[A-List] The coming savage downturn

[Michael Keaney]

Investors who buy the low risk traunches (and sometimes these are held
by the investor who either can't sell because of the risk or maintains
because of the high rate of return) MAY be in for disappointment, but I
seriously doubt that there will be a "savage downturn" in the AAA
market.

****

Perhaps it all depends on how you define AAA...


Optimism is not the best predictor
By Barry Riley
Financial Times: June 4 2007

These are tough times for bonds. Just before the Memorial Day holiday
the 30-year US Treasury yield edged above 5 per cent. While bull markets
still bubble away in other asset classes such as equities, real estate
and commodities, the fixed income scene is glum.

Bond yields move in great extended supercycles. It was fascinating for
me to see Henry Kaufman in action in New York last month and hear his
talk on the long-term behaviour of interest rates.

The yield on high grade long-term US corporate bonds swung up from 3 per
cent in 1900 to 5 per cent by 1920, then fell to about 2.5 per cent by
1945. There ensued a destructive rise to 14 per cent in 1980, and yet a
decline to little more than 5 per cent in 2004.

Is a subsequent rise to about 6 per cent just a short-term fluctuation
or the beginning of a prolonged uptrend? Dr Kaufman did not come to a
judgement one way or the other.

But he commented that there is a clear bias in the markets against
negative predictions, although history shows that it is dangerous to
predict the future simply by projecting the recent past.

My own response to the extraordinary long run patterns of interest rates
is that short-term factors are powerfully but misleadingly seductive.
Bond investors, especially in the US, are obsessed by the activities of
the US Federal Reserve and other rate-setting central banks.

But in the long run, or even the medium term, the Fed is driven by
events, not the other way round.

Many bond managers have been desperate this year for short-term interest
rate cuts to save them from the consequences of long-term rate rises.

It is tempting, on the basis of very recent history, to regard 5.25 per
cent as a high Fed rate, likely to be swiftly cut, but it is in fact
below the average of the past 40 years.

The harsh possibility is that global factors, especially the purchase of
dollar bonds by price- insensitive buyers led by foreign central banks
(not least the Chinese), have pushed bond yields too low. If so, the
inversion of the yield curve is not a preliminary sign of an economic
recession of the kind that would put bond fund managers back in the
driving seat of a buoyant asset class. It may be simply an anomaly, and
a reversible one.

Now there is evidence that those foreign central banks are diversifying
their currencies and their asset classes, even going - in the case of
the Bank of China - as far as private equity. Instead of a quick
cyclical turnround there is the disturbing possibility of a big secular
yield uptrend driven by growth and inflation.

We last passed this way in the 1960s and 1970s in a bond bear market
that endured in all for some 35 years.

If it is that bad, how could investors and asset managers hope to
adjust? After all, the conventional bull market approach of seeking to
add a few basis points a year to a bond market benchmark is scarcely
likely to satisfy investors when bond prices are falling.

Well, one radical method has been to reinvent the fixed income asset
class as structured finance.

This can be seen as a strategy for avoiding the anomalously low yields
on long-term government bonds and feeding off lower grade credits. This
sub-class depends heavily, though, on some supportive sleight of hand by
the credit rating agencies: now you see sub-prime, now you see triple-A.

Another approach has been to offer liability-matching products to
regulated investors, notably pension funds. The returns may be poor, but
at least risks related to accounting standards and regulatory targets
are being hedged out.

Rising yields, meanwhile, in this sector carry the bonus that it may
appear cheaper for pension fund sponsors to buy out their liabilities.

A third approach has simply been to convert fixed income asset
management into a pursuit of speculative bets in order to generate
"alpha" or "absolute return". In theory such strategies can thrive in
either bull or bear markets. But the risks have very little in common
with the fundamentally low volatility of the bond markets.

Bill Gross, managing director of the US west coast bond giant Pimco,
appears a little apprehensive in his latest monthly letter. He
recommends that clients diversify their asset mix with a growing
percentage of commodities; Pimco "will hopefully be able to assimilate
equity-type returns into new products", he says.

As for Henry Kaufman, he argues that liquidity in the markets today is
beyond the control of the central banks. People assume that credit is
always available at a reasonable price. There is no evidence that recent
trends, including the refinancing of equity through debt, in an amazing
wave of takeovers and buybacks, are about to be reversed.


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