DEBT: The Poison and the Antidote

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Do not be fooled by the recent surge in share prices. The depths and breadth of the current recession is as yet unfathomable for even the shrewdest of economists and investors. Unlike most economic contractions, which are usually fueled by rising inflation and vanquished over time by graduated interest rate hikes, the financial crisis that bedevils us today is a consequence of unsustainable indebtedness. Until American banks and households right their balance sheets, a process that could take years, lending activity and consumption will stagnate and the economy will continue to struggle. Just this week, it was revealed that the Federal Reserve Bank sharply downgraded its outlook for 2009 and forecast flat growth for much of 2010.

With fundamentals this bleak, investors looking for opportunity in the US market must tread warily. For the time being, the emphasis is on investment-grade dollar-denominated debt – sovereign, corporate, asset-backed – that offer sturdy yields over a two-to-five-year horizon. Successive stimulants like last week’s $300 billion currency swap between the Federal Reserve and its European counterparts appears to be steeling investors, but for top-quality instruments only.

For the truly risk-averse, there is the redoubtable ten-year US Treasury bill, which due to a massive flight to quality now offers a miserly yield of three percent. In fact, most sovereign debt issued by G-10 countries is thought to be overbought – even US banks, at least the solvent ones, are guaranteeing interest rates of about 2.0 percent on a two-year certificate of deposit – so many investors are turning to the so-called “tier two” issuers, which includes emerging markets like Mexico and the Philippines. The sale this week of a $3 billion South Korean sovereign bond was so successful it was enlarged by a third of its original offering. Demand for the five and ten year Korean notes, which were issued respectively at 400 and 438 basis points – or 4.0 percent and 4.38 percent – over same-maturity US Treasuries, revealed how hungry investors are for high-grade sovereign paper.

The same goes for corporate debt. Listed companies issued $200 billion in bonds in the first quarter of the year, according to Thompson Reuters, compared with $188 billion during the same period last year. Though economic fundamentals remain bleak, investors are snapping up two-to-three-year paper issued by companies with healthy balance sheets and strong cash flow, many of which offer yields in the double digits. Investors tout debt from companies like soft-drinks producers Coca Cola and Pepsi, and fast food outlets like McDonald’s, which are such an immutable part of America’s consumer culture that they tend to weather even the most severe economic downturns. Utilities like gas and telecommunications companies and health care providers are also considered safe harbors in this still-fragile market, as are resilient financials like JP Morgan and Wells Fargo.

On the other hand, investors are less enthusiastic about heavy-goods manufacturers like Caterpillar; the torrent of funding earmarked for public works under President Barack Obama’s economic stimulus package doesn’t necessarily imply increased sales of heavy equipment, as many construction and engineering companies are likely to make do with what they have for now. The same it true for arms makers like Boeing and Lockheed Martin, given the steep cuts in the Defense Department’s acquisition budget proposed this week by US Secretary of Defense Robert Gates.

Government intervention in the housing market, however, has restored the image and the appeal of mortgage-backed securities, the abuse of which by lenders was a root cause of the financial collapse. Under the $1 trillion plan, the Federal Reserve buys pools of mortgages issued by federal home-loan agencies and resells them to investors. As the value of the mortgages increases, interest rates for existing mortgage debt and new home loans declines – to as low as 4.5 percent this week, down from pre-crisis levels of about 6.5 percent. A government-based security with a yield that exceeds long-term US Treasuries by some 150 basis points is the closest thing to a sure bet in this market, and the lower rate has encouraged millions of Americans to refinance their homes.

Investors also suggest diversifying a defensive portfolio with inflation-linked bonds. Notes like Treasury Inflation-Protected Securities, or TIPS, offer a lower coupon than US Treasuries but the principal is indexed to inflation, which makes them particularly attractive among investors who anticipate a sustained rise in consumer prices. Though stagflation appears to be the greater peril today, economic recovery and the enormous amount of public debt the US government has taken on to engineer it will no doubt resurrect inflation eventually.

The same goes for commodities, particularly agricultural products and building materials, according to Suhail Dada, executive Vice President and head of Middle Eastern and North African markets for Pimco, the world’s largest bond trader. “Given all this money that is being printed,” said Mr. Dada, “there is a very good chance for inflation under a three-to-five year scenario.”

Is there no appetite in this market for equity? Yes, albeit of a suitably conservative nature. Preferred shares – hybrid stock that carries no voting rights but which pays a bond-like fixed yield – offer double-digit returns. Banks such as JP Morgan and HSBC account for all but a small fraction of the demand for preferred shares.

Needless to say, volatile and uncertain times like these calls for cautious investment strategies. With even the Federal Reserve anticipating a dreary economic outlook, it is no wonder institutional investors favor bonds over equity. Even the commercial real estate market, where prices are lingering at historically low levels, has yet to find a bottom. Debt is not the most glamorous instrument – unlike stocks, which offer unlimited upside (and downside), the most you can recoup with a bond is principal plus interest – but considering the environment, it does offer safe refuge against the storm.


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