Easing Into 2001

SAN FRANCISCO -- In last night's episode of GuruVision, the question of whether a given strategist's view was right or wrong was left for another time.

That time is now. At least as it pertains to Thomas Galvin's comment about a pending "credit crunch."

In an interview Tuesday, the chief investment officer at Donaldson Lufkin & Jenrette stood by his call, predicting a 60% possibility the Federal Reserve will ease (yes, ease) by the end of March 2001 to alleviate the impact of this looming credit crunch.

"Anyway you slice it, spreads [between yields of corporate and Treasury bond yields] are high, leading to a bifurcation in the ability of companies" to access capital, he said. "Some small-sized companies are jeopardized by this limitation."

On the salient question of whether this really is a recent phenomenon, Galvin conceded that high-yield bonds never fully recovered from the 1998 debt crisis. But he contends the problem is worsening and that more firms are having a tougher time getting access to capital.

If so, you'd think corporate bond defaults would be rising. But they're not -- for now.

After peaking at 6.1% in October 1999, the default rate among all corporate issuers has fallen steadily, totaling just 4.9% in July, according to Moody's Investors Service. As a percent of total principal outstanding, the default rate has gone from a high of 8.23% in November 1999 to 5.7% in July, Moody's said.

Still, it's too early to discount Galvin's concerns. Most bond market observers -- including Moody's -- expect the default rate will reaccelerate.

Meanwhile, Martin Fridson, chief high-yield strategist at Merrill Lynch, reported the "distress ratio" for high-yield bonds hit 19.5% on July 14, the highest level since 1992 and up from 11.2% in February. The distress ratio is the percentage of high-yield bonds trading at 1,000 basis points or more above Treasuries. A measure, that is, of how much "risk premium" investors are demanding.

Merrill contends there's a high correlation between the distress ratio and the default rate, which makes sense because the higher the interest rates corporations have to pay, the higher the likelihood they won't be able to make said payments.

Richard Bernstein, chief quantitative analyst at Merrill, takes it a step further (albeit an obvious one, as Chris Edmonds wrote in the RealMoney.com Columnist Conversation earlier Tuesday), noting a high correlation between default rates and the relative performance of low- and high-quality stocks. Specifically, higher quality issues tend to outperform when the default rate rises, and vice versa.

Expectations for rising defaults is one reason Bernstein is bullish on drug stocks while simultaneously wary of tech stocks. While you might say he's just trying to justify his long-standing caution, it's also an investable angle to this story, which I figure many of you are clamoring for (already).

Here's another: If the Fed eases in response to the presumptive credit crunch, competitive local exchange carriers such as Allegiance Telecom (ALGX), Time Warner Telecom (TWTC), Nextlink Communications (NXLK) and Net2000 Communications (NTKK) "could enjoy a huge rebound over the next 12 months," DLJ's Galvin wrote.

DLJ has done underwriting for Allegiance, Time Warner Telecom and Net2000.

The Bigger Picture

Still, the paramount issue is whether Galvin's credit-crunch warning should be taken seriously. For the sake of this exercise, presume the key to answering that question is figuring why so many observers believe more corporate bond defaults are forthcoming.

"People say [rising defaults are] strange when the economy is booming," but there are factors other than economic growth that contribute to defaults, said Merrill's Fridson.

Most prominently, defaults rise in correlation with how tough commercial banks are in lending to "marginal companies," he said, offering the Fed's survey of senior bank loan officers as the best measure of lender attitudes.

In the first-quarter survey -- released in May -- the Fed reported almost 25% of domestic banks reported tightening their lending standards, the highest percentage since third quarter 1998 and up from 11% in the fourth quarter of 1999.

"There's a risk banks could pull back [lending] too much and help trigger a more severe slowdown," Fridson said, adding he'll closely monitor the Fed's second-quarter survey, due before the FOMC's Aug. 22 meeting. "That's not a forecast, but it's a risk."

The Merrill analyst described the current environment as the "other side" of 1996-1997, when "banks were throwing money at companies" and it was "impossible to fail."

Fridson referred to the high-yield market. But it's fair to say a similar pattern has emerged in equity financing, be it venture capital funding or the IPO and secondary markets.

So if it's getting tougher/more expensive for corporations to get capital either through bank lending, the high-yield bond market or the equity market, Galvin's credit-crunch theory has bite. Or, at least, bears further nibbling.

The latter is the choice of Jim Bianco, president of Bianco Research in Barrington, Ill., who said, "We're still a step or two away" from getting bit by a credit crunch.

"Rates are high, but the high-yield market is not being shut down," Bianco observed. "People are still bringing deals."

Additionally, corporations can access capital via the Euro or convertible bond markets, as well as the equity market, as the calendar's recent resurgence attests.

As is his wont, Bianco then offered a new twist on the question at hand. To him, the rising stress in high-yield bonds (and other "spread" products, such as mortgage-backed securities) is a reflection of the "systemic risk" associated with such financial instruments.

"The bond market sees big problems out there" and is thus demanding more yield from less creditworthy issuers, he said. "What is the problem? It's the stock market."

Yes, those nutty bond-fund managers are "scared [witless]" that the "overvalued" stock market is "going to crack" and "crack the economy" in the process, Bianco mused. "It's almost as if the bond market is making this giant bearish call on the stock market."

Just because one market is making such a call doesn't mean it's going to come true, and the researcher noted the bond market has been so disposed for roughly three years now. Spreads have stopped widening since the Nasdaq Composite peaked in March and are currently "in a holding pattern, much like the stock market," he noted. "Everyone is trying to figure out the next move -- is it up big or down big?"

Stock bulls such as Galvin are betting (hoping?) increased credit strain will prompt the Fed to ease, propelling stocks higher in the process. Yet the bond market suggests such strains augur a much different outcome.

Ironic, isn't it?

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