Dark Clouds on the Economy: The Crash of Junk Bonds
We got what looks like a good intermediate term bottom in the Nasdaq this week and a nice rally. Overshadowed by this rally and the cheerleading by CNBC was a dire story to give any bull a pause. The business journal The Economist reported this week that several of the largest investment banks in the world, among them being Morgan Stanley Dean Witter, Deutsche Bank, and CSFB, have lost a fortune as corporate bonds crashed in value. Unable to transfer the losses to gullible clients they are rumored to have lost over $1 billion dollars.
Investment banks underwrite billions of dollars in loans to corporations and governments. Corporate loans are what are called "junk bonds" and provide a high yield return. The disintegration of corporate profits has devalued corporate junk bonds. One of the worst victims was XRX whose stock crashed last week as their bonds crashed. One investment banker that was interviewed by the economist estimates that $25 billion dollars is at risk.
William Gross, who is the largest bond fund manager in the world, has moved his clients money out of junk bonds and into morgtage-backed securities. He's advised his clients to stay away from corporate bonds. If you look at the two charts above you can see why. They are crashing. they have not declined at this rate since the world financial crisis of 1998. Gross believes that the collapse of corporate bonds is an indication that the markets are factoring in a serious economic downturn by next year: what the people on CNBC call a "hard landing". What the folks in the street call a recession. They don't like to say that word on TV.
The companies that are going to be hardest hit by this crash in corporate bonds are the telecom and tech stocks. Some of them will quite simply go bankrupt if they continue to post losses. Companies like Priceline.Com, Amazon.Com, and Etoys.com have relied on secondary offerings and bonds to keep themselves afloat. With crashing stock prices its unlikely that they will be able to convince anymore suckers to buy more secondary offerings and if the bond market doesn't strengthen they won't be able to go there for money either. These companies are in danger of insolvency.
But even profitable companies will be hurt. Unable to raise money from banks and Wall Street, or to do so at a higher cost, they'll have to cut wages and expenses in order to maintain their bottom line. This will put a deflationary effect on the economy and slow down economic growth.
There are a lot of danger signs in the US economy, one of the worst of which is the current-account deficit, and I'll discuss more of these in the future in my series on Stock Market Crashes and Financial Cycles. The next thing I plan on writing is how stock market sectors rotate as the economy goes through a "business cycle." By looking at what sectors are hot and cold now we can tell what the stock market is telling us about the direction of the economy and which sectors will become attractive investments in the future. And which sectors we should get out of if we manage to get a year end rally.
The Wall Street Journal and the Financial Times has picked up the story on the collapse in junk bonds also:
Corporate-Bond Market Faces a Gloomy Outlook
From Wall Street Journal 2000-10-18
Faced with unrelenting bad news, the U.S. corporate-bond market is staggering through its worst period since the bleak days of 1998.
Though it had been a strong year for corporate bonds until recently, investors' losses have mounted of late, corporations are finding it difficult to sell their bonds and Wall Street dealers are becoming gun-shy about trading them for fear of getting stuck with bonds while prices are falling.
If the problems get worse, the U.S. economy could feel the pinch as companies find it difficult to raise financing.
Treasury securities, the safest bonds, still sell like hot cakes (they rallied Tuesday as stocks continued to fall). But other, riskier bonds suddenly are struggling. Taking the biggest hit: junk bonds, otherwise known on Wall Street as high-yield bonds, a major source of capital for many growing companies that pose a higher credit risk. The proportion of junk bonds trading at distressed prices surged during the past month to the highest level since the early 1990s, when the market was paralyzed by recession and the collapse of Drexel Burnham Lambert.
Nearly one in four junk bonds is trading at distressed levels, defined as yielding 10 percentage points or more over Treasurys, says Martin S. Fridson, chief high-yield strategist at Merrill Lynch & Co. The distress ratio "is a leading indicator of the default rate [for corporate debt], so it suggests some further pain coming," Mr. Fridson says.
Tuesday morning, Gary Goodenough decided to sell $12 million of top-rated corporate bonds, which normally would be a snap for a professional money manager. Not now. When he picked up the phone and asked six Wall Street dealers for bids, two passed. Three made bids that weren't close to the market price. The sixth gave an initial price indication, but said he would only buy the bonds at a lower level.
A year ago, Mr. Goodenough would have hung up the phone. Tuesday, the co-head of fixed-income investments at MacKay Shields Financial in New York said, "Sell 'em" to the sixth dealer. Even though he wasn't happy with the price, Mr. Goodenough was relieved to get out of his position amid a tumbling corporate-bond market -- where it suddenly has become much harder just to get in and out of positions.
"There's been a massive erosion of liquidity," says Margaret Patel, manager of the $120 million Pioneer High Yield Fund, referring to the ability of investors to easily get in and out of bond positions without moving prices.
