Inside investment: Credit’s gloomy message


Andrew Capon
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Six months into a credit crunch there are few signs of an improving outlook for non-government bond markets. It is a signal equity investors would do well to heed.

One of my more successful Christmas presents last year was "The Pessimist’s Mug". It is made of glass and halfway down the mug a line is etched. Underneath that line the text reads, "This glass is now half empty". Every time the mug gets used thoughts turn to the markets. Since August, every piece of news emanating from the bond markets has been unremittingly gloomy. Stock markets, in contrast, have only just begun to play catch-up.

Maybe the knowledge that the best you can do as a bondholder is to get paid out at par creates a "glass half empty" mindset. Equity investors, by contrast, chased the MSCI World Index (Free) up to a record high on October 31, three months into the credit crunch. It has since fallen 19%, so is now skirting bear market territory. If this move feels extreme to eternally optimistic "glass half full" equity investors, it still pales by comparison to the carnage in bond markets. The iTraxx Europe index and iTraxx Europe Crossover index have just hit record spreads.

The Crossover index widened 75% from 200 basis points in early June 2007 to about 350bp at the end of the year. It hit record spreads of 578bp in the second week of February. This seems to be pricing in the inevitability of a sharp economic slowdown and a spike in defaults. Given that the constituents of the Crossover index include such familiar equity market names as German chipmaker Infineon Technologies Holding, UK engineering group Invensys and nuclear power provider British Energy, the dramatic spread widening should at least be an orange warning light to stock market investors.

However, the ability of investors in different asset classes to remain in a state of cognitive dissonance is a persistent market anomaly. It may be the glass half full vs half empty mindsets at work. Or it could reflect the structural rigidities of modern markets. In both buy-side and sell-side institutions there are fixed-income people and equity people. They sit on different desks and in different departments. Their education and training is also likely to be quite distinct.

But gloomy bond markets do have a track record of signalling trouble ahead. Back in 1997 as the final leg of the great equities bull market was just starting, global bond default rates stood close to where they are today, about 1%. However, corporate bond spreads began to widen in spite of the euphoria in stock markets. By 2003, default rates stood at 7% and stock markets were in the final throes of a bear market. Bond spreads then started to tighten, a harbinger of better equity markets around the corner.

The macro interaction between bond and equity markets can also be seen in volatility. The equity rally from 2003 coincided with remarkably low volatility. The Vix index, the so-called fear gauge of Wall Street, fell from 40% in late 2002 to 10% and lower during the early part of 2007. This coincided with a massive deleveraging of corporate balance sheets. Corporate bond issuance in the US slumped from $350 billion in 2001 to $60 billion in 2005. However, in the four quarters just before the credit crunch, ending June 2007, bond issuance soared once more to $235 billion and stock buybacks to $600 billion. The Vix soon followed suit.

If equity investors have been guilty of missing signals from the bond market at the macro level, the same is also true for individual companies. It makes sense for equity investors to be aware of negative credit watch announcements, outright downgrades and activity in primary bond markets. The last period of credit (and equity) market distress, which followed the US recession in 2001, offers many instances of a failure among equity investors to heed clear warnings from bond markets.

For example, in June 2002, British Energy tried and failed to raise $400 million from the US bond market. It was a company in the grip of a working capital crisis. The share price did not budge until August when it traded down from 145p to about 80p. However, on September 4 the company was forced to go to the UK government for a bail-out. Its shares were suspended and when it was readmitted to the market it was as a penny stock.

Before the current credit crunch and economic slowdown are over there will doubtless be similar disconnects between bond and equity markets for savvy investors to exploit. But the overall picture offered by credit markets and the experience of previous turns in the cycle suggest that equity markets are at present behind the curve. Their glass is still half full but it is rapidly emptying.