The credit bull market’s second wind
Ecuador defaulted on its sovereign debt in 1826, then again in 1868, 1894, 1906, 1909, 1914, 1929, 1982, 1984, 2000 and 2008. In practical terms, the country has defaulted on every debt instrument it has ever issued. But hope springs eternal, and surely this time will be different? Last week, Ecuador tapped the market for US$2 bln at 7.95%. If nothing else, this underlines how the hunt for yield among investors remains in full force.
And why not? The US Supreme Court has just sided with investors to banish Argentina to the equivalent of debtors’ prison, thereby ensuring that countries will be more reluctant to default in future—or, at very least, that the next country to default will not be as adversarial as Argentina and will settle more quickly. Moreover, the world’s major central bankers have promised either to keep the printing presses humming through the night (the European Central Bank and the Bank of Japan), or to keep interest rates at their floor for the foreseeable future (the US Federal Reserve). As a result, credit investors can be confident they have both central banks and the courts in their corner. So why not reach out for that extra bit of yield? A sentiment which should encourage the following:
1) The recent rebound in emerging markets to continue. After all, further falls in bond yields across the emerging markets will encourage an expansion in domestic banking multipliers and increases in infrastructure spending, triggering possible productivity gains.
2) A continued rise in mergers and acquisitions and leveraged buyouts in developed economies. Indeed, with the difference between corporate bond yields and equity earnings yields reaching extremes in most markets, the incentive to embrace ‘financial engineering’ (i.e. issuing debt to buy back equity) is at an all time high. And that’s before going into the change of fee structure at most private equity funds-which now charge management fees only on capital used, rather than on capital committed-which will only encourage private equity managers to be even more aggressive in this cycle than in the pre-crisis 2005-2008 cycle.
Of course, as students of financial history know, reaching too eagerly for yield is a recipe for disaster, if only because bond investors, unlike equity investors, are not willing to ride losses through the cycle. So the current hunt for yield across all categories of the fixed income universe might look worrying.
But in a world of zero interest rates, investors seem happy to brush their concerns aside. That leaves two possible near term risks to the current benign environment.
The first risk would be a change in policy by the world’s major central banks. The most likely trigger would be a rebound in inflation, perhaps driven by higher oil prices as the Middle Eastern conflict disrupts supplies.
Clearly it looks as if Janet Yellen’s Fed will be content to stay behind the curve, but that does not mean a rise in inflation would not impact markets. Higher prices would hurt either US disposable incomes (especially if the rise comes through prices for food, energy or housing), squeeze US corporate margins (if the rise is wages), or increase the volatility of the economic cycle (if the rise pushes companies to stockpile goods). As a result, we would not be surprised to see ‘the pick-up in US inflation’ become the market’s main source of concern over the coming months.
The second risk would be an increase in defaults. Granted, with interest rates at such low levels and economic activity still expanding, it is hard to see what the catalyst for a rash of defaults might be. Perhaps a spike in energy prices might lead to a deterioration in the current account balances of weaker issuers like Greece, Spain or India.
But apart from a rise in US inflation, or a potential spike in oil prices, it is difficult at this stage to see what could shake the complacency of all those investors reaching out so eagerly for yield. Instead, it seems far more likely that the low cost of funding combined with the stable macro environment will trigger the next wave of M&A and LBO activity. If you thought Ecuador’s ability to issue 10-year debt at 7.95% was a late cycle indicator, wait and see the rates at which investors will lend money to Ukraine, Iraq, or Afghanistan in a few months’ time!