The average junk bond is trading at 80.65 cents on the dollar, down from more than 84 cents in early September, and almost 90 cents at the beginning of the year, according to Merrill Lynch. Junk bonds now trade at their lowest level since March 1991.
Junk bonds sell at a yield of 7.1 percentage points above comparable Treasurys, markedly higher than the 4.5-point spread at the beginning of the year. Bonds of companies with investment-grade ratings also are sliding amid poor trading conditions. Swap spreads -- the difference between Treasury rates and the rate at which top-rated companies can conduct interest-rate swaps, an indication of sentiment in the bond market -- remain near their widest levels ever.
If bond issuance remains difficult, it will put pressure on an important area of financing for U.S. and global companies, potentially hurting economies around the world. Further, the premium that investors are demanding for riskier bonds could be a signal that the U.S. economy's growth is set to slow substantially, perhaps resulting in a recession.
"I lean toward a hard landing" for the U.S. economy, says William Gross, of Pacific Investment Management Co., the bond heavyweight.
Storm clouds gather
Barry Riley, FT, October 14
Momentum was the great theme in the global bull market in equities, which finally appeared to peak last March. The downturn began a little earlier outside the technology-based sectors (though there were signs of a double top in some countries early in September). Now a Middle East war threat reminds us of event risk of the kind that last hammered the stock market in 1990.
During the bull market, investors chased the fashionable stocks and sectors ever higher. Those people looking for basic value and recovery potential usually did very badly.
In the uptrend it did not matter that there was no conventional value to justify the scarily high prices of high fliers. Now there is no value to support their sinking prices.
The Nasdaq Index, in which became concentrated much of the US stock market's value, but also most of the risk, has fallen by 25 per cent since the beginning of September.
Asian markets have already entered a substantial bear market, with Tokyo down by 26 per cent and Taiwan off by 42 per cent since peaks last spring. The Nasdaq has declined by 39 per cent since the early March top.
The stock markets have arguably been driven by a remarkable, but unsustainable, burst of corporate profits growth. Earnings per share growth in 2000 is expected by analysts to be 16 per cent in the US, 20 per cent in Japan and 25 per cent in Continental Europe.
Even in the better-performing markets the earnings bonanza is unsustainable. The US market is already being undermined by important individual company downgrades, ranging from Intel to Home Depot.
Then there are the credit markets, which can also usually be relied upon to send up some smoke signals of trouble just ahead. Admittedly the banks, and their regulators, are determined not to repeat the regular past mistakes, which have usually been concentrated in the real-estate sector.
But it is complacent to rely on lessons from old crises; the next problem usually emerges from a totally unexpected direction. This time it is the new-economy sector, especially tele-communications. Junk bond spreads over government bond yields have been widening, and the ability of telecoms companies (even substantial ones) to refinance temporary bank borrowings through the bond market is suddenly in doubt.
We can see a classic pattern here, as repeatedly rehearsed in real estate in the past. At one stage, in the middle of the bull market, entrepreneurs and investors are obsessed with growth. The more grandiose the ambitions, the better. Mobile phone giants are paying out something over $100bn to European governments this year, just for the rights to use extra parts of the radio spectrum. This is a symptom of over-investment; then the realproblem turns out to be one of overcapacity.
This week Motorola, one of the mobile phone leaders, warned of a slowdown. The company's already weak share price crashed further, and is now down 66 per cent from the peak.
Throughout the technology sector it is time to ponder on the longer-term consequences of such meltdowns: not just whether it will become difficult to finance negative cashflows but whether it will prove possible to retain key staff when the stock option plans become worthless.
Beyond that, the threat is that the whole process of leveraging companies, partly through stock buybacks, concentrating the growth potential into equities but offloading downside risk into bonds and bank credit, may come unstuck.
In the US, credit quality has already been deteriorating during the boom. Much worse could happen if there is a serious economic slowdown aggravated by an oil famine. So far, however, there is little sign of any loss of confidence in the banking sector - though banks stocks wobbled on Thursday. Banks are viewed by investors as secure alternatives to the dangerous tech wrecks. Mostly, the scare stories have been confined to investment banks, which may have suffered from losses on junk bond positions and the halting of the lucrative flow of new stock market flotations.
Yet it would seem prudent to declare an end to the long global bull market which has been driven by the extraordinary expansion of the US economy.
Over the five-year period 1995-99, the S&P 500 Index multiplied in value more than threefold, equivalent to average annual growth of 26 per cent.
The puncturing of the bubble is scarcely surprising. In this space last new year's day I forecast that bonds would beat equities in 2000, more particularly in the second six months. So far this year the total dollar return on the FTSE World Index has been minus 11 per cent, and on the J.P.Morgan Global Government Bond Index minus 2 per cent. Bonds are ahead, then - if you have avoided telecoms paper. |
