The ‘dash for trash’ is on, as the near-record low yields available on safe assets has prompted investment professionals to move further out the risk spectrum in a desperate bid to earn nominal returns that satisfy client needs. Cautious optimism persists among buy-side commentators, but actions speak louder than words, and market movements suggests investors are behaving quite differently than their rhetoric, as robust demand continues to outstrip supply and push the yields on lesser-quality bonds ever lower. The resulting valuations confirm that a substantial part of the market for fixed income securities has entered the speculative phase of the credit market cycle.
It was all so different not so long ago, as the bullish complacency apparent at the height of the credit bubble, turned to all-embracing fear following the collapse of Lehman Bros. The first tremors of what would soon become the worst financial crisis in seventy years erased the irrational exuberance evident in the prices of risky debt, but the failure of a major investment house proved lethal; the credit markets ceased to function, as forced selling – and the resulting illiquidity – pushed yields to unfathomable levels.
Extreme risk aversion prompted investors to flee the market for corporate credit en masse, which saw investment-grade bonds suffer double-digit losses in a matter of weeks. The carnage in high-risk segments was far more punishing, as the spike in the yields of junk bonds to more than twenty per cent resulted in losses of some 45 per cent for their unfortunate holders.
All told, the default rates implied by the yields available on even the highest-quality credits moved to levels that were without modern precedent, and savvy investors could bank on equity-like returns with bond-like risk. Of course, outsized rewards could be expected if, and only if, the Bernanke-led Fed’s unconventional monetary policies could unfreeze the markets, and return risk appetite to more normal levels.
Near-zero interest rates, in tandem with credit-easing policies proved successful, and the spread on lesser-quality credits versus default-free Treasuries dropped from a peak of more than six per cent at the end of 2008 to below three per cent just eight months later, as investors priced out an economic and financial apocalypse. Fed policy ensured a quick return to ‘business-as-usual’ on Wall Street.
Corporate bond pricing may not seem excessive to many on first glance. After all, the credit spreads on lesser-quality corporate bonds have made little progress in the past three years, hovering around three per cent for most of that time, while current spreads are more than one percentage point above the lows registered at the height of the credit bubble. This observation has seen many buy-side commentators argue that the bull market has further to run.
However, vigorous demand for safe assets, in concert with aggressive central bank purchases, has pushed the yield on ten-year Treasury debt deep into negative territory, when adjusted for long-term inflation expectations implied by the yields available on Treasury inflation-protected securities (TIPS). As a result, current spreads for lesser-quality corporate credit imply a real yield of just two per cent – a level of return that rewards investors for delaying consumption, but provides little to no compensation for default risk.
It is quite clear that risky corporate debt is dangerously overpriced, but identifying a trigger that changes the status quo is always difficult. Nevertheless, the trigger could well be a peak in corporate profitability, which may not prove sufficient to derail the equity market, so long as aggregate earnings do not come in too far below expectations, but a wide dispersion of profit outcomes across the individual constituents that comprise stock market indices, could punish corporate bond investors.
To appreciate why, it is important to grasp the financial theory that explains the pricing of corporate credit. The Nobel laureate, Robert Merton, increased our understanding of corporate debt pricing, when he applied contingent-claims analysis way back in 1974. He argued that owning a corporate debt claim is analogous to owing a risk-free debt claim of the same maturity, and issuing an option to default to the company’s shareholders – an option to put the firm at the value of the risk-free claim.
The value of the put option is determined by total firm volatility – both firm-specific and market-related – unlike equity prices, which only incorporate the latter. Thus, if firm-specific or idiosyncratic risk increases on the back of a wide dispersion of earnings outcomes among equity index constituents, the value of the put option will increase and benefit shareholders at the expense of bondholders. In other words, if stock market volatility and firm value remain unchanged, wealth will simply be transferred from the holders of debt claims to the company’s shareholders.
The theory helps explain why the market for corporate debt typically leads the equity market at important turning points. Indeed, credit spreads bottomed in the spring of 2007, or more than half a year before aggregate stock prices reached their apex. A similar dynamic could well be in the offing today.
The Federal Reserve’s unconventional monetary policies may well underpin the excesses apparent in the pricing of lesser-quality corporate credit for now, but liquidity is a dubious concept at best, and can disappear in a heartbeat. Stormy weather may not be far away.
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