If I Had Told You a Year Ago…

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It’s always amazing to watch sentiment change.  Go back in time to December 2008, shortly after Lehman went away and ask yourself whether you would have ever expected the stock market to rally 60% after bottoming on March 9th.  Few among us would have predicted such a big move (which is probably why it happened), but we’re used to the idea of this rally, since we see it in the news every day.  Of course, we wonder whether this rally is a reflection of liquidity, economic recovery, irrational optimism or simply a recovery from an oversold market.

What’s more amazing is to look at the bond market.  I’ve always tended to think of the bond market as “smarter money” that is less susceptible to extremes.  But it’s hard to view the credit markets as more rational / less volatile when you look at how they have behaved in the past year.  Think about these facts:

1. junk bonds have rallied over 50% this year — a huge increase for securities that represent promises made by the weakest companies to repay money in a still-weak economy.  (Again, what a difference a year makes.  Last year, junk bonds underperformed Treasuries by 41%.)

2. investors have put more than $20 billion into high yield funds this year — money has rushed back into risky assets.  As I like to say in class…this my friends is the power of marketing…I’d never invest in a “junk bond,” but you could certainly interest me in a “high-yield opportunity.”

3. The compensation for risk has dropped precipitously.  One year ago, investors required an extra return of 19.9% in order to buy junk bonds rather than Treasuries.  Now, the spread is down to 7.5%.  The long term average spread is closer to 5.5%.  We’ve come a long way, but the market is still pricing in a small amount of above-average risk.  (One could argue that on a relative basis (with Treasury rates low), this spread of 7.5% is far above normal.)  Regardless, while we’re still on the “above-average” side of the spreads, the economy is weak and the majority of “easy money” has already been made.

4. investment grade bonds have also done well this year — outperforming Treasuries by 25%.  That’s an incredible amount of outperformance for buying highly rated bonds.

5. the municipal bond industry is about to hit $400 billion of annual issuance for the third time ever.  This shows large demand for these bonds.  Think about this…tax receipts are down 9%; unemployment is at 10%; municipal debt has doubled in the past ten years (to $2.9 trillion).  Who wouldn’t want to loan money to a municipality?  In addition, virtually no new issues are being supported by insurance (compared to times when close to 50% of new issues were backed by the guarantee of an insurer such as AMBAC or MBIA).

Of course, to some extent, it is unfair to compare this $400 billion of issuance to other years.  The government has subsidized much of this issuance by giving a subsidy of 35% of the cost of interest to municipalities which issue debt that is NOT tax exempt.  (This was the Build America Bond Program, not to be confused with the Bilk America program which was completely different.)  In other words, the government made municipal bonds attractive to taxable investors (increasing demand) by shifting the tax benefit for some bonds from the investor to the municipality (and allowing the municipality to issue higher interest rate taxable bonds).

6. muni bonds have outperformed Treasuries by 12% this year, the highest yearly outperformance ever.  (The previous high in 12 month outperformance was 4.90%.)

7. A few Commercial MBS deals are being securitized and are approaching issuance and they are doing so without the term-asset backed securities loan facility.  Fortunately, it does not seem like the market is ready to accept tranched securities that represent multiple properties and are not transparent.

8. Most alarming, some of the most liberal bond practices are apparently re-emerging.  There have been stories about covenant-lite bond issuances (bonds with very few terms protecting investors), bond issuances that are being used to pay dividends (in other words, borrowing money to pay to shareholders) and payment-in-kind toggle notes (which allow the issuer to repay the bond by issuing more debt; in other words, if the borrower can’t pay the investors back, the borrower will just issue more bonds rather than payment).

In sum, in the past nine months we’ve seen an incredible re-acceptance of risk.  This makes sense if you believe that the markets had priced in too much fear by the end of last year.  But, it’s scary if you think that we’re simply on our way to returning to old practices.  It’s going to be interesting to watch what happens in the next few months as bond investors start to talk more about risk again…after Dubai World and yesterday’s downgrade of Greece’s debt.

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