LIGHTER THAN AIR
____________________
By Eric J. Fry
The Daily Reckoning
July 3, 2003
dailyreckoning.com
It's official: The bond market is a bubble. GM's brand-new
$17.6 billion offering is positive proof.
Investors are so desperate for yield - any yield - that
they will make a risky loan - any risky loan - to get it.
Along comes cash-light, debt-heavy GM, offering up a great
big bundle of near-junk paper that promises to pay
investors 4% more per year than a Treasury bond. Enticed by
the plump, "American-sized" yield, investors lined up to
buy the deal, turning a blind eye to the automaker's
parlous financial health.
Unfortunately, in the case of bond yields, bigger is not
always better, especially when bigger isn't all that big.
But when markets are rising, investors tend to buy first
and ask questions later. In other words, bond buyers have
become very indiscriminate, and an indiscriminate buyer is
a stupid buyer. It follows that wherever many
indiscriminate buyers congregate - like in the bond market,
for example - many stupid purchases are certain to occur.
And when many stupid purchases occur in rapid succession,
prices rise to stupid levels.
Before you know it, you've got a full-blown bubble.
The stock market bubble of the 1990s (as everyone belatedly
calls it) was merely the first of the serial financial
bubbles of the Greenspan era. Financial excesses spewed
forth from Greenspan's monetary policies like bubbles from
a child's bubble-wand. The bond bubble is simply
Greenspan's latest frothy creation.
When - not if - the bond bubble bursts, the resulting
economic concussion could make the stock market's three-
year implosion seem like a mere tremor before the bond-
market Vesuvius. A burst bond bubble, for example, would
devastate stocks, particularly the stocks of homebuilders.
Some of the strongest evidence in support of the bond
bubble argument is the "sniff test." This thing just
doesn't smell right. Even an investor who knows nothing
about current economic conditions in the U.S., but a little
something about the history of government finance, should
be repulsed by the stench of 3% yields on a 10-year
government bond. Like a week-old tuna fish sandwich, it
just doesn't smell right.
The anecdotal evidence of irrational exuberance in the bond
market is also plentiful. "The deflation alarms have caused
savers to climb stepladders to reach for yield in the upper
branches of barren trees," observes James Grant, editor of
Grant's Interest Rate Observer. GM's rotting balance sheet
may be one of the most barren trees on the fixed-income
landscape. The express purpose of the automaker's titanic
$17 billion bond offering - the largest ever by an American
corporation - is to shift liabilities from one corner of
its balance sheet to another corner.
Like a college kid borrowing money from Mom and Dad to pay
his credit card bills, GM is using the bond offering
proceeds to pay off other debts. Specifically, most of the
proceeds are earmarked for bolstering GM's badly
underfunded retirement plan...Of course, "issuing debt in
an amount equal to about half its equity-market
capitalization to finance future benefits is a stark
reminder of the extent to which GM's fate resides largely
with its unions and retirees," remarks Barron's Michael
Santoli.
"Although GM touted the debt issuance as 'an overall effort
to accelerate improvements in GM's balance sheet and
financial flexibility,' the truth is that GM is merely
substituting one debt, much of it off-balance sheet, for
another debt that remains on the balance sheet," observes a
very skeptical Apogee Research. "Can anyone realistically
consider this outcome a positive indicator for GM's future
prospects?...This is nothing more than a red flag signaling
that escalating pension and 'other post-retirement employee
benefits' (OPEB) obligations are placing a menacing burden
on the interests of common shareholders.
"Simply put," Apogee continues, "the $17 billion of debt-
raised proceeds is not going toward R&D or product
development or improved manufacturing processes, any of
which might conceivably improve the fortunes of the common
shareholder. Instead, the proceeds will go to support the
growing needs of GM's substantial retiree base." All
together, GM's underfunded pension liabilities total a
staggering $75 billion. Even the largest-ever $17 billion
corporate bond sale, therefore, is literally a drop in the
bucket. But none of this troubling math seems to vex the
folks who are clamoring to lend GM billions of dollars.
Statistically speaking, the bond market is also looking
very bubblesque. "The bond market surge in recent months
looked and felt much like the spike from 3,000 to 5000 in
Nasdaq in late-1999 to early 2000," observes Donald
Straszheim of Straszheim Global Advisors. "Consider the
similarities - Treasuries and the Nasdaq. The Nasdaq rose
320% (April 1997 to March 2000), 1201 to 5048. In a shorter
span, it rose 260% (October 1998 to March 2000), 1419 to
5048.
"In Nasdaq, the 3000 to 4000 move took just 70 trading
days. If there ever was a mania, this qualified. In the 5-
year Treasury, the yield declined 70% (May 2000 to June
2003), from 6.83% to 2.08%. In a shorter span, it declined
by 57% (April 2002 to June 2003). This decline in yield
(price rally) is unprecedented in the postwar era....The
deflation story has been overdone," Straszheim winds up.
"Fashionable for a time, the Fed has plenty of capability
to flood the system with liquidity in the effort to avert
deflation....We don't expect an inflationary surge in
rates, but recent lows were far below sustainable."
What has been helping to sustain these "unsustainable"
yields, of course, is the massive flood of dollars into
bond mutual funds. In the 12 months ended April, $160
billion of new cash flowed into bond funds. "The bond
market is over-bought, over-valued [and] over-leveraged,"
says Jim Bianco, president of Bianco Research in Chicago.
We wouldn't argue with him. So letting this bubble float on
by seems like the best way to stay out of harm's way.
Regards,
Eric Fry,
The Daily Reckoning
Ed note: Eric J. Fry, the Daily Reckoning's "man-on-the-
scene" in New York, has been a specialist in international
equities since the early 1980s. He is also a renowned
portfolio manager, author, and financial commentator. |
