Analysis: Two years on, credit rallies, and it’s no bubble

By Alex Chambers

LONDON (BestGrowthStock) – Bond investors’ increasing appetite for risk, which has triggered a wave of cheap finance for companies, appears sustainable because it is driven by a shortage of supply and credible alternatives.

Near-zero interest rates and quantitative easing have opened the floodgates to allow cash to flow to banks and corporations at lower cost — policymakers’ key objective.

The past month saw Australia’s Santos sell a deeply subordinated perpetual bond, effectively equity capital, paying 8.25 percent.

But for Santos the cost falls to just 6 percent because debt is tax deductible, compared to the 12 percent it would have cost to raise true share capital.

Against a backdrop of bond deals that are reminiscent of the great bull credit market that ended in 2007, it is unsurprising that some are unsettled by unconventional monetary policies.

This week, new vice chair of the U.S. Federal Reserve Janet Yellen said in her first speech it was possible for low interest rates to contribute to financial bubbles.

But one key element has been stripped out — leverage. And credit bubble theorists have little supporting evidence of asset inflation in the real economy.

“There are differences between now and 2006. Back then, corporate leverage was increasing, and external leverage was used to maximize returns, in the form of structured credit vehicles,” said Goldman Sachs strategist Alberto Gallo.

“Now, credit quality is improving, and demand comes from un-levered investors.”

Furthermore, unlike the pre-crunch era when the credit bubble boosted economic growth and financial assets, now both private and public sectors are delevering, cutting systemic risk.

Strategists at Citi expect European banks’ asset/equity ratios to fall to around 23 in 2010 from a peak of 29 at the end 2007.


Investment-grade bluechips, who have amassed massive cash piles, are no longer borrowing in the bond market at a rate that can satisfy investor appetite.

By the third quarter, their volumes fell 7.5 percent compared with the same period in 2009.

And even when they do issue they can do so with record low coupons, with Microsoft paying just 0.75 percent for a three year bond in September.

This has created a technical imbalance, prompting fixed income fund managers to cast their eyes elsewhere in a search for investments.

The benign backdrop and low yields helps explain the boom in riskier bonds such as the corporate hybrid for Santos, and also sub-investment grade and ultra-long dated deals.

Pimco’s co-chief investment officer Bill Gross noted on the bond fund’s website that investors are “faced with 2.5 percent yielding bonds and stocks staring into new normal real (economic) growth rates of 2 percent or less.”

Investor concerns about sovereign default and fears of a double-dip recession have roiled stockmarkets this year.

“The volatility in equities is what a lot of investors are concerned about — they want a little bit of risk with manageable volatility,” says Sarang Kulkarni, a European credit fund manager at Schroder Investment Management.

Bonds are sought after precisely because the macro outlook is fragile, with the long-term prognosis of the euro zone’s periphery far from healthy.

“There is a lot of demand for fixed income because we’re in a low growth and low rate environment,” says Goldman’s Gallo.

He argues that many investors are comfortable, given low inflation and defaults, and that historically corporate bonds perform well when economic growth is between zero and 2 percent.

And yet purchasing investment-grade bonds currently offers thin returns of roughly 3.5 percent in dollars and 3.1 percent in the euro zone, a sharp drop from October 2007 when the yield was 5.96 and 5.12 percent respectively.

“Are they really overvalued? Maybe, compared to historical norms, but they seem to be reasonably well priced given the outlook for inflation and growth. Most corporates will continue in shoring up their balance sheets,” said Kulkarni.

He said that much of the gains made by bonds have been down to the strong performance in underlying government bonds.

Both Kulkarni and Gallo argue that it will be hard for investment-grade bonds to see double-digit returns in 2011 as has been seen in the previous two years.

Barclays Capital’s Euro aggregated corporate index (investment grade) has returned 7.24 percent year-to-date, compared with 15.7 percent in 2009. The corresponding high-yield index has returned 16.55 percent this year, even if it is down from 76.1 percent in 2009.

Against this backdrop the boom in riskier bonds such as sub-investment grade, corporate hybrids and ultra-long dated deals makes a lot of sense.

Mexico’s fresh 100-year bond, which yields just 6.1 percent, was another which highlighted the fact that the risk versus reward trade-off is skewed in borrowers’ favor.

Sub investment grade issuers, in particular, have benefited from investors’ search for yield. But investors’ willingness to lend is by no means indiscriminate, as it was before the buggle burst, when every credit could find a price.

Now weak banks and sovereigns, such as Greece and Ireland, in the euro zone cannot find buyers, and even high grade companies have found demand wanting if spread is lacking.

(Reporting by Alex Chambers, editing by Sitaraman Shankar)

Analysis: Two years on, credit rallies, and it’s no bubble