[Mb-civic] An article for you from an Economist.com reader.

Wed May 18 10:40:19 PDT 2005

- AN ARTICLE FOR YOU, FROM ECONOMIST.COM - 

Dear civic,

Michael Butler (michael at intrafi.com) wants you to see this article on Economist.com.

(Note: the sender's e-mail address above has not been verified.)

Subscribe to The Economist print edition, get great savings and FREE full access to Economist.com.  Click here to subscribe:  http://www.economist.com/subscriptions/email.cfm 

Alternatively subscribe to online only version by clicking on the link below and save 25%:
http://www.economist.com/subscriptions/offer.cfm?campaign=168-XLMT

A NEW CONUNDRUM
May 17th 2005  

The upsurge in new financial instruments may be changing the
relationship between debt and equity markets in ways that are still
hard to fathom 

BUTTONWOOD has been wrestling with a financial Sudoku of her own this
week. It started at a City lunch, when Jacob de Tusch-Lec, an equity
strategist at Merrill Lynch, produced a great chart showing the
different reactions of certain European corporate bonds and shares in
the market turmoil sparked by concerns over the creditworthiness of
Ford and General Motors. Credit markets screamed trouble, with spreads
widening dramatically, while share prices barely flinched. Are the
corporate-bond and equity markets decoupling in their appetite for
risk? If so, why?

This turns out to be about ten $64,000 questions rolled into one (OK,
two). First of all, it is not clear that the corporate-bond and equity
markets were ever really "coupled"--ie, linked in a predictable way.
There are plenty of reasons why it seems that they should be. They are
both, to some extent, priced off the yield available on allegedly
risk-free bonds (Treasuries). Furthermore, both stocks and bonds
represent claims on the cashflow and assets of a given enterprise, so
the holders of both should react similarly to at least some sorts of
news affecting the health of that enterprise.

There is a ton of academic research on the interaction between stock
and bond markets going back several decades. The broad picture is that
depending on inflation, mainly, and other factors, returns on shares
and returns on bonds move together at some times, are opposed at other
times, and occasionally are simply mutually irrelevant. 

For the past five years or so, however, bonds and shares have had a
fairly consistent relationship. As spreads on corporate bonds have
widened, share prices have fallen; and as spreads have narrowed, shares
have risen. This has given rise to a popular trading and hedging
strategy: going long on credit and shorting stocks in various ways. But
this strategy is coming unglued as credit spreads widen and share
prices fail to fall.

Last week's turmoil in structured-finance products and credit
derivatives has focused minds wonderfully on how some of the more
obscure financial products and operators actually work. There has been
gall galore about the Danger of Derivatives and the Horror that is
Hedge Funds. It may all be true, and there is certainly more pain to
come as the latter continue trying to unwind unprofitable positions in
the former. But is there a more general pattern about changing market
behaviour here?

Some people argue that the current decoupling of equity and bond
markets is circumstantial. The heavily advertised woes of GM and Ford
are a special situation, they say, one that does not reflect on the
health of the corporate sector in general. Many investors in equities
are looking through what they see as a temporary economic "soft patch"
to growth and profits ahead. 

Another explanation for the relative buoyancy of share prices is that
they are supported by the continued prospect of leveraged buy-outs
(LBOs), and by mergers and acquisitions generally. Some deals are
proving harder to finance than their originators thought but there is
still a wall of money out there looking for something to loom over.
LBOs are famously good for shareholders and bad for bondholders: they
are usually done at a premium to the existing share price, they
maximise returns to new shareholders too, and by loading the company
with new debt they push it a step closer to bankruptcy, to the chagrin
of old bondholders. So it is easy to see that equity and bond markets
would respond differently to them. 

THE ODD COUPLE
Buttonwood's hunch, though, is that stock and bond markets are not so
much delinking as linking in a new way. There has been explosive growth
in new financial products bridging the old gap between debt and equity.
Ten years ago, an investor eager to play the two side by side had
essentially one instrument: the convertible bond (debt switchable into
equity). Today, convertible bonds exist mainly as arbitrage
opportunities--unprofitable ones, for the moment--for hedge funds, who
own more than 80% of the $290 billion market. 

