I don't know if you've ever prowled around an old deserted house. I did when I was a kid. The floors would shake with each step. Patches of dry rot threatened to give way and send you plunging into the basement. If you put your weight against a beam, the whole house would sway. Exciting -- and dangerous.
Unfortunately, that's also a pretty good description of today's bond market. The unstable foundation is built on overseas cash flows and currency manipulation by foreign central banks. Dry rot threatens the whole system of credit ratings. And some of the banks propping up the market for credit derivatives shake at the slightest touch.
The professionals in this market -- the traders, the underwriters and the more sophisticated investment banks -- know exactly how shaky the whole edifice has become. They're determined not to be the last out the door.
The result? It doesn't take much to turn a market decline into a rout. That's exactly what happened in the four weeks that ended June 12. In that period, yields on the 10-year U.S. Treasury bond soared from 4.7% to 5.25%. Prices on this "safe" bond plunged 10.5%.
And while bond prices have stabilized for the moment, nothing fundamental has changed about the nature of this market. We could get another replay of this panicky drop at any time over the rest of the year.
A Novel Idea: Cash
What should you do if you've got money in the bond market? Ever hear of something called "cash"? With the 10-year Treasury bond yielding a tad less than 5.25% and banks paying a top rate of 5.25% to 5.45% on a 12-month
certificate of deposit, I frankly don't see any reason to take on the risk in bonds right now. Let bond prices recover a bit from the recent panic, and then move.
It hasn't mattered much that this bond market was rotten through 2006 and into 2007, because bond market trends were still supportive. But now the fundamentals have turned, and that is putting pressure on all the shakiest parts of the bond market structure.
Those now-negative fundamentals include:
- Interest rate increases from all of the world's major central banks -- except, so far, for the U.S. Federal Reserve.
- Rising food and energy inflation around the world -- almost 7% in the first quarter of 2007 in the U.S.
- The end of the "Wal-Mart inflation bonus" as China, India, Vietnam, etc., shift from exporting deflation to exporting inflation.
- A shift away from the dollar by overseas central banks.
All these are long-term trends, you'll note. They've been in place for months, quarters and, in some cases, years without having much negative effect on the bond market, despite the jeremiads preached by financial market bears. So why did the market panic now?
Because, I'd argue, while bond-market professionals -- with a few exceptions, such as Bill Gross of Pimco, who publicly turned bearish in late spring -- have maintained a "what, me worry?" stance in public, they're actually now deeply worried about the structure of the bond market. And the closer they look, the more rot they see in the structure.
It's becoming increasingly clear to bond market professionals that an unfortunately large percentage of their peers didn't have a clue what they were doing as they ramped up to take advantage of the boom in the market for corporate debt. In the U.S., 2006 was a record year for corporate debt, with $1.05 trillion in corporate bonds issued, 40% above the level for 2005. The rest of the world kept pace: In China, 2006 set a record with $13 billion in corporate bonds issued, and 2007 started out on a pace to double that total.
Wait! There's More
Corporate bonds were just the tip of the global-debt-market iceberg in 2006, however. The big action was in derivatives, packages based on bonds (derived from them, so to speak) that sliced and diced risk to lower corporate interest bills and to give investors, such as insurance companies and pension funds, investments tailored to exactly the risk and reward needs of their portfolios.
Derivatives based on bonds and loans climbed by $15 trillion in 2006, a 100% increase over 2005, according to the Bank for International Settlements. (The total derivatives market, which includes derivatives based on commodities, currencies and stocks, climbed to $415 trillion in 2006.)
But did every bank or investment house that looked for a piece of the profit from this boom know what it was doing? Not a chance.
For example, Banca Italese, an Italian financial company that had specialized in asset-based lending, dove into the derivatives market in 2003. The bank started to offer fixed-rate financing, instead of its typical floating-rate deals, and used derivatives intended to offset fluctuations in interest rates. At the end of 2006, the bank reported, its exposure in the derivatives market was about $300 million. Not excessive, perhaps, for a bank with a market capitalization of $8.5 billion.
But Banca Italese never bothered to build a derivatives department devoted to analyzing the risk of its deals. Whoops. By the beginning of June, after euro interest rates had moved substantially higher, the bank's exposure had climbed to $800 million from the earlier $300 million estimate. The bank has spent $300 million to cap its interest rate risk -- it hopes. And the bank's market capitalization has dropped to $2.9 billion from $8.5 billion in a little more than five months.
