accompanied by falling inflation and possibly deflation. The yields on the US 30-year bond has plunged to 3.3%. The return for owning a two-year note has fallen below 1%. Market trading in the Chicago bond futures pits and in electronic trading has been unprecedented. The below-3-per-cent yield on the US Treasury note is a level not seen in 50 years. In the UK, the 10-year Gilt yield is now below 4% for the first time since 1961, according to UBS. The yield on the 10-year Germany Bund has crashed below 3%, a level not seen since at least 1960. The US forward swap rates indicate that the 10-year Treasury will yield 2.78% in 10 years’ time, notwithstanding the remarks of Fed chairman Ben Bernanke that the US Fed could drop dollars out of a helicopter in a deflationary pinch. This risk aversion away from equities and into bonds have offset the growing cost of planned government interventions and stimulus and bank recapitalisation packages, which are bound to dramatically increase the size of bond offerings in 2009.
The question as to whether we are in bubble territory can be answered by determining the inflationary expectations present. Of late, the relative prices of fixed-income and inflation-linked bonds are implying that the US will have deflation for the next five years, a situation not seen since the Great Depression in the early 1930s.
In the US, sounds of deflation were last heard in 2003 when the yield on the 10-year note touched a low of 3.07%. As deflation proved to be a false alarm, the 10-year yield moved back up quickly to 4.60% with resultant loss in bond values. A similar fate awaits the government securities market which has now clearly entered ‘overvaluation zone’ or ‘bubble territory’ although I believe it will be quite some time before the bubble in this asset class eventually bursts. The main difference with 2003 is that the economy is slowing down much more sharply and is expected to extend its losses through 2010. This backdrop could keep yields on government securities low for quite some more time and the bubble will keep inflating accordingly. This backdrop could also keep investors from buying risky corporate debt, where yields have, of late, risen to the widest spread ever recorded till date over government bonds.
While investors have embraced government securities, they continue to shun paper offered by AAA-rated corporates. According to JP Morgan analyst Eric Beinstein, ?We conclude that current spreads compensate investors for a default rate in high grade bonds that is 14 times that of the worst period in the past 25 years.?
In a similar vein, high yield spreads currently available are consistent with a default rate of 21% over the next 12 months, according to Credit Suisse strategist Andrew Garthwaite. Yet, in 1933, the junk bond defaults peaked at a mere 15%.
According to John Lonski, chief economist at Moody’s Capital Markets Group, current market levels are indicative of a default rate at least as high as 15.4%, the level reached during the Great Depression.
As per the Merrill Lynch High-Yield Master II Index, risk premiums or spreads for speculative companies, as compared to Treasury Bonds have risen to a new high of 1595 bps. The previous high came in 2002, when spreads hit 1120 bps, in the midst of corporate scandals such as Enron and WorldCom.
Investment grade companies trading above 1000 bp include Glencore, the Swiss commodities trading company; Continental, the German car parts maker, GKN, the UK technology and engineering company; Lafarge, the French construction company and the finance arm of ArcelorMittal, the world’s largest integrated steel manufacturer.
The CDSs of these blue-chip companies are all indicating a possibility of default. IBM, which enjoys a high investment grade rating, tapped the corporate bond market recently for $4 billion, but it had to offer yields of up to 8% for long-term funding, a spread of 400 basis points over comparable Treasuries. Credit default swaps on the Russian oil major Gazporm’s debt has risen sharply to 1,400 basis points. That means it would cost $1.4 million to insure $10 million of Gazprom’s debt for five years. A figure of more than 1,000 is widely seen as a sign of a company at risk of default. During the boom years, risk was ludicrously underpriced. In a process of ?reversion to the mean?, it should now become overpriced by a similar magnitude.
The author is a Wharton Business School MBA and CEO, Global Capital Advisors
