Three More Reasons to Doubt Bond Market's Sanity: Mark Gilbert
Jan. 20 (Bloomberg) -- Investors are lending free money to junk-rated companies. Argentina is blackmailing its lenders three years after taking the prize for the biggest default ever. And the Federal Reserve says there's evidence of ``excessive risk-taking'' in the low yields investors are accepting on corporate bonds.
These three examples should chill fixed-income money managers. Fear and greed are omnipresent in financial markets; they also seem to be achieving omnipotence in the current bond market environment, with fear of unemployment prompting investors to make greedy bets they'd typically run a million miles from.
In the past four months, bond buyers have made more than $2 billion of ``borrow now, pay much later'' loans to non-investment grade borrowers including Inmarsat Ventures Plc, a London-based satellite operator, and New York-based Warner Music Group, the fourth-biggest record label.
The loans are in the form of so-called discount notes. In November, for example, Inmarsat sold $450 million of bonds that are interest-free for the first four years, after which the issuer starts paying 10.375 percent. Investors pay just $668.94 for $1,000 of the notes, which boosts the return when they're due for repayment in November 2012.
Provided Inmarsat meets its obligations, buyers will make 635 basis points more than if they'd bought a U.S. Treasury note of similar maturity. A basis point is 0.01 percentage point.
Big Risk, Scant Reward
Standard & Poor's responded by cutting the company's credit rating to B+, four levels below investment grade, citing Inmarsat's ``more aggressive than expected'' financing policy. The bonds themselves are rated CCC+, seven steps away from investment grade. S&P defines debt with such a low rating as ``currently vulnerable to nonpayment.'' That's four years of big risk, no reward.
A desperate search for yield is making investors willing to hand over free money for four years or more to companies such as Kohlberg Kravis Roberts & Co. and Clayton Dubilier & Rice Inc., two New York-based buyout firms that have also sold discount notes. High-yield dollar bonds offer an average of about 322 basis points more than government debt, down from about 1,000 basis points in mid-2002, according to indexes compiled by Merrill Lynch & Co.
That hunt for yield also means emerging-market countries have enjoyed their cheapest borrowing costs for at least seven years -- even though Argentina, in the messy aftermath of its December 2001 default, is a reminder of just how risky lending to high-yield countries can be.
New Bonds for Old
Argentina wants the holders of about $104 billion of debt to forgo three-quarters of the money they're owed by accepting new securities worth about 25 cents on the dollar, less than half of what Russia and Ecuador ended up repaying their bondholders after defaulting. It's ignoring calls from the representatives of thousands of small investors, many based in Italy, to sweeten the deal.
The debt of emerging-market countries yields an average of about 384 basis points more than Treasuries, according to JPMorgan Chase & Co.'s benchmark index. That spread got as low as 360 basis points last month, and is down from an average of about 660 basis points since the U.S. bank began calculating the measure in December 1997.
This kind of profligate lending behavior is enough to give central bankers nightmares. The minutes of the Fed's Dec. 14 meeting, published earlier this month, suggest Chairman Alan Greenspan and his team are starting to worry about sleepless nights.
Get This Party Ended
``Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets,'' policy makers said. They cited corporate bond spreads, an increase in initial share sales by companies, a jump in mergers and acquisitions, and suggestions that speculators are bidding up house prices.
The Fed is worried that its efforts to avert deflation with ultra-low interest rates have started a party that will end in tears. Even as it takes away the punchbowl by raising interest rates, the guests may already be too drunk to care.
``When central bankers start musing publicly about asset price inflation, asset managers need insurance,'' Paul McCulley, a managing director at Pacific Investment Management Co. in Newport Beach, California, wrote in a research report last week. ``In the present circumstances, that means getting prepared for an increase in volatility in financial asset prices, both stocks and bonds, and maybe currencies too.''
`Excessive Risk-Taking'
The U.S. central bank's reluctance to participate in puncturing or even identifying so-called bubbles is well documented. As McCulley argues, that makes its sanction of the phrase ``excessive risk-taking'' in the December minutes all the more telling.
As Greenspan said on Nov. 19, ``rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money.'' In its own opaque, idiosyncratic way, the Fed is screaming at us to be wary of bonds at their current valuations.
The bond market, though, still isn't listening. |
