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:
- The New Age Economy for all its benefits of marginally higher productivity and fuller full employment has brought with it a rapidity of change that is no corporate bondholder’s friend. Think about it. If you held a corporate bond, would you prefer a dynamic economy where some companies profited immensely and others plunged towards bankruptcy? Not me. My favorite economic environment would be an Old Economy environment, semi-regulated, semi-subsidized, certainly not New Age cutthroat. If profits only grew by 5% a year, then fine. Bondholders don’t benefit by the upside, they only get hurt by the downside. So slow and steady is our best friend, not “damn the torpedoes, full speed ahead.” One of those torpedoes could sink (and recently have sunk) a corporate bond or two, or three, or…see what I mean?
- Examples abound of New Age destruction in seemingly impervious blue-chip companies. Many of them are PIMCO clients so I don’t dare mention their names, but you know who they are. Actually its not just the blue chips but the NASDAQ chips as well that are at risk. It’s like the “Invasion of the Body Snatchers,” except in our New Age version of the movie substitute “Bond Snatchers.” No matter where you look, there’s no one or no company you can really trust anymore. Today’s winning technology is tomorrow’s sinkhole and the 10-year debt that financed the supposed winners just 12 months ago could now have a maturity that’s 9 years too long. If the New Age is to be financed, it must be financed with risk capital – venture capital, equities, and high yield bonds (with yields to reflect New Age risk) – not investment grade debt.
- New Age companies have been and will increasingly be forced to invest beyond their means in order to keep up with their competition. If a mile race suddenly becomes a 100-yard dash – winner take all – then the rules on the track suddenly change. Focus is placed on a quick start, being first out of the blocks and a maximum expenditure of energy shortly after the starter’s gun goes off. In New Age corporate terms, that means heavy expenditures for R&D, investment in plant & equipment, advertising, etc., in a desperate race to demolish the competition. Recall the dotcoms heavy use of advertising in the last two years’ Super Bowls? There’s your perfect example of New Age excess, because for the most part those funds were wasted instead of conserved for the long haul. This New Age Economy encourages destructive behavior at a micro level, and it’s at the micro level where a corporate bond investor places his bets. The macro level is the realm of governments and agencies, where the safe harbor for a bond investor currently waits.
- Aside from the rapidity of change, the New Age Economy threatens corporate bondholders in a way that has never occurred before. Since technology and the Net have become almost synonymous with our New Age, it pays to assess the Net’s personality to see whether it is corporate bond friendly or unfriendly. Perhaps one of the most visible features of the Net is its ability to make information available to its users almost instantaneously. When that information comes in the form of “prices” on relatively uniform products such as books, CDs, computers, automobiles – perhaps a majority of our consumer purchases – then the consumer has been armed with a powerful weapon. Even if most consumers avoid the Net entirely, the marginal Internet consumer will probably dictate prices, and corporate profit margins will therefore be at risk. The Internet, in other words, stands an excellent chance of being consumer not business friendly and if so, the corporate bondholder will suffer as margins deteriorate and bankruptcies mount.
- This argument about pricing information and access says nothing about the possible change that the Internet may inflict on entire industries such as music, publishing, and retail investment brokerage. Corporate bondholders in these and other associated industries should be leery.
- Last, but not least, is the increasing litigiousness of American society and the damage one accident, one good lawyer, and one substantial class action suit can do to an established company’s balance sheet. Tobacco litigation has been around for some time but in the last few years investors have witnessed attacks – legitimate or otherwise – on the tire and automobile industries, companies associated with asbestos health issues, antitrust-related suits on computer and telecommunications companies, and now of course government attacks on electricity suppliers and providers in the state of California. If what our heretofore nearly invisible (both body and brain) governor of the Golden State, Gray (turning to Black) Davis, has threatened in recent weeks doesn’t scare a corporate bondholder, then I don’t know what will. His behavior - screaming “eminent domain” and threatening confiscation of generating plants - is akin to something out of Dr. Zhivago and the beginnings of Lenin-style communism. Woe be not only to the bondholders of PG&E and Southern California Edison, but to its out-of-state suppliers as well – Duke Energy, Dynergy, Calpine, etc., etc…
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