Tuesday, February 6, 2007

The Hybrid Market

The astronomical rise of credit derivatives from less than $1 trillion in 2001 to likely $35 trillion at the end of 2006 has undoubtedly been the hot topic in finance. Credit Default Swaps are responsible for bringing down the cost of borrowing to record lows - investment grade companies now pay around 30 basis points - just 0.30% - over what the US Treasury pays to borrow. Lower rated, or "junk", bonds are issued around 235 basis points over Treasurys.

So here is a question:

Does it pay to invest in cash bonds anymore? If a bond buyer is paid so little to provide his capital to a borrower, why bother? Why not just buy a Treasury bond?

For one, that will result in even lower returns and for another there just aren't enough Treasurys issued, even if one wanted to do that (I never thought I would ever say that the US government doesn't have enough debt!).

So what are bond investors to do? In this brave new world of derivative finance what they do is buy stocks, often coupled with CDS's. The rationale is that current stock prices, just like bonds before them, do not adequately reflect the low risks associated with owning them - i.e. "low" stock prices are a reflection of high risk premiums. Buy buying stocks plus cheap credit protection via the proper CDS's they aim to get the upside potential of stocks and the downside protection of bonds.

This strategy results in a circuitous logic: "bond" investors rely on the stockmarket for signals of financial risk and "stock" investors follow bonds (or rather CDS's) for the same thing. Instead of a traditional countercyclical relationship between stock and bond markets, we now have a self-reinforcing, feedback loop hybrid market for which perceptions can only be always positive - or always negative once it turns.

1 comment:

Anonymous said...

Sounds like they all look at the same data from the "ministry of truth", the happy times will continue.
As you have so well outlined the landscape before us it gives me a headache just thinking of the absurdity of all these financial "investments". I think it will not end well except for the ones at the top of the food chain.