Overheating Credit Markets 'One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability.' Jeremy Stein, US Federal Reserve Board Governor 38 'This is the hardest time to be an asset allocator. Normally, you find that safe-haven assets are expensive and riskier assets are cheap and vice versa. But today, largely because of the central banks around the world, we've got a very distorted opportunity set, such that there is nothing you can buy and hold.' James Montier 'We are concerned by the growing downside of zero-based money and QE policies among them a worrisome distortion in asset pricing, the misallocation of capital and ultimately a dis-incentivizing of risk taking by corporations and investors.' Bill Gross 'If something cannot go on forever, it will stop.' Herbert Stein 'Never underestimate the value of doing nothing.' Winnie the Pooh RE:CM holds minimal funds in bonds at present. This article discusses how we see the current credit market conditions and explains why we choose not to participate for now. Credit markets are currently artificially priced Both developed and emerging market economies are currently characterised by record low interest rates and a global search for yield. Stimulus programmes like quantitative easing (QE) introduced in the US, Europe and Japan have injected increased liquidity into global financial markets and kept interest rates low in these economies. Central bankers manipulate monetary policy in an attempt to stimulate economic growth through increased spending and bank lending. The result is that markets distort as continuous intervention by central banks suppresses the yields on traditional safe haven assets and prevents efficient price discovery. The entire yield curve shifts down as the risk-free rates of government bonds are depressed and yield seeking investors are forced towards higher risk assets. Bond investors refer to this behaviour as 'reaching for yield', where capital is allocated to riskier assets in order to generate the returns they were accustomed to earning before the decline in yields occurred. Following the global financial crisis of 2007/08, the main beneficiaries of excess liquidity in capital markets have been emerging market government bonds and non-investment grade corporate bonds in the US, more commonly referred to as junk bonds. Strong investor demand and record new issuance have pushed yields in these credit markets to historic lows. But are these yields sustainable without the constant flow of easy money from QE? If markets are artificially priced then buying these assets purely for yield will have dangerous consequences for investors once the market normalises. South African government bonds have appealed to foreign investors Along with emerging market peers, South Africa has attracted large foreign capital inflows into government bonds over the last few years. Why do foreign investors like our bonds? Interest rates are near zero in developed market economies and emerging market bonds offer significantly higher nominal yields. The spread of South African government bonds over equivalent maturity developed market bonds is appealing to yield oriented investors searching for income generating assets. The 'carry trade' is therefore attractive to foreign investors as they can borrow money at low rates in developed markets and
invest in higher yield bonds in emerging markets like South Africa. losses if they bought without an adequate margin of safety. The downside risk for foreign investors is volatility in currency markets, where the base currency of the country invested in depreciates and erodes the purchasing power of foreign investors' money. Foreign investors tend to withdraw capital from bond markets when a currency is particularly volatile and this was evident during the rand's recent depreciation. Chart 1 shows how foreign investor demand for South African government bonds has increased since 2008 with record issuance of around R90 billion recorded at the end of last year. Foreigners make up just over a third of the market for South African government bonds and the sell-off in the local bond market over the last month showed that a change in sentiment could easily trigger an exodus of capital. The repricing of markets for the normalisation of US Treasury yields once any Fed stimulus is eventually scaled back will see foreign investors becoming more risk averse and thus less amenable to owning local government bonds at their current prices. The expensiveness of local government bonds means there's a risk of a sharp correction when the market re-prices and investors are likely to suffer permanent capital Mispricing is also evident in South African corporate bonds With foreigners bidding yields down on benchmark South African government bonds, local investors have moved down the credit curve into corporate bonds in search of yield. Chart 2 shows the recent growth in the domestic corporate bond market. Annual new issuance of corporate bonds has more than doubled between 2011 and 2012 with around R30 billion issued at the end of 2012. Total market issuance has also increased to approximately R122 billion and includes corporates, financials, municipalities and State Owned Enterprises and securitisations. Strong local investor demand for investment grade corporate bonds has resulted in higher prices and lower yields with new issuance regularly oversubscribed. Unsurprisingly, corporate issuers have taken advantage of cheap financing rates So do corporate bonds offer good value to investors? In our view, they do not. It's important to remember that corporate bonds price off benchmark government bond yields. So in a situation where government yields are at record 39 Chart 1: Foreign Purchases of South African Government Bonds vs. 10-year Government Bond Yields Source: I-net Bridge, JSE, Absa Capital, RE:CM