Instead, that investor has a new, equity-like instrument in the shape
of credit-default swaps, which permit him to insure against the risk of
corporate default in a liquid market now worth more than $5 trillion.
Or there are newer and less liquid collateralised debt obligations, or
CDOs, in which referenced company debt is bundled together, divided
into tranches of varying degrees of riskiness and sold to investors. As
James Bianco of Bianco Research in America puts it: "They have stripped
out the essential 'bondness' of bonds--market risk, duration,
yield-curve--and ended up with a pure credit instrument that they think
should walk and talk more like a stock than anything else in bond land."

The trouble is that credit derivatives and structured-finance products
are not equities, and when events arise that divide the sheep from the
goats--ie, the interests of shareholders from the interests of
bondholders--investors who think they are the same thing get caught
out--as they are now.

And there is no reason for this to change soon. Company bosses made
their bondholders happy by paying down debt in the early 2000s; now
they have switched to stroke-the-shareholder mode with big share
buybacks and special dividends. This--plus a wave of LBOs and corporate
raiders like Kirk Kerkorian--looks likely to continue to drive a wedge
between bonds and equities, which will cause yet more pain to hedge
funds that are already believed to have lost billions on positions that
required stocks and bonds to behave similarly. Wall Street firms and
big banks that deal with the funds will also suffer. And that is before
investors head for the exit.

This is not yet a crisis. But these are early days, and it seems that
relatively few positions have been successfully unwound yet. It is
possible that some time next autumn a couple of big banks will announce
big losses in their prime-brokerage and proprietary-trading
businesses--and if this were to raise their cost of funding
substantially, it could begin to be a crisis.

On a less cataclysmic note, however, all markets overshoot, and new
instruments and risk-control techniques, plus new participants, make it
more likely. So another possibility, suggests Mark Kiesel of PIMCO, an
American bond-investment firm, is that hedge funds and dealers will
have their wrists badly smacked, learn a lesson and dedicate themselves
henceforth to fundamental credit analysis and due diligence. PIMCO is
looking to make profits by picking up and holding debt whose spread has
widened further than it should have in the general conflagration.
Others will follow suit. As you see, Buttonwood strives always for
cheer.

- - - - - Send comments on this article to Buttonwood (Please state
whether you are happy for your comments to be published) 

Read more Buttonwood columns at www.economist.com/buttonwood[2]

-----
[1] http://www.economist.com/agenda/displaystory.cfm?story_id=2428735
[2]
http://www.economist.com/research/articlesBySubject/display.cfm?id=2512631

See this article with graphics and related items at http://www.economist.com/agenda/displaystory.cfm?story_id=3982368&fsrc=nwl

Go to http://www.economist.com for more global news, views and analysis from the Economist Group.

- ABOUT ECONOMIST.COM -

Economist.com is the online version of The Economist newspaper, an independent weekly international news and business publication offering clear reporting, commentary and analysis on world politics, business, finance, science & technology, culture, society and the arts. Economist.com also offers exclusive content online, including additional articles throughout the week in the Global Agenda section.

- SUBSCRIBE NOW AND SAVE 25% -

Click here: http://www.economist.com/subscriptions/offer.cfm?campaign=168-XLMT

Subscribe now with 25% off and receive full access to: 

* all the articles published in The Economist newspaper
* the online archive - allowing you to search and retrieve over 33,000 articles published in The Economist since 1997 
* The World in 2004 - The Economist's outlook on 2004 
* The US Election 2004 - providing dedicated coverage of the election, including articles from Roll Call, Capitol Hill's leading political publication 
* Business encyclopedia - allows you to find a definition and explanation for any business term 

- ABOUT THIS E-MAIL -

This e-mail was sent to you by the person at the e-mail address listed
above through a link found on Economist.com.  We will not send you any 
future messages as a result of your being the recipient of this e-mail.

- COPYRIGHT -

Economist.com privacy policy: http://www.economist.com/about/privacy.cfm