America’s slide towards a probable recession is likely to cause interest rates to fall around the world, making investment grade and government bonds attractive for the first time in years.
Structured credit markets are the latest domino to fall in what has been a dramatic and protracted unravelling of financial markets this year. News that American banks are propping up their money market funds to prevent rating downgrades also shows just how far the credit crisis has spread through the financial system.
The seeds of the crisis were sown in 2001 when Alan Greenspan, the then Federal Reserve chairman, slashed interest rates in an effort to keep America out of recession. This worked, but the rate cuts created a problematic surge in liquidity. Consumers and corporations alike took advantage of the low cost of borrowing to leverage up to the eyeballs. Corporate profitability and economic activity boomed, and risky assets enjoyed a phenomenal run right up to the start of summer 2007.
The pressure of bag-loads of money being pumped into limited investment opportunities inevitably resulted in corporate bond spreads compressing. Financial institutions reacted by devising new products to eke out returns, mostly involving more leverage. This compressed spreads still further, leading to yet more leverage and grinding bond spreads ever tighter. High-yield spreads in America and Europe reached record lows in May this year.
All the while, American economic growth slowed, and it has been below trend for about a year – a situation normally accompanied by wide spreads. This could not continue, and markets began to unravel at the beginning of the summer. American consumers who had borrowed excessively between 2003 and 2005 were the first to run into problems, especially when house prices started falling around summer 2006. Widespread subprime mortgage defaults meant the array of structured products that invested in these mortgages also got into trouble. Hedge funds began to topple and investors started to panic, dumping risky assets amid a large high-yield sell-off.
As banks’ loan books deteriorated and the structured credit they held plummeted in value, Libor (the rate at which banks lend to each other) rocketed. Money markets malfunctioned, and institutions such as Northern Rock, whose business models relied on short-term financing from money markets, suddenly found themselves in deep trouble.
Just how far away were we from a full-blown banking collapse in mid-September? If the Government had not guaranteed all Northern Rock deposits when it did, late on September 17, we would have been there. The share prices of Bradford & Bingley and Alliance & Leicester, two similarly funded mortgage banks, had started to slide. Failure to rescue Northern Rock would have been negatively reported in the press, leading to queues in all directions.
Queuing was not an irrational response. Deposit protection is limited and how long it would have taken for investors to get their money back? For all the criticism of the authorities, they averted a run on the British banking system.
Whether or not America will fall into recession remains hotly debated, but the economy, which has shown signs of deteriorating for some time, will inevitably continue to slow. I also expect American consumers to experience further difficulty in the coming months as fixed-rate mortgages are refinanced at higher interest rates.
Compounding the problem is the record overhang of houses on the American market. In addition, house sales are plummeting and house prices falling, which, historically, has always culminated in or coincided with a recession.
It has also been argued that the American yield curve acts as a crystal ball, predicting recession with more accuracy than economists and professional market watchers can. History shows that when long-term bond yields in America fall below the American interest rate, the country’s economy slips into recession about 18 months later. The chart shows this happening in the early 1970s, mid-1970s, early 1980s, early 1990s, and in 2001 (recession was not officially declared in 2001 because two consecutive quarters of negative growth did not occur). Thus the yield curve has been an accurate predictor of economic weakness. And the bad news is that we have seen an inversion in the yield curve since the summer of 2006, implying that there will be a recession in 2008.
The American economic slowdown is likely to have a significant effect on the global economy. I expect to see interest rates start to fall around the world. As such, we have seen the end of the bear market for government and investment grade corporate bonds and these assets now look good value.
However, corporate bond spreads are still tight and I think this is only the start of the high-yield sell-off. Corporate bond spreads are far from high enough to compensate investors for the increased risk of default that now exists.
The high-yield market has not sold off as much as expected, largely because defaults are still low. The global default rate has been below 2% for more than two years, the longest stretch since 1978 (when the high-yield market did not really exist). This low default rate is a bit artificial, however. In the recent liquidity-fuelled cycle, investors were perfectly happy to bend over backwards for loss-making companies. Covenants were broken, which meant bondholders could legally bring in the receivers and sell a company’s assets to recover their money. But investors were happy to waive these breaches and many troubled companies were able to borrow even more money from shareholders.
This phenomenon could not be sustained. As liquidity dried up, even banks had trouble getting financing. The default rate should therefore tick up as bond investors continue to rein in lending, and high-yield spreads widen.
As the economy slows down, high yield does not look great value, but highly rated investment-grade corporate bonds and government bonds now look attractive for the first time in years. We have seen the end of the bond bear market.