Chart 2: South African Corporate Bond Issuance (R billion) 40 Source: JSE, Standard Bank lows and corporate bonds only provide a marginal uptick over those benchmarks, the starting yield isn't adequately compensating for interest rate, credit or liquidity risk. Companies issuing these bonds are the big winners in the growth of the corporate bond market as they're able to leverage or restructure their balance sheets at much lower financing rates than those available through the primary banks. This isn't a win-win situation. What corporates gain, investors must give up. US junk bond yields are plumbing historic lows US junk bonds are trading at their most expensive levels relative to US equities in over 20 years. Chart 3 shows that US junk bond yields fell below the earnings yields of the S&P 500 for the first time ever at the end of 2012. The earnings yield is the inverse of the price-to-earnings ratio and can be used to compare equity and bond valuations. To put this anomaly in context the lowest quality bonds are priced to yield less than the equity of the highest quality companies. Junk bonds should always pay a premium over equity as the risk of default and capital loss is high enough for rating agencies to assign a speculative grade credit rating to their debt. This pricing anomaly in junk bonds is a classic example of investors reaching for yield with record issuance of $330 billion recorded in 2012 despite (or, more likely due to) the obvious mispricing. Instead of attracting less capital as yields have declined and prices have risen, the recent performance of junk bonds has validated investors' belief in the asset class and actually resulted in increased market issuance. Not only is this a sign of the market overheating, but if this trend continues the junk bond market is well on its way to overheated territory. As value investors we have a preference for the more senior tranches of debt in a high quality business as opposed to speculative or junk bonds. Real yields on South African bonds are far from fair value With bonds, what you see is what you get yield is the largest component of total return so it's important to lock in a sufficiently high real yield upfront to protect against the risk of rising interest rates and inflation. Chart 4 shows that the average real yield on a 10-year government bond since the introduction of inflation targeting in 2000 is 3.2% with average inflation at 5.9% over the period. While inflation can fluctuate widely over shorter periods of time the evidence would suggest that over a 10-year period the reserve bank would be able to manage monetary policy in line with this historical average. Our valuation therefore uses
Chart 3: US S&P500 Earnings Yield vs. BofA ML US High Yield Bond Index 41 Source: Federal Reserve Bank of St. Louis, Thomson Reuters Datastream, RE:CM Chart 4: Real Yield on a 10-year South African Government Bond (Nominal Bond Yield Less Average Inflation of 5.9% Source: I-net Bridge, Bloomberg, Stats SA
42 average inflation at 5.9% as our best estimate of future expected inflation. A real yield of 3.2% is therefore the minimum investors should expect to earn on a 10-year South African government bond. The nominal bond yield on the SA 10-year bond (R2023) was around 7.1% at the end of May which provides a real return of 1.2% based on inflation at 5.9%. A real yield of 1.2% is more than one standard deviation below our estimate of fair value, which means that the market would need to normalise fully before we'd consider bonds to be attractively priced. Theoretically, government bonds shouldn't carry any credit risk as the government has the ability to print money or tax its citizens to meet its debt obligations, but corporate bonds should provide an additional margin of safety to compensate investors for credit and liquidity risk over the full life of the bond. This is especially important in South Africa where bond markets aren't as deep and liquid as our developed market counterparts. We are watching and waiting In the immortal words of Winnie the Pooh 'Never underestimate the value of doing nothing.' Choosing to do nothing isn't the same as not doing anything at all. The decision not to actively participate in bond markets at this point in the cycle is a choice we're conscious of in protecting investors' capital and not exposing our clients to a permanent loss of capital. Bond markets are overheating because yield-oriented investors are indiscriminately allocating capital to higher risk assets and discarding the critical relationship between price and value. We aren't certain when bond markets will normalise, but the recent sell-off in South Africa and emerging market government bonds demonstrates that valuations in global bond markets are currently stretched. The artificial pricing of markets through unconventional stimulus programmes isn't sustainable in the long term. Economist Herbert Stein wryly stated, 'If something cannot go on forever it will stop'. As value investors, we believe that opportunity comes to the prepared. The current overheating in bond markets will provide attractive buying opportunities when the market ultimately corrects in the future. Sean Neethling