Is it the End of the World?

On the July 27, 2007 post, assiduous reader kaspu asked: 

Your point about not owning junk bonds is well taken. And I fervently hope that your loyal readers have taken your past advice and are watching all this sturm und drang from a viewpoint of relative safety.

But the eternal pessimist within me forces me to ask you this:If there is a complete corporate credit debacle, other than cash and gold, are there any other safe havens that will preserve capital value? Will even those of us who invest in the quality canadian prefs (P2h and higher) escape the hysterical fleeing from corporate debt? after all, the covenant of bank prefs in canada specificies that they are non-cumulative. The market might decide that this is an unacceptable risk and demand a wider spread. Lower yielding Canadas (yes…this time I do remember to call them Canadas) don’t have tjis provision. American bank prefs of even higher quality (AAA) almost always have in there convenants that they can defer dividend payments for as much as 20 quarters.

So will all the money flee to government bonds, with the spreads between them and prefs widening to a ridiculous degree?

Y’know, kaspu, without meaning any offense: I hate this sort of question.

It’s completely open-ended and the only parameters that you’re giving me are “complete corporate credit debacle” – which is a very open ended kind of thing. For any scenario I propose as a base case, for any scenario I propose as a worst case, you can say “Well, yeah, but what if … “. One of my favourite pieces of economic trivia is the fact that the during the Great Depression, there were instances of US Treasury Bills trading above par. Why shouldn’t they? Put your money in a bank, it’ll go bust. Put your money under your mattress, it will get stolen. Buy US T-bills above par and at least you know how much you’ll be losing…

What I’m trying to say is … you might not be satisfied with my answer!

I don’t think the current situation is as bad as all that. It’s certainly bad enough, for those who bought junk mortgage paper and those who had indirect, but highly leveraged, exposure via hedge funds, but I don’t see the world ending any time soon.

We are definitely heading into a period during which junk yields will be higher than they have been in the past few years; this will choke off leveraged buy-outs (at least until the next frenzy) and thereby blow a little froth of the equity markets. This is happening right now … according to Markit’s daily wrap-up:

Panic set in yesterday in the credit markets, with indices worldwide experiencing massive daily movements. Both the CDX NA HY and iTraxx Crossover indices broke through key levels yesterday, the former rising above 500bp and the latter 400bp. Investment grade indices also widened sharply. The turmoil has been sparked by a crisis in the US sub-prime mortgage market, which in turn has led to a broad increase in risk aversion. This has created hostile conditions for borrowers, particularly private equity companies. Their arrangers have had difficulty, to put it mildly, in enticing investors into buying LBO financing. Alliance Boots in Europe and Chrysler were set up as barometers of the leveraged loan market. If so, the market is in a poor state indeed as the arrangers pulled large chunks of the debt packages and took big losses on their fees. HCA led the high-yield sector yesterday in its rapid decline. The hospital operator was acquired last year in what at the time was the largest LBO in history. It is now laden with large amounts of secured financing that have also declined in recent days (see chart below). Like another totemic deal, KKR’s buyout of RJR Nabisco in the 1980s, the HCA LBO may come to embody the hubris of the times.

According to this wrap-up, credit derivative swaps on HCA blew wider by 102bp to 555bp, while GMAC LLC was 94bp wider to 480bp. I do not profess to be an expert on CDS history – or even to have a huge amount of expertise in the field – but it seems to me that this kind of move, in the absence of company specific news, must be some kind of record. We are in the panic phase, and spreads might even go as high as they were in 2001!

2001? Have a look at what the Federal Reserve Bank of San Francisco had to say in 2001, when spreads spiked into the +1000bp area:

Before the terrorist attacks on September 11, the yield spread of the Merrill Lynch junk bond index had risen more than 300 basis points since the beginning of 2000 (Figure 1). This was accompanied by a gradual increase in the comovement of bond yield spreads. These patterns seem to suggest that before the attacks, the run-up in junk bond spreads was driven by concerns about rising credit risk. However, following the attacks, the spread skyrocketed almost 200 basis points to 968 basis points, just 46 basis points shy of the peak recorded during the 1990–1991 recession. While there is no question that a large part of the rise in junk bond yields reflects investors’ reassessment of credit risk, the comovement in bond yield spreads, shown in Figure 2, shot up to a level not seen before. Both the rate of the increase and the level of comovement in yield spreads after September 11 indicate that some of the sizable jump in yield spreads may be attributable to the limited liquidity in the junk bond market.

In other words … it’s all about liquidity. We have just been through a period in which every brain-dead retail stockbroker in the world was telling his clients that an extra 300bp on bonds was free and easy … we are now entering a period in which they are calling their clients and triumphantly telling them that they were able to get out at only +500. The more time I spend in this business, the more influence I attribute to the brain-dead retail stockbroker!

Now, none of this can really be called a direct answer to your question, but I’ll start trying now. There will be an influence on investment grade corporate bond spreads – and there already has been. Spreads moved wider on the week, because credit quality is a continuum. There is no magic line between Investment Grade and Junk … if Junk yields move higher, then Investment Grade will, to some extent, follow them, because investors will connect the dots and say ‘Gee … I can pick up a whole bunch of extra yield by accepting a relatively small amount of extra credit risk! When I divide return by risk, I get a big number! Time to trade!’

Spreads on paper of the quality you were talking about are something of a conundrum. Bank perp prefs are now yielding 5%-odd, interest equivalent of 7%-odd, which is basically Canadas +250bp, which is basically OK by me. I have previously expressed surprise at the very narrow spreads the market gives to Innovative Tier One Capital – which is basically a pref sold in the bond market, and these spreads have a long way to go before they’re even close.

If anything, I think a flight to quality corporates should be good for the high-quality end of the preferred share market, but I’m not going to hold my breath. The bank-perp-pref tax-equivalent spread to Canadas could very well vary by 50bp – up or down – and trying to outguess that is a mug’s game. If one of the banks gets into trouble with Junk exposure, we could very well see a spike in yields of those – but at that point, I’ll probably be in there buying!

Update 2007-07-30: More comment … Tom Graff’s headline is “We’re doomed” … but the post itself is at least a little bit more cheerful.

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