Drunken, Raucous Bond Market Is About to Be Ill: Mark Gilbert
Like a drunk at a party, the bond market is starting to bump into tables, telling off-color jokes, talking too loudly and spilling drinks. The smart guests will steer clear before he starts screaming at his shoes and wanders off to pray to the porcelain.
Did you think a 950 billion-euro ($1.2 trillion) emergency backstop cobbled together by the European Union and the International Monetary Fund in May was the answer to Europe’s debt crisis? Were you expecting central banks to turn off the money taps as normal funding service resumed in the banking industry? Had you hoped the heavy hand of government would only briefly slide its interfering digits into the folds of finance?
Ireland, which proudly brewed its own flavor of austerity medicine and swallowed the potion without demanding so much as a spoonful of sugar, now pays a record 3.8 percentage points more than Germany to borrow 10-year money. Spreads on Greek debt, which triggered the crisis by revealing that it forged its euro- membership qualifications and lied ever since, have surged to 9.5 points, a whisker away from a record.
The U.S. and Germany, meantime, are enjoying the cheapest borrowing costs they have ever had. That schizophrenia follows a pattern seen before during this credit crisis, with an endgame that is all too predictable.
First, the allegedly good banks were distinguished from the undoubtedly toxic ones -- until they all turned out to be as bad as each other. Next, the financial system was perceived to have been rescued by governments -- until the cold sting of logic pointed out that risk was being transferred, not dissolved.
Now, the bond market is differentiating between fiscally irresponsible governments and those ostensibly big enough to weather the storm. That seems to be missing the point -- when the brothel gets raided, even the piano player gets arrested. All governments are tainted with the same stain of indebtedness and profligacy, especially should a slump back into recession undermine their debt-paying abilities.
You may be agnostic about U.S. President Barack Obama’s politics, and the desirability of Keynesian stimulus packages. Still, lending 10-year money to a government for a yield of 2.65 percent when the administration is proposing to spend $50 billion on roads, railways and runways to goose the economy doesn’t seem like the most prudent of investments.
The corporate-bond market looks even more like an accident waiting to happen. Investors decided to lend $400 million for 30 years to Stanley Black & Decker Inc. this month. They will be paid an interest rate of 5.2 percent by the toolmaker, which has total debts of $4.5 billion in the form of bonds and loans, according to Bloomberg data.
The job of a fixed-income investor is to balance risk and reward. That interest rate seems like an awfully skimpy reward for quite a big risk.
Peer three decades into the future. Tell me you don’t see some new globetrotting enterprise from China -- where Western retailers now do most of their manufacturing -- employing the workers Stanley Black & Decker trained and undercutting the U.S. company with cheaper screwdrivers, drills and hammers.
Collapsing yields make buying corporate debt a gamble. One way to calculate riskiness is using duration, a measure of how much a bond will lose for a given change in yield. The sensitivity of bond prices to shifts in yield is at a record, according to indexes compiled by Bank of America Merrill Lynch.
If, for example, you bought Telecom Italia SpA’s 5.25 percent notes due 2055 in June, when they yielded about 7.2 percent, you risked losing about 4 euros for every 100 euros invested, in the event of yields climbing 50 basis points. Buy the same notes today at the current yield of about 6.2 percent, and you’ll lose 50 percent more if the bond market slumps.
The global default rate among so-called speculative borrowers dropped to 5 percent last month, down from 5.5 percent in July and less than half the 12.3 percent failure rate of a year ago, according to Moody’s Investors Service. The credit- rating company says even fewer companies will renege on their obligations in coming months, with nonpayments dropping to 2.7 percent by the end of 2010 and to 2 percent a year from now.
That sounds like good news -- unless you are of the cynical bent of mind that suspects the lack of defaulters has nothing to do with the financial health of junk-rated companies and everything to do with the reluctance of asset-impaired banks to push any more of their ailing borrowers over the edge unless it is absolutely unavoidable.
Alarms Switched Off
There’s also the connected problem of lax lending standards during the credit boom. The loan covenants that would normally get triggered when a borrower is in distress were watered down to the point of uselessness. So it is entirely plausible that zombie companies are blundering along in the twilight lacuna between alive and dead, distorting the default data.
Next week, it will be the two-year anniversary of the collapse of Lehman Brothers Holdings Inc. Sadly, the bond market suggests the investment community has learned none of the lessons of the misguided adventures of recent years that prompted the biggest bankruptcy in history.
The problem with hangovers is that once they fade, the prospect of getting drunk all over again starts to seem like a great idea. This fixed-income party will end badly.
Mark Gilbert, author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable,” is the London bureau chief and a columnist for Bloomberg News. The opinions expressed are his own.)
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