FT.com
Everyone loves a sure bet, but sometimes the overwhelming favourite disappoints.
During the last few months of the global credit cycle in 2007, investment markets were focused on the US subprime crisis and the negative trend in housing prices. Flying below the radar, however, was a relatively recent innovation known as a CPDO – constant proportion debt obligation – that was rated as triple-A quality and promised returns of Libor plus 200 basis points or more.
CPDOs leveraged credit spreads by 10-15 times and rating agency models suggested little if any risk. They showed a vanishingly small probability of investment grade risk spreads widening out from the then current level of 35 basis points to the 180 bps plus level they reached at the peak of the crisis 24 months later. In other words, it was about as likely as a black swan in a world where white was the unvarying rule, to use Nassim Taleb’s famous analogy.
CPDO holders, along with investors in subprime structures, were soon to experience the hard reality of a credit cycle headed south, instead of north. Markets plummeted as investors sought the haven of government guaranteed bonds and bills. CPDO holders lost much of their money, while subprime asset backed structures traded at 20-30 cents on the dollar before central banks rushed to the rescue.
Today there is a similar CPDO character to many risk markets, and corporate credit serves as a useful illustration of a broader phenomenon. While spreads are not as narrow and prices as high as five years ago, hundreds of billions of investment dollars are pouring into corporate bonds on the assumption that credit spreads are the least overpriced asset in a world of near-zero sovereign interest rates.
Rating agency downgrades of triple-A countries such as the US, and most recently France, have accelerated the switch from sovereign debt, even producing some speculation that multinational corporations are better credit risks than top rated countries. The strong price performance of investment grade and high yield corporate bonds relative to Treasuries, Gilts, and Bunds in 2012 has only quickened the gold rush into corporate credit by individuals and institutions alike. It seems that vanishingly small probabilities of loss have returned to the marketplace once again.
Yet investors should take note that the appeal of corporate credit rests on a tenuous foundation much as CPDOs did in 2007. CPDO structures worked on a mean reverting basis that mandated the purchase of further risk assets from a cash reserve if and when credit spreads widened. A similar mechanism appears to be benefitting investors in today’s risk markets, with central banks and quantitative easing acquisitions substituting for the cash reserves of the CPDO, obviously with much more firepower.
Whenever equity prices go down or credit spreads widen, central banks inject tens of billions of additional reserves. In effect, the Bernanke, King, or potentially Draghi "put” serves to elevate asset prices and preserve the semblance of a "can’t lose”, low risk character to many risk markets.
Investors should understand, however, that aggregate credit outstanding, which in the US totals $54 trillion according to the most recent Flow of Funds survey, is levered at the same 10/15 to 1 ratio as were CPDOs. The Fed’s monetary base – its cash reserve – approximates $4 trillion. This base has permitted the expansion and ultimate maintenance of $54 trillion of sovereign, corporate, and household credit. Similar ratios exist in the UK and the eurozone.
With such substantial leverage, investors should question the sustainability of existing risk spreads if monetary policy fails to sustain current economic growth rates. Commentators, including this one, have previously noted the possible negative consequences of quantitative easing policies and zero bound interest rates.
Net interest margins for banks have narrowed, liability structures of insurance companies and pension funds are now threatened, and the real economy ultimately may be affected as layoffs continue and unemployment remains unsatisfactorily high. Zero bound yields, while initially stimulative, may eventually anaesthetise real economies, lower real growth rates and therefore threaten risk spread assumptions based upon historically healing monetary policies that have turned impotent and even cancerous.
Certainly the destructive price experience of subprime and CPDO structures in 2008 cannot be replicated by an unlevered portfolio of corporate bonds in 2012. Yet the economic growth on which their currently narrow spreads are based is levered in a remarkably similar fashion. Investors in risk markets under the assumption of minimal price risk should be wary of historical white swan investments with "grey” swan potential.
Bill Gross is founder and co-chief investment officer of Pimco.
Copyright the Financial Times 2012.
