As Big Brother steps up, time for credit

By J Saft
January 21, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

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.”


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. —


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Interesting article. Any suggestions on what might be the best funds for long term investors interested in high yield debt?

Posted by Leo Gallagher | Report as abusive

“Otherwise healthy corporations” that need to float on short-term debt to survive are also known as extremely unhealthy corporations. If readers are sold on the idea of buying up debt when interest rates are very low, it seems they have never taken an introductory college course in finance. My argument is, if we rely on a variation of a pyramid scheme to support the economy, there is no net positive effect. We can unload debts on the shoulders of average investors. The seller gains but the buyer loses. The net impact is neutral. So if that is the general plan, it was devised by really dumb people.

Posted by Don | Report as abusive

This is a seductive argument, and one which has been widely adopted by financial advisers and the like. Like any investment script, who knows how it will play out – but one factor that ought to go alongside the default risk, is medium term inflation. This latter is something many commentators (including John Kemp on this website) regard as inevitable. That being the case, the 7% or 8% corporate bond yield that are softening the capital risk at the moment, may, in a 4%, 5%, or more, inflationary environment look lame. All in all, corporate bonds may be worth a go – but keep reading the newspaper, because you may want to be out long before 5 years are up

Posted by Chris Bruce | Report as abusive

Contrary to Chris’s point, we appear to be entering a deflationary cycle, making these bonds even more attractive. If the hypothetical 5% inflation comes to pass, look elsewhere, but that’s clearly not the case now. An 8% bond becomes a 10% bond when deflation is running at 2%.

Posted by P de Villiers | Report as abusive

Nobody knows whether we’re headed for inflation or deflation, you can make a good argument for either. Chris is right to point out that if the Fed and the fiscal authorities can get any velocity going, those high yields won’t seem so high any longer. On the other hand, if the programs don’t work and deflation sets in, one has to remember where it is coming from. The deflation we have seen so far looks like a result of debt destruction. Should this continue, it would presumably reflect higher corporate default rates and wipe out a lot of the high expected coupon payments. So, I wouldn’t necessarily expect deflation to be a boon for corporate debt either.

Posted by Tom | Report as abusive

the prices declining is deflation but at the same same time since october the money supply has risen by over 70 percent: the effect of this inflation are not being fealt at present but with the presses running full time there will be a crisis in confidence in the dollar soon…i would not touch bonds they will crash, its the end game starting up commodities like gold will be a safe store of wealth

Posted by brian mcnamee | Report as abusive

my question is: if these bonds are really so interesting and worth buying, why the current investors want to sell them? the fact that there is huge supply in the market in spite of all the positive factors being explained in this note suggest that there is something fishy.

Posted by kushal | Report as abusive

It is absurd for governments to nationalise bad debts, to bail out banks and financial institutions. This will just free up irresponsible companies to make the same mistakes over again.

The US government has to nationalise the banks, and failing financial institutions. At least that way they are left with assets which they can privatise, to recoup their investment, when market conditions are favourable.

Posted by Emo | Report as abusive

Well the whole world doesn’t know what they are doing but UK is in the most worse shape unfortunately. Joe Stiglitz says not spending money is a problem but as we know spending is also a problem “between the hard and the rock place”. Every country now the banks are (temporally) in the hands of the state.

Money has to pored in but with which argument or economical theory? The do it because everyone else is doing it, that’s my conclusion. It’s the same as Greenspans inflating, inflating low interest rates which exactly (well there are more factors) caused this! There won’t be an alternative approach before the whole system collapses again with the next treasury bubble and dollar fall.

Joe Stiglitz; “in the long run we have to face the depth”

I like to add that the situation in which taxpayers have to rescue the financial business with future generations of taxpayers having to pay the bill is
simply ridiculous! It’s the biggest scam of the 21 century which will unravel itself in the coming months – years. The rightious way to have handled this situation in my opinion is the way they handled the Tulp Mania in 1637 in Holland (the Netherlands) ania

I proposed this (but who am I) far back in 2008 to throw away the old book keeping and start all over again. I will assure you that this eventually will happen anyways but on the hard way cause it’s already to late for the soft way with all these reckless bailout spending. A world currency or dollar devaluation is exactly the same so, why didn’t they do it right from the start? Cause they are (and the world also) are out of their “sane lets be real minds”, it’s mass delusional psychology in my humble opinion.

The will try to inflate themselves out of depth!

Posted by Youri Carma | Report as abusive

Does 10% per annum seem such a great return in the current environment? If (when) inflationary shocks occur, which is very likely as the central banks make various attempts to get money moving again, there will be some companies with lower leverage and less variable unit sales which will do very well. If you’ve got a 5 year plan maybe to sit and wait for a few years but then buy equity. They key now is not optimal return, but optimal liquidity. There’s no point have a bond yielding 10% pa if it take 10 days to cash out if the market turns and it’s time to get out of the currency…

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