As Big Brother steps up, time for credit
Want to do well out of the rolling and ever expanding bailouts? Hold your nose, buy corporate credit and try not to read any news for the next five years.
First off, let’s get one thing clear: the prospects for companies in Europe and the U.S. are absolutely awful and many will default, quite probably more than in any post-war recession.
But company debt is being priced for Armageddon, and while things will indeed get very bad we have good reasons to believe that governments will be there directing loans into the economy, effectively socializing many of the losses investors in credit would otherwise suffer.
Britain on Monday bailed out its banks for a second time in three months, taking steps including allowing its banks to insure themselves via the government for loan losses and instituting a fund to buy up to 50 billion pounds of securities to free up credit.
Job one for the incoming Obama administration will be to devise its own plan, both for how to spend the second half of a $700 billion bailout fund and what to do about its banks.
None of this may be enough for the banks, many of whose liabilities exceed their assets, a state sometimes rudely called insolvency, and many may be nationalized before they are able to earn their ways out of their current holes.
But in some ways none of this may even matter to credit investors, and could even be construed as a positive.
It is clear that we are seeing a massive transfer of risk and of doubtful loans from the banking sector to the taxpayer and further that government will step up and lend, directly or indirectly, to businesses needing credit. The sooner this happens and the greater the scale, the more positive it is, in a broad sense, for credit.
Currently the Markit iTraxx Crossover index, made up of mostly “junk”-rated credits, is priced at just under 1000 basis points, meaning that investors wanting to insure against default over the next five years must pay 10 percent per year of the face value of the debt.
Assuming that creditors will be able to recover about 20 percent of the value of the debt from any companies that go under, that 1000 basis points implies that almost half of the companies will go under over five years.
For a similar index of higher rated credits trading at 162 basis points, and assuming a much higher 40 percent recovery rate from bankruptcies, the implication is that 13 percent default — even though 20 percent of the index are banks whose creditors will almost certainly be made whole by government.
“I would guess that if these implied default probabilities come through it’s the end of the system,” said Jochen Felsenheimer, co-head of credit at Assenagon Asset Management in Munich. “If 50 percent of all European high yield companies were to default over next five years, that’s worse than the Great Depression.”
REFINANCING AND LIQUIDITY RISK
Of course those prices are not just compensating investors for the risk of default, but for uncertainty and for a variety of liquidity risks, not least that there will be many more forced sellers of corporate credit as the system seeks to deleverage.
In other words, the price might be okay on a fundamental basis, but could go lower if hedge funds or banks need to unload their very chunky exposures in order to build capital, or as the result of a forced sale.
From that perspective, any move towards full nationalization, or the quasi-nationalization of the “bad bank” schemes being considered could help to minimize that risk.
Instruments in a “bad bank” won’t be dumped all at once and may be managed to maturity, reducing the chance that big ugly investors drive prices lower once you’ve bought in.
Similarly, the chances that otherwise healthy corporations are driven to the wall by banks without enough capital to lend is diminishing, though still high. Government is stepping in and you can bet that there will be tremendous pressure to keep viable businesses alive. Heck, some non-viable businesses will be kept upright as well, which may be lousy for the economy long-term but good for creditors.
And of course, this is what the bank bailouts and central bank interventions are intended to do — to make it attractive enough that some private capital decides to step up and take risks. Equity risk in the financial services industry, no thanks, but corporate credit risk looks reasonably good.
None of this is to say that it will be a smooth ride; we are going through a wrenching deleveraging and deep and prolonged economic decline that will doubtless take down many companies. But, compared with equities especially, it just might be worth a shot.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. —