For the past three years, especially since the collapse of US tech mania, the world has benefited from a massive credit boom, brought about by the central banks’ easy money policy. While the US Fed has raised interest rates to double what they were a couple of years ago, it is still maintaining low (inflation-adjusted) real interest rates. So low, that in fact, rates on the US Dollar are now at zero.
This environment, coupled with ten years of easy money policy in Japan, has allowed for a new kind of bubble to develop, one which has enabled low-quality corporate and sovereign issuers to have unprecedented access to the credit markets. This liquidity orgy has, among other things, allowed the equity markets to stay afloat, although they appeared to peak in early May, when two major issuers, Ford and GM were downgraded to Junk.
In the two previous years, the spread had been generously dubbed “risk free” and low-quality issuers, such as Lebanon or Turkey, had narrowed to unsustainable levels. As US long rates bottom out and begin to head higher, the implications, especially for emerging economies, will be devastating.
Trouble starts with bonds
The trouble will begin (if it has not done so already) where the good times began: in the US corporate bond market, which until recently had, on the surface, appeared calm. Profits had reached near-record levels, economic growth was strong, implied default rates were low and global demand for corporate bonds seemed insatiable. Over the past several years, corporate investors could hardly go wrong, and spreads have tightened virtually across the board. But risks lurked just under the surface. Today’s more turbulent waters have altered the opportunity and risk in the corporate bond market, making it, according to PIMCO, the worlds largest bond manager, an “adult swim only” zone.
In the past five years, there has been massive growth in credit derivatives, collateralized debt obligations (CDO) and collateralized loan obligations (CLO). The global market of credit default swaps (CDS) has grown nearly five-fold in four years and is expected to be up another 50% by the end of 2006.
All this has allowed corporate investors to gain significant exposure to the credit markets. The use of credit derivatives index (CDX) products, such as CDX IG (125 names) and CDX HVOL (30 names), has given investors greater exposure to credit risk in the corporate bond market through a simple, liquid vehicle, while the diversification of the CDX index products has allowed certain investors to feel more comfortable with credit risk.
The increased use of the CDO market has been driven by the unappetizing low, short-term global interest rates. CDOs could carve out tailored risk exposures, giving corporate investors the ability to take leveraged exposure to the credit markets through junior tranches. As spreads tightened, CDO investors took increasingly more risk in these structured products, comforted by credit ratings based on historical default rates and diversity scores. This trend in leveraged loans followed a similar trend to credit derivatives and CDOs. CLOs and loan issuance have risen due to strong demand for credit risk. This demand was especially robust from European and U.S. banks as well as hedge funds due to low, real short-term interest rates with few alternatives. The tightening in LIBOR spreads for bank paper and the decrease of protective covenants attested to this demand. However the result of the increased use of CDX index products, CDOs and CLOs, means more investors with limited knowledge of the bottom-up analysis needed for picking companies, bonds and structures, find themselves out of their depth. How big is this risk? The $131 billion of structured credit risk in CDO deals done in 2004 actually translates into $350 billion of credit risk on a delta-adjusted basis. As such, structured credit investors in junior tranches of CDOs have significant leveraged exposure to spread widening. In the corporate bond market, single-name issuer CDS spreads tend to widen dramatically as investors and dealers attempt to delta-hedge their credit risk exposure, amplifying the volatility of the market. The problem is that many of these leveraged instruments and structures are also new to the market and as such, large waves could materialize in the future as the underlying models investors use to hedge and dealers use to construct these leveraged credit products have yet to be properly tested in a storm. Of course, these waves and the resulting turbulence could result in opportunities for investors to pick up cheap credit exposure, via the CDS market, in storm-battered solid credits.
The significant change in both the growth and composition of the credit markets has caught the attention of policy makers. Chairman Greenspan, in a May 5, 2005, speech titled Risk Transfer and Financial Stability, noted, “The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress.” He further commented that “a sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds.”
Buired in the hedges
Hedge funds, while not new, have created new conditions in the corporate bond market due to their massive size and frequent trading. They attracted a record $27.4 billion in the first quarter of 2005. In 1990, there were 790 hedge funds with $39 billion in assets under management. Today, there are 7,900 funds with over $1 trillion in assets under management.
Interestingly, hedge funds are the largest users of credit derivatives and CDS. Several of the largest Wall Street firms estimate that 50-60% of their current trading volume in CDS is with hedge funds. These leveraged funds use CDX index products to gain a diversified exposure to credit, thus earning positive carry.
Hedge funds are amplifying the volatility in both the equity and CDX index options and corporate bond market, as these investors rush into and out of the water. In addition, low barriers to entry for the CDX index products have resulted in indiscriminate buying with little relative value thought or bottom-up credit research. As the markets turn, indiscriminate buyers turn quickly to sellers, creating choppy seas but relative value opportunities for those investors anchored by longer-term, top-down macro and bottom-up credit skills. While there are risks under the surface of the ocean, experienced sailors can navigate these waters and find selective treasure. In addition to hedge funds and other investors searching for credit exposure, Wall Street dealers have increased their presence in the market by using CDX index and single-name CDS products to hedge their large inventory of corporate bonds. Over the past several years, Wall Street has been in a “risk taking” mode as credit spread tightening has led to strong profits. As such, dealer inventories have risen sharply.
So far, Wall Street hasn’t been hit with many losses because credit spreads and interest rates have remained relatively low. However, this past month’s widening in credit spreads likely caught some dealers off guard and with too much inventory. As such, corporate bond traders have been told by their bosses and risk managers to reduce credit risk. As traders buy protection to hedge large inventories, credit spreads should widen and CDX index products and CDS on single-name issuers may begin to trade cheap versus intrinsic value. The dealers and hedge funds prefer to use CDX index products to hedge credit exposure due to their liquidity. Due to the large size of current dealer corporate bond inventories, credit spreads will likely be volatile over the next few months as more repositioning takes place. In addition, high yield investors are starting to sell high yield bonds to make room for any potential investment grade “fallen angels” which may be coming their way. This has likely left Wall Street with too many swimmers in the ocean.
So yes, leveraged credit investors and credit derivatives have made waters choppier and potentially more dangerous. However, it is not only what lurks in the water that makes the seas risky for swimming. Changing conditions above the surface can make the seas difficult to maneuver in too. Corporate America has had the wind at its back, in the form of low borrowing rates and a consumer-driven economic expansion, but those tailwinds are turning steadily into headwinds and corporate bond sailors should be prepared to chart a new course.
The recent good health of the corporate sector has been largely influenced by low-interest rates, rising consumer leverage and mortgage equity withdrawals, and a steep yield curve. For the last several years, tax cuts and low short-term rates have provided a huge tailwind for Corporate America. As a result of this record stimulus, profit margins are at 35-year highs.
The fragility of the corporate bond market will no doubt begin to seriously damage Emerging Market bond environment, including the Middle East. Favorable conditions in risky emerging market bonds may have already ended making managing excess deficits an even more precarious exercise. Central bankers and policy makers in the region should take heed. The easy money in bonds is off the table.