ending is not based primarily upon money or property. No sir. The first thing is character.”
Being more “intro” than “extra”-verted, I always had a preference in my younger days for historical/biographical mentors, as opposed to the flesh and blood, live and in person kind. Besides, having lived in Newport Beach for all my career, at the geographical edge of the bond management universe for much of that time, the need for literary role models was all the more acute. There were lots of yoga gurus walking the beach, but hardly a bond maven in sight. And so it was that a picture of J. Pierpont Morgan came to grace the wall of my PIMCO office in the early 1980s complete with the quotation mentioned above. Admittedly, this politically incorrect, financial market titan with the bulbous nose and menacing stare may have seemed like an odd choice, but I liked that “character” quote, and so he joined my office wall of fame along with Bernard Baruch and Jesse Livermore, the quotations from whom will have to wait for another day and a future Outlook .
Baruch’s emphasis on “character” was admittedly a little hard to implement. It was one thing to envision ol’ J. P. sitting at a partner’s roll top desk, while scrutinizing the cringing applicant on the other side – but quite another to implement the same quality scrutiny in the late 20th century with increasing geographical dispersion and a plethora of deals coming to market on a daily basis. Balance sheets and assets were by far the easier of the two to analyze. Still, I wish I had relied more on character when I made a private placement loan to a rail equipment leasing company called Itel in the mid-1970s. The company’s San Francisco office had the thickest carpets and best looking secretaries I had ever seen – surely in retrospect a sign of a profligate as opposed to a penurious corporate character. Within 6 months, the company was bankrupt and their railcar assets fetched only 30-40 cents on the dollar when all was said and done.
Morgan’s emphasis on character was called to mind as I read a recent strategy piece from Tim Bond of Barclays Capital. Although the two of us have only met through our mutual Investment “Outlooks” – carrying on that introverted, Newport Beach mannerism that has characterized my years here – Mr. Bond seems to me to be a rising star in the business of economic analysis and market forecasting (careful Tim – a guru not busy being born is busy dying). It helps of course that we share mutual outlooks at the moment, but nevertheless he appears to have a deep historical foundation combined with a New Age orientation that permits him to analyze current conditions with a different slant than the conventional Wall Street/City street crowd.
My New Age bond market thesis has been spelled out frequently over the past year or so, most specifically in April with an Investment Outlook titled “Goodbye to Butler Creek” and then again last month with “Into the E-byss.” In summary, it suggested that bond market performance in 2000 would most critically be a function not of duration/maturity positioning, but of sector/quality orientation. Bonds in the New Age Economy were less about interest rate changes and more about corporate quality deterioration and government treasury surpluses. To date, that thesis has proved to be correct and PIMCO portfolios have managed to outperform their benchmarks while competitors have suffered due to their continuing use of corporate bonds which have attempted to add a yield “tilt” to their portfolios.
The reasons for the performance disparity are numerous but can be simplified by referring to economist Joseph Schumpeter’s classic phrase of “creative destruction.” “Corporate bond investing in a New Age Economy,” I wrote last month “is a dangerous proposition. It flies smack into the headwind of Schumpeter’s ‘destruction,’ while a diversified portfolio of equities seemingly moves in the other direction, soaring then jet streaming along at the benefit of Schumpeter’s ‘creative’ tailwind.” Bonds are “destroyed” more frequently in this New Age because change and creativity produce an increasing number of winners and losers. The winners, in bond market rules can only return 100 cents on the dollar while the losers can sink to 0 even if their carpets are wafer thin and their secretary/assistants resemble Bette Midler instead of Kathy Ireland. In addition to the destructive headwinds of “creative destruction,” corporations are assuming more and more debt, as seen in the graph below, as they are forced to invest and innovate in a furious attempt to keep up with their Silicon Valley compatriots. But falling behind these days is akin to falling off a cliff, so the debt piles up along with the hopes that it can be serviced and paid off sometime in the not-so-certain future. Some of it won’t be.
U.S. Corporate Sector Borrowing
Henry Kaufman in his recent book Financial Institutions in the New Century explains our New Age Economy from a slightly different perspective:
As for financial markets, they are likely to see the continuing privatization of a growing array of activities and enterprises presently run by governments. And as privatization accelerates in many nations, credit demands will continue to shift from the public sector to private enterprises. At the same time, the decline of central government financing will leave the task of evaluating and accommodating credit demands to the financial markets. As a group, such demands of credit will become more and more diverse in their needs and their risk levels – and thus pose higher risks than when their governments played a larger role.
Kaufman approaches deteriorating corporate credit from the standpoint of globalization. Yours truly and Barclays’ Tim Bond have emphasized the trend from the standpoint of technological innovation and its “creative destruction.” Combined, the two concepts are a somewhat lethal two-barreled shotgun pointed straight at the weakest of investment grade and high yield bonds alike. The strategy here at PIMCO is to weed them out, and to hold them at the short end of the credit curve, which is another way of saying, we prefer to hold Baa and lower corporates with very short maturities only.
But what of J.P. Morgan, Tim Bond and lending on “character?” Well Mr. Bond hopefully bears little resemblance to old man Morgan – either personally or physically, nor has he ever referred to lending on “character” in his recent missives. He has, however, brought up the tantalizing concept of what it means to lend based on assets or “property” in a New Age Economy. He suggests that the pool of capital assets that might be available to offer collateral for business loans in this New Age will progressively shrink in relation to the size of the business sector’s borrowings. That is, if corporate investment capital becomes increasingly defined by information and knowledge as opposed to railroad tank cars, then woe be to the creditor who tries to collect in the event of bankruptcy. If a company’s primary assets consist of people and systems (processing information), then the mercurial movement of those intangible assets can disrupt a company’s future faster than you can say Yahoo or Ebay or any other red hot company that tantalizes with future prospects and very little tangible, foreclosable asset value. “To pursue the argument to an extreme,” writes Mr. Bond, “a pure knowledge based economy will have no capital assets upon which to secure borrowings.”
A fine and potentially valuable insight to add to Barclays’, PIMCO’s, and now your growing library of ideas concerning bonds in a New Age Economy. J.P. Morgan, I’m sure, would have hoped to fall back on character as his determining criteria for lending in the New or any age. Perhaps – but you can only visit so many companies and check out so many carpets – not to speak of the secretary/assistants who now days come in two different sexes and are out of bounds for married men such as myself. And the closest you can get to Scott McNealey or Larry Ellison these days is on CNBC or CNN’s Moneyline. I like McNealey’s teeth, but they don’t say much about his character. So corporate bond buyer beware. It’s close to impossible to analyze character these days, and the hard assets are disappearing from the New Age horizon. “Neither a corporate borrower nor a lender be” is becoming my New Age motto. Move over J.P. Morgan, William Shakespeare is about to grace my office wall.
William H. Gross