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hatever men attempt, they seem driven to try to overdo. When hopes are soaring I always repeat to myself, “Two and two still make four and no one has ever invented a way of getting something for nothing.” When the outlook is steeped in pessimism I remind myself, “Two and two make four and you can’t keep mankind down for long.”
— Bernard Baruch
Forbes Magazine’s up and coming edition featuring PIMCO is sure to be a bestseller – at least with PIMCO households. My favorite copy however, at least until now, has been their 75th anniversary edition issued in September of 1992. The cover title hypothesizes “why we feel so bad” and leaves it to ten or so of the country’s best and brightest to provide the answer. 1992, of course was a year of recession, a period of sky-high government deficits, above-average interest rates, and an era which still had failed to recognize the beginning of one of our longest “feel good” periods in American history. Goldilocks was about to replace Little Miss Muffet in the national lexicon of fairy tale characters, just as the NASDAQ would supplant the Dow as a symbol of our New Age Economy. Aside from brilliant writing by authors such as John Updike, Paul Johnson, and Saul Bellow, the most instructive lesson to be learned from that Forbes issue was how backward instead of forward looking the group was, and how the current trend prohibited them from seeing what lay just around the corner: A move towards balanced budgets, the blossoming of the internet, an extension of globalization, and the introduction of the American public to day trading with all of its joys and endless riches (sic). What Forbes should have done, I suppose, would have been to put roaring twenties financier Bernard Baruch’s quotation on its cover in reverse order. “Two plus two equals four and you can’t keep mankind down for long… two plus two equals four and no one ever invented a way to make something for nothing.” It would have foretold the next eight years better than anything I know.
The Forbes and Baruch examples warn against moving to extremes in optimism and pessimism, although it must be noted that timing can be critical. “Mankind” was kept down for quite a long time during the depression of the ‘30s, and remains down currently in Japan after 10 long years of “malaise,” to use a kind description of their economic predicament. In the U.S., now that the free lunches have been vanquished along with the dotcoms, we have moved from Baruch’s “something for nothing” to looking for mankind to come off the deck - all in six quick months. The Fed has cut rates, the NASDAQ appears to have bottomed, and high yield bonds are being heralded as the can’t miss compromise of 2001. I’m sure about the Fed, but the NASDAQ and those high yield corporate bonds seem dependent on more longer term, secular considerations than whether or not Greenspan can lower interest rates fast enough to reinvigorate the animal spirits of U.S. investors. Granted, those animal spirits and that “risk capital” are critical to a revival of the American economy on a short-term cyclical basis. If they don’t pop their heads up before Groundhog’s Day then the NASDAQ and high yield bond market have no chance whatsoever in 2001. But the NASDAQ aside, the ultimate fate of our high yield and even investment grade corporate bond market rests on analysis of secular not cyclical straws in the wind. I have no doubt that the Fed and Dubya can stimulate enough to reinvigorate corporate profits at least temporarily. I do have extreme reservations, however, about the health of the corporate sector over the long term. Here’s why:
A New Age Faustian Bargain Investment Grade Corporate Spreads vs. Treasuries
Source: Lehman Brothers
The ultimate value of any asset, corporate bonds included, depends upon an assessment of its risk and return. Some would claim that with high yield bonds near 14% on average, and expected default rates as high as 8 or 9% over the coming year, that a return in excess of 6% is nearly “guaranteed,” especially considering 30% recovery rates during bankruptcy settlements. Perhaps. We are certainly closer to a point of value in high yield than we were six months ago, although I believe there is more damage to come. For the overwhelming majority of investment grade bonds, however, current yields of 7 and 8% and spreads of up to 200 basis points to Treasuries as seen in the chart above, still do not adequately compensate for sudden overnight shocks on one or several of the aforementioned New Age Economy fault lines. Whether it’s PG&E, Southern California Edison, Polaroid, or a host of visible heretofore impregnable telecoms, there seems little refuge and little return when compared to government guaranteed alternatives. Forget the business cycle risk. Greenspan and Dubya will temporarily alleviate that damage. I’m most concerned with New Age problems, the ones a Fed Chairman and newly elected President can do little about. It’s the New Age Economy stupid. And in this New Age Economy, the “something for nothing” mentality still prevails in the corporate bond market. Granted, as the 1992 Forbes edition points out, it pays not to get too pessimistic at the wrong time. But for now, only when yield spreads widen out further will “two plus two equal four” and the bond investor be rewarded for his New Age Economy risk. Corporate bondholders had best pay attention or risk having their coupons snatched away.
William H. Gross Managing Director
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