A new conundrum
The upsurge in new financial instruments may be changing the relationship between debt and equity markets in ways that are still hard to fathom
BUTTONWOOD has been wrestling with a financial Sudoku of her own this week. It started at a City lunch, when Jacob de Tusch-Lec, an equity strategist at Merrill Lynch, produced a great chart showing the different reactions of certain European corporate bonds and shares in the market turmoil sparked by concerns over the creditworthiness of Ford and General Motors. Credit markets screamed trouble, with spreads widening dramatically, while share prices barely flinched. Are the corporate-bond and equity markets decoupling in their appetite for risk? If so, why?
This turns out to be about ten $64,000 questions rolled into one (OK, two). First of all, it is not clear that the corporate-bond and equity markets were ever really “coupled”—ie, linked in a predictable way. There are plenty of reasons why it seems that they should be. They are both, to some extent, priced off the yield available on allegedly risk-free bonds (Treasuries). Furthermore, both stocks and bonds represent claims on the cashflow and assets of a given enterprise, so the holders of both should react similarly to at least some sorts of news affecting the health of that enterprise.
There is a ton of academic research on the interaction between stock and bond markets going back several decades. The broad picture is that depending on inflation, mainly, and other factors, returns on shares and returns on bonds move together at some times, are opposed at other times, and occasionally are simply mutually irrelevant.
For the past five years or so, however, bonds and shares have had a fairly consistent relationship. As spreads on corporate bonds have widened, share prices have fallen; and as spreads have narrowed, shares have risen. This has given rise to a popular trading and hedging strategy: going long on credit and shorting stocks in various ways. But this strategy is coming unglued as credit spreads widen and share prices fail to fall.
Last week's turmoil in structured-finance products and credit derivatives has focused minds wonderfully on how some of the more obscure financial products and operators actually work. There has been gall galore about the Danger of Derivatives and the Horror that is Hedge Funds. It may all be true, and there is certainly more pain to come as the latter continue trying to unwind unprofitable positions in the former. But is there a more general pattern about changing market behaviour here?
Some people argue that the current decoupling of equity and bond markets is circumstantial. The heavily advertised woes of GM and Ford are a special situation, they say, one that does not reflect on the health of the corporate sector in general. Many investors in equities are looking through what they see as a temporary economic “soft patch” to growth and profits ahead.
Another explanation for the relative buoyancy of share prices is that they are supported by the continued prospect of leveraged buy-outs (LBOs), and by mergers and acquisitions generally. Some deals are proving harder to finance than their originators thought but there is still a wall of money out there looking for something to loom over. LBOs are famously good for shareholders and bad for bondholders: they are usually done at a premium to the existing share price, they maximise returns to new shareholders too, and by loading the company with new debt they push it a step closer to bankruptcy, to the chagrin of old bondholders. So it is easy to see that equity and bond markets would respond differently to them.
The odd couple
Buttonwood's hunch, though, is that stock and bond markets are not so much delinking as linking in a new way. There has been explosive growth in new financial products bridging the old gap between debt and equity. Ten years ago, an investor eager to play the two side by side had essentially one instrument: the convertible bond (debt switchable into equity). Today, convertible bonds exist mainly as arbitrage opportunities—unprofitable ones, for the moment—for hedge funds, who own more than 80% of the $290 billion market.
Instead, that investor has a new, equity-like instrument in the shape of credit-default swaps, which permit him to insure against the risk of corporate default in a liquid market now worth more than $5 trillion. Or there are newer and less liquid collateralised debt obligations, or CDOs, in which referenced company debt is bundled together, divided into tranches of varying degrees of riskiness and sold to investors. As James Bianco of Bianco Research in America puts it: “They have stripped out the essential ‘bondness' of bonds—market risk, duration, yield-curve—and ended up with a pure credit instrument that they think should walk and talk more like a stock than anything else in bond land.”
The trouble is that credit derivatives and structured-finance products are not equities, and when events arise that divide the sheep from the goats—ie, the interests of shareholders from the interests of bondholders—investors who think they are the same thing get caught out—as they are now.
And there is no reason for this to change soon. Company bosses made their bondholders happy by paying down debt in the early 2000s; now they have switched to stroke-the-shareholder mode with big share buybacks and special dividends. This—plus a wave of LBOs and corporate raiders like Kirk Kerkorian—looks likely to continue to drive a wedge between bonds and equities, which will cause yet more pain to hedge funds that are already believed to have lost billions on positions that required stocks and bonds to behave similarly. Wall Street firms and big banks that deal with the funds will also suffer. And that is before investors head for the exit.
This is not yet a crisis. But these are early days, and it seems that relatively few positions have been successfully unwound yet. It is possible that some time next autumn a couple of big banks will announce big losses in their prime-brokerage and proprietary-trading businesses—and if this were to raise their cost of funding substantially, it could begin to be a crisis.
On a less cataclysmic note, however, all markets overshoot, and new instruments and risk-control techniques, plus new participants, make it more likely. So another possibility, suggests Mark Kiesel of PIMCO, an American bond-investment firm, is that hedge funds and dealers will have their wrists badly smacked, learn a lesson and dedicate themselves henceforth to fundamental credit analysis and due diligence. PIMCO is looking to make profits by picking up and holding debt whose spread has widened further than it should have in the general conflagration. Others will follow suit. As you see, Buttonwood strives always for cheer.