Market update — The case for the corporate bond market

William F. (Ted) Truscott, Chief Investment Officer
Dec. 2, 2008

"Credit spreads are unprecedentedly wide, central banks unimaginably openhanded…. a value investor from Mars might [ask] — Why do earthlings want Treasury bills so much more than high yielding, decent quality corporate bonds? Or better-quality residential mortgages, or senior secured bank loans? — Only yesterday, investors were panting after yield. Now, they turn their backs on it. Not six months ago, central banks were battling inflation. Now, like corner men fanning towels over a wobbly fighter, they are trying to revive it."

James Grant — "Bullish on credit, bearish on money"
Grant's Interest Rate Observer Vol. 26, No. 22

The credit crunch — what it means and why it's happening

The current financial crisis is often called a "credit crunch" for a reason. The market for debt obligations is not functioning with any degree of normality. Liquidity is poor, there is little in the way of new issuance, and spreads¹ are some of the widest ever seen in multiple sectors of the bond market. In my opinion, the stock market is not going to recover until the bond market gets a whole lot better and some sense of normality returns to the world's credit markets.

As such, one potential investment strategy over the next 12-18 months is to focus first on high-quality mortgages, investment-grade corporate bonds, high-yield bonds, and high-yield loans. All of these categories currently offer wide spreads and historically high yields. It is my view that price appreciation will occur first in the bond market, followed by the stock market. To be blunt, the equity of many companies will be worthless if they are unable to pay off or refinance their bonds. The bond market, therefore, tells us a lot more about the state of the battle against the credit crunch than the stock market.

Credit is the grease of the economic engine. We are lacking the grease necessary for the U.S. and the world economy to function normally, which is why the onset of this recession feels so sudden. It is also why we believe this recession will be much more severe than the last two recessions. While some banks are lending, many others are not. Of greater importance, the bond market is basically shut down for most types of debt issuance. This affects everything from credit cards and auto loans, to basic financial needs of medium- and smaller-sized companies.

Let's take credit cards as an example. Banks and credit card companies make loans to consumers via credit cards so they can purchase items today rather than save the money to purchase the items later. Banks and credit card companies do not always retain these loans on their balance sheet. They often package these loans into securities that are then sold off to investors. This process, known as "securitization," is one of the tools of modern-day finance. It is beneficial in that securitization frees up capital and allows banks and credit card companies to make additional loans. This has increased the velocity of money in the financial system and has allowed consumers to enjoy a higher standard of living. The same principal is true for auto loans, student loans and mortgages.

Today, the securitization market is largely closed. This means that banks and credit card companies need to retain loans on their balance sheets. As such, there is less capital available for new loans. If we then factor in the capital losses from rising defaults, banks must make fewer loans in order to maintain adequate levels of capital. As a consequence, credit has become rationed rather than abundant.

The credit crunch extends well beyond the U.S. consumer, however. One of the basic tools of international trade is called a letter of credit (LC). An LC allows exporters and importers to use their banks to assume credit risk rather than take on this risk themselves. One of our analysts, along with many financial publications, has noted that this part of the credit market has dried up. When a basic tool of international trade is taken away, the ripple effects on the world economy are enormous.

The basic problem is that the credit pendulum has swung too violently from reckless credit extension to credit rationing. The re-establishment of a sense of balance has been enormously difficult to achieve as no one is sure who is a safe credit risk and who is not. Since any financial system is based mostly on confidence and trust, the unwillingness to lend money can be seen as an evaporation of confidence and trust. Thus, the bond market can also be seen as a confidence barometer.

Government response and the bond opportunity

Both the Federal Reserve and the U.S. Treasury are working overtime to restart the stalled credit engine. This is not easy. The Fed, which used to be the lender of last resort to banks, is now a lender of last resort to industrial America. In recent weeks, General Electric (GE), one of the largest corporations in the world, has sold short-term debt known as commercial paper to the Federal Reserve. No one else was willing to buy the paper at a reasonable rate of interest! The current environment is unsustainable and I believe that a return to a normal credit market where GE can sell commercial paper directly to investors is not only likely but also a necessity.

As a result of its direct lending and purchase of all kinds of assets, the Federal Reserve's balance sheet has grown to a size of over $2 trillion. According to Grant's Interest Rate Observer, the earning assets of the Federal Reserve topped $1 trillion for the first time in history on Sept. 24 of this year!

It is my view that the numerous programs undertaken by the Federal Reserve, The U.S. Treasury and other Central Banks will eventually begin to work. Once investors begin to believe that these programs are working, the bond market will respond accordingly. In the meantime, bond investors are being richly compensated for the risk that the programs will not work. According to the Dec. 1 Wall Street Journal Online, investment grade Triple-B-rated (Baa) corporate bonds² now offer yields of 10.16%. This is some 7% more than 10-year Treasury notes. Spreads are even wider in the high-yield and loan markets.

Many customers and advisors who read my Nov. 5 market update and saw the preference for bonds mistakenly believed that I was calling for a more conservative investment strategy. This is not true. The purchase of debt obligations entails taking risk — including the risk of default. I am also not suggesting that investors abandon the U.S. stock market. As noted in previous updates, there are many stocks that are currently cheap by just about any valuation measure and also offer rich dividend yields. Simply stated my preference for bonds is a relative value strategy as there is more value right now in the non-treasury portion of the bond market than the stock market. Beyond that, the bond market will be the bellwether for an improving credit market and a functioning credit market is very much a necessity.

We urge you to consult with your financial advisor to re-evaluate your financial plan in light of today's market conditions. Your advisor can help you determine which part of the generic strategy I have laid out may be suitable or applicable to you. Your advisor can also help you with the extension of credit, if necessary. Ameriprise Bank is open for business for its clients with competitive cash-flow management solutions. They provide a HELOC product with several attractive benefits and rates as low as Prime, as well as a suite of Premium Credit Cards with unique lifestyle/travel benefits and some of the lowest interest rates in the market. These can be used to set up a back-up line for liquidity when needed or to help investors meet short-term financing needs.