31 December 2007 – The Aleph Blog

Two Final Notes in 2007

Posted on 31 December 200731 December 2007 by David Merkel

When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click to many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 90s. For the US, that will peak in the early teens. Now, it is possible that the more market-oriented culture of the US has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the US. This is also a cautionary note to those that thing that lower short-term rates will benefit the US markets; after all, what good have they done for Japan?

Thanks to all my readers, and especially my commenters. You make the blog worthwhile to me. I hope to better for all of you in 2008. Happy New Year to all of my readers, whether here, or at other sites that use my posts. May God bless you richly in 2008.

What the Treasury Yield Curve is Telling Us About Corporate Bond Yields

Posted on 31 December 2007 by David Merkel

I learned from a dear friend of mine who manages high yield at Dwight Asset Management (one of the largest fixed income management shops that you never heard of), that with high yield bonds, spreads over Treasuries aren’t the most relevant measure for riskiness of the bonds.? Because they are more equity-like, high yield bonds have intrinsic risk that is independent of the level of yields in high quality bonds, the leading example of which are Treasury bonds.

In general, Treasury bonds can be thought of as a default-free debt claim (not perfectly true, but people think so), while other bonds must carry a margin for default losses.? As one moves down the credit spectrum, the riskiest corporate bonds act like equities, largely because as a company nears default, the equity of the firm is worthless, and true control of the firm is found in some part of the debt structure.
Spread curves of high yield bonds tend to invert when the Treasury yield curve is steeply sloped. ? The slope of the Treasury curve for that effect to be active now, particularly since high yield spreads have widened out from earlier in 2007.? The effect can be seen though, in higher quality investment grade bonds.? Given the lower spreads over Treasury yields on investment grade debt, the relative uncertainty in the present economic environment, and the lack of liquidity in the short end of the yield curve, it’s no surprise to find the spread curve inverted on Agencies, and flattish, but still positively sloped for single-A and BBB corporates.

What this means is that there are intrinsic levels of risk affecting the yields on high quality corporate debt, lessening the positive slope of their spread curves, or with agencies inverting the spread curves.? As the Treasury curve gets wider in 2008, those corporate? spread curves should flatten, and then invert, unless more macroeconomic volatility leads to still wider credit spreads, or a rise in short term inflation expectations causes the yield curve to stop widening.

Another way to say it is that if the short end of the Treasury yield curve falls dramatically, don’t expect the yields corporate debt to follow suit to anywhere near the same degree.