It all sounds worryingly familiar. Mutual funds are experiencing record inflows, issuance is at record highs, prices of the securities concerned seem to be immune to bad news, and the investment banking divisions covering these popular products are going gangbusters.
This time, it’s not equities that are booming, it’s bonds. Will they crash too?
According to the Investment Company Institute (ICI) in the US, there was nearly $150 billion net new cash flow into US bond funds last year, following nearly $100 billion in 2001. Inflows into government bond funds topped $40 billion in the second half of last year, money market funds are doing well, savings rates are up. Insurance companies also have a surfeit of cash to invest, and they, along with almost everyone else, are avoiding stocks.
Compare that to equity inflows at the height of the bubble: more than $300 billion went into equity funds in 2000, according to the ICI.
Bond issuance has responded to the demand for product. In the first two months of the year $125 billion was issued in the US, 25% more than in the same period last year. A desire to fund early before the invasion of Iraq surely played a role, as did the lure of historically low interest rates.
In March, the leading US investment banks with first quarters spanning December 2002 to February 2003 reported quite sparkling results. Lehman and Goldman posted returns on equity of 14%, Morgan Stanley posted 16% and Bear Stearns managed a stunning 20%. Remarkably, these results come in a quarter when completed M&A volumes were running at a mere 20% of the peak seen in 2000 and equity capital markets were lousy. There wasn’t a single IPO in the US in January – the first year this has happened since 1974 – and only four deals in February. Secondary market equity sales and trading volumes are also declining as investors progress from panicked withdrawal to passive funk.
The good news was in everything related to fixed income. Extreme risk aversion among investors induced a 50 basis points rally at the short end of the US treasury market and the search for yield contributed to a 30bp tightening in high-grade spreads – covering everything from agencies to corporates – and 70bp in high yield.
The banks are delighted with such respectable returns at the low point in the cycle. The worry is that it can’t last and that the fixed income bubble will burst before equity and M&A revives.
What would pop the bubble with a very loud bang would be a sudden jump in interest rates.
Economists are pondering the impact of a weak dollar, rising oil prices and the potential for a sharp economic rebound in the – increasingly unlikely – event of a swift and happy outcome in Iraq. But for now, most economists are downgrading growth forecasts for the US.
A prolonged war may further hurt consumer and business confidence. Worries about resurgent inflation are receding. The Federal Reserve appears incapable of articulating a monetary policy bias: a comfort to bond market bulls.
If a spike in interest rates doesn’t prick the bubble, what else might? Perhaps a rising supply of government bonds: from the US to fund the war; from the UK to fund unproductive public spending; and from European governments, which have torn up the stability and growth pact and need to fight off recession.
The worry for corporates is that many still urgently need to raise new equity to shore up their balance sheets but they can’t because investors won’t buy new issues. Investment bankers now talk hopefully of profiting from the re-equitization trade towards the end of 2003, after investors have seen more signs of economic stability and corporate resilience. Of course, if that happens then the bursting of the bond market bubble is more likely.
Investment banks can content themselves that diversity has saved them. But investors who sold equity well after the peak had passed and bought bonds in the past few months, are left on a knife edge.
