Harry Koza's Weekly Column
May 18, 2007
Happy Friday, Gang.
Here's this week's rant from the Globe. The newspaper version has the unwieldy title "Outperforming the herd means you've got to walk further out the edge." I don't know where they get these things. Anyway, here's this week's opus, and it will be the last one until the 2nd week in June - I need a hiatus to work on my speech for the ABS conference in Whistler, June 3-6. (Maybe I'll see you there). HK
PS - Padang-Padang, by the way, is a beach in Bali, said to be one of the world's gnarliest surfing spots. I'm taking the word of some surf dudes on this, in case anyone decides to argue this point, because, to paraphrase Apocalypse Now, 'Harry don't surf.'
|Corporate bond watchwords |
13:53 EST Thursday, May 17, 2007
TORONTO (GlobeinvestorGOLD) - The sky is falling, the sky is falling! We must run and tell the King! Never mind, it's just slabs of marble spalling off from First Canadian Place. Sorry, I didn't mean to startle you. Man, you guys are sure jumpy these days.
Can't say I blame you. I mean, government bond yields, frankly, suck lately, with Canadas desultorily bouncing back and forth in the same rut they've been in for the last six months, with little opportunity to make any serious jack trading them.
Sure, you can trade the range, put a bunch of singles on the scoreboard, and make the index return of 4 or 5 per cent, but it's like watching paint dry.
Paul Samuelson, the author of Economics, a doorstopper that's been the bane of millions of undergraduates over the years, once said, "investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."
He was right, of course, but every trader, down in the cockles of his heart, assuming he has one, wants to hit home runs. Singles are okay, but if you want a bonus that's so big it has to be expressed using scientific notation, you have to hit homers, or even better, some of those Peter Lynch 10-baggers. Those arriviste hedgies and private equity Geckos are buying Lamborghinis in six-packs, for Pete's sake, while bondies are sitting around waiting for something to happen.
Something will, eventually, probably one of bond trader and author Nick Taleb's "Black Swans," an exogenous event to spark the mother of all trend lines, some tsunami-like wave that you can carve like the beach-break at Padang-Padang.
In the meantime, if you want to outperform the herd, you've got to strap on some yield, so everybody and his dog has crowded into the corporate bond market, loading up on spread product and generally driving spreads tighter.
That means you've got to reach a little further to get some spread, a little further out the risk continuum, out where bonds are a bit less like watching paint dry and a little more like doubling up on a hard eight at Caesar's Palace.
Naturally, the investment community has responded to the demand for yield by issuing a veritable junkyard of high-yield debt, about half of it to finance the $366- billion (U.S.) worth of leveraged buyouts done so far this year.
Even with all that, the relentless demand for extra juice has driven spreads to levels that haven't been seen in 10 years. The average yield spread over Treasuries of a single-B rated junk bond has squeezed in to 261 basis points, the lowest since 1997. Back in 2002, when WorldCom and Adelphia went tapioca, there was $166-billion in junk bond defaults. Then, the average spread on a triple-B rated bond (which is investment grade, not junk) was roughly 100 basis points higher than a single-B bond -which is definitely junk, only a couple of ratings notches from the level where bondholders begin to ask themselves, "What's that funky smell?"- today.
So what if you're not earning a yield commensurate with the risk? Default rates are the lowest they've been since the dinosaurs walked. What could possibly go wrong?
Admittedly, all these LBOs have put the whammy on spreads of bonds hitherto-considered investment-grade, such as ones issued by, say, Sallie Mae, or Bell Canada, or any Canadian telco for that matter, not to mention any other issuer even remotely bruited as a possible LBO candidate. That's got people suddenly remembering the maxims of Investing 101, like the three most important things to consider when investing in corporate bonds: credit, credit, and credit.
Parts of the market seem to have forgotten that axiom. This week, I noticed the ominous and FWSS (fraught with semiotic significance) return of the PIK. PIK stands for payment-in-kind, a junk bond feature that enjoyed a spasm of popularity just before the last time the junk market blew up. Nowadays they're referred to as "Toggle" bonds, which is like naming your Rottweiler "Cuddles."
The basic idea is that you lend someone money and if they can't make the interest payments, they just give you more of the bonds they can't pay the interest on. That's no problem, since nobody defaults any more, or at least, not so far anyway. This is pretty much the principle behind the sub-prime option-ARM (adjustable rate) mortgage, and look how well that's turning out.
Of course, nowadays we have all kinds of nifty derivatives to make all that nasty risk magically go away, or at least get off-loaded onto someone else, which is close enough. I visited my friends Marley and Scrooge (not their real names) on a bond desk downtown this week and they were handing out buttons that read, "I use derivatives. You got a problem with that?"
Well, not yet, maybe, but as Jake and Elwood Blues might have said, had they been walking by First Canadian Place earlier this week when a big chunk of Italy's finest Carrera marble smashed into King Street, "Dudes, it's a sign from God."
Sr. Market Analyst,
36 Green Meadow Crescent,
Richmond Hill, Ontario,
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