Bond professionals know that Banca Italese isn't alone. They know that most players in the derivative market aren't capable of accurately assessing the risks of these instruments. In fact, they're increasingly worried that even the big credit rating agencies like Moody's, Standard & Poor's and Fitch aren't up to the job.
The Bond Buddy System
It's important to understand that bond professionals don't want to think badly of the job done by the credit-rating agencies. The bankers pay the rating agencies' fees. (Bet you didn't know that. Yep, the issuers of debt are the ones who pay the bills.) The bankers literally sit across the table from the rating agencies. The banks poach anybody on the other side of the table who they think has the talent to work for them. And the banks rely on the credibility of the rating agencies to sell their debt offerings. It's a pretty cozy club.
But the subprime debacle has been big enough to disrupt the club. Buyers of packages of subprime mortgages and derivatives based on these packages that have been burnt by rising defaults on these mortgages and falling prices for the debt they hold have angrily wondered if banks issuing the debt disclosed all the risk. And the banks have passed the buck, saying that they relied on the ratings from the three agencies.
Big problems with recently rated issues have turned up the heat on the agencies another notch. For example, as late as March 14, 2007, the day that the
New York Stock Exchange
delisted New Century Financial, the second-largest subprime mortgage lender in the U.S., the ratings agencies had downgraded fewer than 1% of the subprime mortgage securities issued in 2006.
Buyers were asking why the agencies hadn't moved faster -- and indeed, why they hadn't caught the problem when these mortgage-backed securities hit the market in the first place.
One possible answer is that the ratings agencies have become so entwined with the banks that issue the debt they're called upon to rate that they really aren't independent any longer. A study by Joshua Rosner, a consultant at investment research company Graham Fisher, and Joseph Mason, an associate professor of finance at Drexel University, argues that in the age of increasingly complex derivatives, debt rating agencies often actively work with debt underwriters to ensure that the different pieces, called tranches, of the offering are crafted to earn the necessary credit quality ratings to appeal to investors with different appetites for risk.
Why is that important? Because the agencies have become active participants in structuring the deal so it will sell, the study concludes, and this has compromised the agencies' independence. (If you see a similarity with the accounting profession in the era of the Enron scandal, you aren't alone, and the comparison scares some people on Wall Street silly.)
You don't have to believe in collusion between debt underwriters and the ratings agencies, however, to worry that the system isn't working. The criticism here is coming from bond professionals who have produced a series of studies showing that pools of debt called CDOs (for collateralized debt obligations) aren't showing the patterns of return and default that their credit ratings predict.
For example, one study shows that tranches of CDOs with the same BBB credit rating, which should trade at roughly similar prices, are instead trading at yields that differ by anywhere from 1.4 to 10 percentage points. At the A and BB levels, the gap is something like 4 percentage points. The U.S. Federal Reserve recently weighed in with a paper that said the ratings for CDOs are riddled with "anomalies."
There couldn't be a worse time for the market to lose confidence in credit-quality ratings. Not only has the debt boom flooded the market with billions, indeed trillions, of new debt, but much of this debt is astoundingly complex. Many buyers know they don't have the in-house capability to analyze these instruments. They really have no choice but to trust the ratings or stop buying.
And many of the most recent debt issues offer debt buyers very little protection if they get the initial risk assessment wrong. Some fall into the category of "covenant lite." These debt issues don't include the usual protections for buyers that prevent a company from issuing more debt if sales fall, for example. Others are very explicit about the ability of the borrower to issue more debt if the company gets into trouble.
One of my current favorites crops up in the financing for the proposed buyout of
, the fifth-largest wireless carrier in the U.S. As part of the $7.7 billion in junk bonds the company will issue to fund its own purchase by Texas Pacific Group and
, Alltel proposes to sell $3 billion in notes that allow the company to pay quarterly interest in issues of new debt. Bond professionals have dubbed this kind of debt "pay-if-you-can" notes.
I assume the "toggle" notes will sell. Bond buyers aren't nearly as worried as bond professionals yet.
The next time the bond market hiccups, I expect the professionals to head for the door in panic again. They know how rotten the structure is.
The market will finally be in real trouble when meat-and-potatoes bond buyers -- the pension funds, the insurance companies and the bond funds -- join in the rush.Most of the time, individual investors are the last out of a market like this. But it doesn't have to be that way.
At the time of publication, Jubak did not own or control any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
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