Dead man's curve
11:16 EST Thursday, Nov 09, 2006
I was about 800 words into a column ranting about Ottawa's plan to tax income trusts when it occurred to me that the subject has been already flogged to death in these pages all week and the last thing my editor was going to want was yet another tirade on the subject, so I'll limit myself to one observation.
Harry's First Law of Government Finance says that whenever you hear a finance minister ? or any politician, for that matter ? use the words "taxation" and "fairness" in the same sentence (as Jim Flaherty did last week), you'd better keep a firm grip on your wallet. Making the tax system "fairer," in the Orwellian language of politics, usually means you are about to get hosed.
I'll reserve judgment on Messrs. Harper and Flaherty until I see their next budget, but I'll tell you, if they don't get it right, the next time I'm in a voting booth, I'll be looking to mark my X in the box that says "None of the above." Actually, now that I think of it, that's one electoral reform that I'd really like to see.
Anyway, I was talking to a bond portfolio manager of my acquaintance this week, and he admonished me for the lack of "doom and gloom" in my recent scribblings. "Doom and gloom, dude," he said, "That's the ticket. I like it when you write about doom and gloom. You're developing an entirely too rosy outlook on things."
Huh! I had no idea. Well, I can do doom and gloom. Doom and gloom is easy. Let's see, now. ..... I was reading this Standard and Poor's report the other day about how "U.S. credit quality is in a 25-year retreat toward junk."
According to S&P, almost half of all U.S. companies are now rated below investment grade. As of September, a record 49 per cent of all issuers were rated double-B plus or lower, up from 48 per cent last year and a low of 28 per cent in 1992. The number of AAA rated triple-A rated issuers dropped to 18 from a peak of 24 in 1998. Sixty-one per cent of all first-time issuers in the U.S. bond market are now rated single-B. In fact, single-B, a highly speculative rating, is now the largest category of debt rating, comprising 27 per cent of all issuers. That's in the United States, but Europe is on a similar trend, though at a slower pace.
Now, it's not so much that corporations are dodgier credits nowadays than they used to be, although, let's face it, after years of loose money central bank policy, share buybacks, restructurings, leveraged buyouts, takeovers and global competition, the old corporate balance sheet just ain't what it once was.
The big factor in this is all that excess liquidity in the global financial system. It has to go somewhere, and a lot of it has gone into the bond market, which has pushed yields lower and flattened the curve. As a result, in order to find decent bond yields, investors have been forced to go further out the credit spectrum, and, handily, they've all managed to increase their tolerance for risk. This has crushed credit spreads, to the point where there isn't a lot of difference in yield between high-grade and junk-grade bonds any more. Or, at least, not as much as I'd need to buy junk bonds.
The basic theory of junk bonds is that if you buy, say, some of each of 100 different ones, even if 2 or 3 per cent of them go into default, the extra yield you earn on the rest more than makes up for the loss. It's true that historically that's been the case, but as politicians like to say, that was then, and this is now. Leverage World, an independent research firm specializing in high-yield and distressed debt, says that if the U.S. economy goes into recession, the junk bond default rate could rise to as high as 15 per cent. Or, as Standard and Poor's definition of a single-B rating points out, "Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation."
Of course, being prudent professionals, the Street has also invented all kinds of nifty derivatives to insure themselves against all that extra risk ? things such as credit default swaps. There is now something like $26-trillion (U.S.) worth of credit default swaps outstanding. Frankly, I think the phrases "26 trillion dollars" and "derivatives" go together pretty much like the phrases "teenage boys" and "car keys."
Meanwhile, for those stodgy investors who still insist on investment-grade bonds, they're mostly limited to debt issued by financial institutions ? you know, the same outfits that are on the other side of the $2-trillion worth of option-ARM (adjustable rate mortgage) loans whose monthly payments are set to skyrocket next year, just as housing prices make their next gap down. Oh, and they are also the same institutions that are intimately involved in that $26-trillion in credit default swaps. Think of it all as the financial equivalent of adding "beer" to the equation "teenage boys plus car keys."
Now, I'm no rocket scientist myself, but I figure that sooner or later it's inevitable that those hypothetical teenage boys in that car with the beer find themselves going through the guardrail on Dead Man's Curve. When that happens, try to make sure you aren't riding in the back seat.