hey say you can’t judge a book by its cover, and that’s fine when it comes to selecting a mate, good friend, or a business employee, but the fact is there are 6 billion people on this earth, and only a handful of close companions. If there is to be an opinion held or judgment expressed on the remaining masses, it more or less has to be based on their covers, or to put it succinctly, it has to be “superficial.” Now superficial is not a nice sounding word, nor is an admission that I judge most people on the basis of their “outsides” as opposed to their innards, but that’s just the way it is, folks. So do you. You’ve got an opinion about Madonna but you don’t really know her. Maybe you think she’s a tramp, maybe a beacon of female liberation. Maybe you like her new hairdo, maybe you think she should be naturally gray. I don’t know. But your judgment is based upon limited knowledge and in many cases a visual snapshot of her wrapper. What’s inside you’ll never see because you don’t have the time or, I’m sure, the inclination to find out.

If this is so (and I hope I’ve convinced you by now), then I thought it would be interesting to at least explore what type of wrappers are the most appealing to me. While that might sound a little boring to you, it could at least get us all thinking about book covers and what a superficial world it really is, and all of that philosophical stuff that’s just as important as bonds and making money. So here, in no particular order of priority, are the wrappers that catch my eye, as I’m walking down the street or watching people on television.

Physical Appearance
The first thing I notice about someone is their overall “attractiveness.” This is not really a sexual thing. Guys as well as girls can be attractive to me without wanting to go to bed with either of them. But the fact is that physically attractive people are, well, uh….more attractive. They have better-looking wrappers and on a superficial level, I like that. In addition to this undeniably cultural and biologically conditioned opinion, physically attractive people signal to me that they care about their bodies and therefore their lives. Granted, it’s a lot easier for a drop-dead gorgeous blonde to be attractive with or without work, but if Fox’s Tori Spelling can make People Magazine’s 50 most beautiful list, anything’s possible.

I can immediately tell if someone’s black or white, of course, but beyond that it’s the nose and lip rings that make the difference. If a white guy’s got’em – he’s out. If a black guy’s got’ em – he’s out too. I’m still not sure about rings on the earlobe for any guy of any color. Give me time.

Clothes & Ornamentation
Neatly dressed people score high on my wrapper scale; pants below the butt score low. Almost all tattoos are out except maybe a little butterfly on the ankle that signals things that can never be. Spiked or radically dyed hair – get lost.

I like to see people that bounce, dislike those that slouch and slink. Picture a deer hop, hop, hopping through the forest. Now visualize a turtle. My dough’s on the doe.

Upon reflection, this should come as no surprise. A smile can outweigh almost everything on this page. A lot of times I’ll walk past a guy who looks bad, smells bad, and has the world’s most God awful tattoos plastered on both arms. But if he’s got upturned lips, all those negative wrappers are instantly erased. “At least he’s got a smile on his face,” I say to myself – “where’s yours?"

So there, dear reader, is my list of superficial wrappers. If you yourself have a tattoo on some body part other than your ankle, please don’t be offended. I’m sure it really looks pretty exciting unless it says “Mom” or perhaps “Dad” with a heart surrounding it. And for all I know, you may not like mustaches or long straight hair on men like me. That’s just part of your wrapper preference. But let’s be honest and admit that we have them. I’d like to buy the world a Coke and get to know each and every person on the inside, but I just don’t have the time. Until then, it’s mostly in the wrapper.

There are lots of wrappers in the financial world as well, and the admonition against judging a book by its cover is just as valid when analyzing a company as when observing a stranger walking down the street. During my early years as a private placement analyst at Pacific Life, the only bad loan I ever made was based upon stardust and makeup, instead of meat and potatoes. I traveled up to San Francisco in 1975 to meet with the management of Itel, a highly levered railcar equipment company. Instead of being frightened by management’s aggressive use of debt in a recessionary environment, I was wooed by the thick carpets and attractive secretaries. Any company that looks this good I thought, has got to be investment grade. Four months after I authorized a loan of $5 million, Itel went bankrupt, taking all of those 25-year-old blondes and their spiked heels with them. Man, what a shame on both counts. I had been hoping to do lots of annual, on-site reviews, but I never got around to even the first one. The wrapper dazzled me and I was lucky to keep my job.

