Bond Outlook October 29th

The immediate crisis of the capital markets seems well on the way to being resolved, with inter-bank lending and liquidity in the money markets much improved. We wish we could say the same about bond markets, but, alas, the easier execution that appeared last week was short-lived. Prices obtained are significantly at variance with those shown on screens. This gives rise to a secondary problem, viz., that the portfolio valuations issued by banks are 2% or 3% higher than the realisable value, as the “market price” used for valuations is precisely the unrealistic screen price. We nonetheless stress that we are still able to complete our clients’ trades; it just takes longer and the bid/ask spread remains wide.

Three causes explain the reduced liquidity of the bond markets:

• A massive reduction (probably a halving) of the capital available within banks for their market making
• Books are so full that many market makers are declining to make any sort of bid, particularly as they approach the end of their financial year
• De-leveraging by hedge funds and managed funds as they liquidate pools of high quality bonds, usually used as collateral with prime brokers, to meet margin calls and/or meet redemptions

In addition, the bond markets, with the exception of government bond markets, appear no longer yield driven. Instead, the key influence on price is the perceived credit-worthiness of the borrower. This has led to many distortions and even opportunities. One of the latter, which we have stressed this last fortnight, is to be found in bonds issued by major banks. Choose your bank carefully; the government guaranty behind many of them eliminates the credit risk. Likewise the bonds of “supra-nationals” are quite inexpensive. Bond markets clearly do not see AIG as out of the woods, even though it is majority owned by the US Government. Could the USA act like an Argentina and simply announce a restructuring at so many cents on the dollar? We do not believe it could, but enough investors do for AIG bonds to remain “cheap”.

The new Barclay’s bonds (issued in EUR) have a full UK Government guaranty, but does not the bank’s debt also benefit from a government stating clearly that no more bank failures will be tolerated or allowed? “Whatever it takes” is the principle behind the “Swedish model” now being followed universally. Obviously it is opposing opinions on subjects like Barclays’ and AIG’s credit-worthiness that makes markets, but our view is that value can be found in bond markets during these difficult times.

As we write, the stock markets have staged a major rebound. Long may the optimism that this has reintroduced last, for trust and confidence are sorely lacking at present. Let no one, however, fall into the trap that a return of optimism to stock markets obviates recession. So long as house prices are falling, and households may no longer spend more than they earn, a recession is unavoidable. Only its length and depth may be debated. What takes years to build, notably the housing bubble and excessive leverage in the finance industry, takes years to rebuild after collapse. When households move from negative saving to a 3% or 4% savings rate, the impact on spending is similar. The early part of the coming multi-year downturn (let us be optimistic in adopting that term in the hope that recession can give way to slow growth in months rather than years) is obviously dis-inflationary, or even deflationary. Food and energy prices are declining, labour has little bargaining power, and the stronger dollar is taming prices for goods and services imported to the USA.

To combat deflation, central banks will be lowering interest rates. More money will be in the hands of consumers as interest charges are eventually lowered and fuel and food costs decline. Yet most of these gains will be redirected to savings, not spending. In them lie the seeds of recovery, but their germination is far off. At some point, probably well into next year, deleveraging will come to an end, consumer spending and savings will have settled down and declining GDP should become merely stationary GDP. It is then that great caution will be required in bond markets as governments will have to borrow at long maturities, thereby steepening yield curves. We would see that as a desirable occurrence as it will let banks and financial markets return to a natural normality, as distinct for the rather artificial one now in place.

Focus

( !) Iceland: overnight rate raised 6 points to 18%

(+) Spain: Government guaranties EUR 100 billion of inter-bank loans in 2009

( !) USA: consumer confidence fell in October to 38 points, versus 61.4 in September, the lowest since its creation in 1985

(?) Governments: the combined investments of all governments amounts to at least USD 3 trillion for the bail-out of capital markets (but some estimates are as high as USD 8 trillion)

(!) Germany: Volkswagen - temporarily becoming the largest company in the world by market capitalisation, purely by short sellers being caught when Porsche announced owning 42.6% equity plus options on another 31.5%, while Lower Saxony own 20.1%, leaving just 5% free float to fill shorts

(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question

Recommended average maturity for bonds.

No change.

Currency:

USD

GBP

EUR

CHF

As of 8.10.08

2015

2015

2015

2015

As of 16.07.08

2015

2010

2015

2015

Dr. Roy Damary