WHAT a difference a year makes. Each year, Jim Reid and his colleagues at Deutsche Bank AG publish an influential analysis of credit markets that puts current yields and fundamentals in historical perspective.
If you buy a bond from a company that might go bankrupt, then you expect to receive a higher interest rate. In an efficient and well-functioning market, the higher yield in a diversified portfolio of such bonds should offset the losses you would incur over time because of defaults. If a 10-year Treasury is yielding 4 per cent, then you should only buy a 10-year bond from a company with a good chance of defaulting if the yield is significantly higher than 4 per cent.
How much higher? That is exactly the question addressed with impressive analytical precision by the Deutsche Bank report. It provides a great thermometer reading of the bond market. The report calculates how large the default probabilities must be to command the current yields on different classes of bonds.
A comparison of this year’s report with last year’s provides a striking and even startling view of how rough the credit crisis has become.
‘Last year, spreads on high-yield bonds were so low that you could have expected to lose money if you purchased them, even if they defaulted at the lowest rate in history,’ Mr Reid, head of fundamental credit research at Deutsche Bank in London, said in an interview last week. ‘This year, spreads are so high that you can expect to make money even if they default at the highest rate in history.’
That’s one way to say that corporate bonds look like a good buy right now. If you think about it in terms of implied default probabilities, the analysis gets downright shocking.
Looking at the iBoxx Dollar Liquid Investment Grade Index, Mr Reid and his colleagues estimated that current spreads imply that 19 per cent of five-year bonds in the index will default during the next five years. This is an unbelievably high rate.
The highest default rate for these bonds was just 2.4 per cent, and the average rate since 1970 was 0.8 per cent. From Citigroup Inc to JPMorgan Chase & Co, financial firms have been particularly hard hit in this crisis. This is apparent in Mr Reid’s numbers as well. Current prices suggest that 21 per cent of five-year bonds in the financial industry are expected to default during the next five years. This places financial bonds – the debt of some of the bluest of blue-chip firms – smack dab between single A- rated bonds (which have an implied expected default rate of 20 per cent) and BBB-rated bonds (which have an implied expected default rate of 22 per cent).
Those implied default rates are also way outside of historical experience. The highest five-year default rate for A- rated bonds was 2.5 per cent. The most for BBB-rated bonds was 5.8
per cent. The mayhem, of course, hasn’t just affected five-year bonds. Longer maturities have even more extreme default scenarios priced in. Current prices suggest that 29 per cent of corporate bonds will default over the next 10 years. That rate is six times higher than any 10-year period since 1970.
It is worth noting that these default probabilities are probably somewhat inflated, as default risk isn’t the sole consideration when looking at bond prices. Even so, the market is pricing in a bond-market catastrophe that’s far worse than anything that has ever happened.
What should one make of these numbers? Even an optimist should be startled by what bond markets are saying. The market isn’t just expecting a downturn; it’s expecting a calamity. A University of Chicago-style believer in the absolute wisdom of markets should be loading up on canned goods and checking the fortification of his underground bunker.
A more rational response to this report might be to recognise that markets, while they are right on average, tend to overreact in both directions. A person with this sentiment would have looked at last year’s prices and concluded that they were irrationally low. Now, panic has set in and spreads are way too high, pricing in something close to the end of civilisation. The world economy has survived wars, oil embargoes and even a depression. That suggests that it can survive this, too, even if things get worse before they get better. If you believe that, then a buy-and-hold strategy on bonds looks about as good as it ever will. If enough investors see that, then this credit crunch might finally begin to ease.
Kevin Hassett is a Bloomberg News columnist. The opinions expressed are his own
Source: Bloomberg (Business Times 5 Mar 08)