Today’s financial environment has lots of similarities to San Francisco’s Itel in 1975: prosperity, easy money, high living – much of which is based upon solid productivity gains and technological innovation – but some of which come from leverage and the extensive use of debt. The market’s eye is smitten by the economy’s three-inch high heels – its brain should be careful and analyze its innards. To my mind, an initial diagnosis should probably begin with a chart of our economy’s total amount of debt relative to its production.

Ratio of Total Debt To Nominal GDP(all sectors)

Figure 1
Source: BEA, Federal Reserve

As part of an income-earning household, you yourself know that the amount of debt you borrow must be paid for with future income. If you borrow faster than your income goes up (especially in an increasing interest rate environment) then there’s a higher probability that some of your bills might go unpaid later on. The U.S. economy in September of 1999 is no different; in fact, it is a composite of all of our individual household, corporate, and government entities which borrow and are expected to pay the money back. What figure 1 shows is that the amount of debt in the U.S. economy has been rising rapidly – since 1981 to be sure – but steadily since the early 90s as well. We all know that the Federal deficit has now turned to a surplus, so by “default” it’s been individuals and corporations that have been the busy borrowers: individuals via credit cards, new homes and margined technology stocks; corporations via computers, stock buybacks, and outside acquisitions. The debt, then, has been piled up by just those entities that are capable of default. The federal government is always going to pay its bills; mom, pop, and low quality corporations maybe not.

Last month, Iridium Communications, a mobile phone company that had borrowed over a billion dollars of high yield debt during the past two years, defaulted on its obligations. Add companies such as Planet Hollywood, Sun Healthcare and KCS Energy to that list for a total of over $15 billion of corporate defaults in the third quarter of 1999 alone. Take a look at the chart below, which shows a trailing 12-month default rate of high yield debt.

Trailing 12-Month Speculative-Grade Bond Default Rates

Figure 2
Source: Moody's Risk Management Services

What it shows is a startling increase in defaults of junk bonds – 7% on a dollar-weighted basis, 5% on an issue-weighted basis over the past twelve months. Those levels are shy of 1991’s recessionary levels of 10%, but they’re occurring in our environment of 3-4% economic growth and record levels of corporate profits. If 7% of junk debt defaults during the economy’s salad days, what lies ahead during an economic slowdown or, heaven forbid, an unlikely but not impossible recession?

The answer requires opening up the cover and delving into the text of the problem. Current defaults, to be sure, are a result of loose underwriting standards during the homestretch of a near nine-year economic expansion. That is nothing new and presumably an investor need only invest in corporations of long standing with a stable bottom line to avoid striking out. But there are other explanations. Banks themselves have been riding the slippery slope of loose lending, participating in financing dream companies with good-looking 25-year-old women and men, to bring my dated analogy into the politically correct 90s. In addition, the swarm of CLOs (Collateralized Loan Obligations) and CBOs (Collateralized Bond Obligations) issued over the past five years have reflected a corporate mentality that has viewed debt as a stepping stone to higher and higher profits, as opposed to a milestone of obligations that must be repaid. As interest rates have moved increasingly higher over the past twelve months, this combination of accelerating debt financed at more expensive yields has placed the corporate debt market at risk.

During such periods of speculative excess in stock and bond markets alike, there are few safe havens in the brewing storm. Aaa government and agency guaranteed mortgages are one; U.S. Treasuries are an obvious other. But even high quality corporates are at risk of spread widening as witnessed by the acceleration of swap spreads in recent months. Y2K may be part of the explanation, but I suspect the fundamental factors listed in this Outlook’s preceding pages are the real culprits. This is a time to peel off the dazzling wrapper of high corporate yields and ask if there is always and forevermore a free lunch in buying junk bonds and even investment grade debt instead of governments. I would say “not always,” and right now might just be one of those times. Proceed with caution. Look underneath that wrapper.

William H. Gross
Managing Director


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