Clouds are gathering over the US credit market as prices on derivatives start moving out of correlation, the high-yield market strives to digest the huge automakers’ debt after S&P roiled the markets with a downgrade, and the synchrony between the prices of bonds, stocks, and credit derivatives is broken. Investors have woken up to the fact that bond investment is not that safe after all, and careful tracking of the borrower’s creditworthiness is essential.
The single greatest event in the last week’s bond market was the downgrade in S&P’s ratings of GM’s and Ford Motor’ debt to junk status. The two companies have about $500 million of combined debt (GM’s $292 million and Ford’s $161million) that has now rushed into the junk market. Although junk investors are drooling at the prospect of owning the auto-makers’ debt that has a relatively high credit quality as compared to the rest of the junk bonds, many of them have limits on how much of the same company’s debt they can own, and a certain indigestion in the high-yield market can be expected.
At the same time, tracker funds that follow a certain index might be forced to sell large quantities of GM and Ford’s bonds as they are not allowed to hold bonds that are below a certain grade. At the moment the automakers’ debt is out of the Lehman Brothers U.S. Aggregate Bond Index that tracks investment-grade securities. On July 1 the new rules take place that will compute the grade of an investment as an average of the three ratings from S&P, Moody’s and Fitch Ratings. If the other two rating agencies do not take action on the auto manufacturers’ debt before July 1, GM and Ford may get back into the index.
Related to the bond market are the prices on credit-default swaps, or CDSs, and collateralized-debt obligations, or CDOs, that have also exhibited deviations from usual patterns lately. CDSs are essentially tools for insurance against the bond issuer’s default, and the markets have now realized that they are in great need of such a cushion, causing prices on CDSs to rise.
CDOs are packages of swaps and corporate debt that are separated into tranches of varying degree of risk. The highest-risk portion has sharply lost value after the GM downgrade, causing hedge funds to bet against the less risky tranches that, as it turned out, did not lose so much of their value. The disruption of these previously stable tendencies may cause massive losses at hedge funds that by now have become major players in the US stock market. Massive exit of investors from these funds can wreak havoc in the equity markets if funds start selling their assets on a large scale.
Frightened by the decline in the high-yield part of the bond market, investors may try to take refuge in higher-graded debt, increasing appetite for triple-A or double-A rated companies. This trend is evidenced by large-scale interest in the $1.5 billion issue of Berkshire Hathaway Inc., $3 billion from triple-A-rated European Investment Bank, and $1.5 billion from double-A-rated Citigroup Inc.
Another potential safe haven may be the government bonds. The US Treasury recently took bond investors by surprise, promising to consider the resurrection of the 30-year Treasury bond, cancelled in October 2001. The demand for these bonds can be substantial given the need for longer-term securities from pension funds and other institutional investors.