Submitted by JM
Credit Spreads in the New Normal
At its very core, to price something complicated, you lay the most similar liquid asset you can find next to it that has a liquid price. You deconstruct the liquid one by its risk premia, and then you reconstruct the one you are trying to price by applying suitable risk premia to it. The output is fair value.
All the talk of “Japanification” is just a variation on this theme at a pretty remarkable order of complexity. Call it modeling, call it storytelling, whatever: one compares an economy going through a multi-year banking crisis with one that is just a few years into a banking crisis. Compare trajectories, similarities, and differences. Then figure out what matters and what doesn’t in a macro-sense. One has either past observation to understand reality, or rely on dumb luck to understand future events.
- High yield spreads are near the top of the list of mean-reverting things in the new normal. I think only vol is more mean-reverting. The new normal accelerates compression speed.
- Watch out for paying too much for higher credit risk bonds in a deleveraging cycle. Nothing new normal here, this is just like always. But the new normal does make blow-outs bigger.
- Top-tier IG credit will trade tight and at times outperform government securities (red arrow) even in times of crisis after multiple boom and bust cycles. This is the new normal.
Japanese 5Y Corporate Credit Spreads over JGBs and Event Overlay, 2003-Oct 1, 2011
The takeaways are rules of thumb, and there is an exception to every rule, so take this as impressionistic and not doctrinaire. The jist of the new normal is higher vol peaks and faster mean reversion due to persistent boom and bust cycles. This isn’t due to government policy. It is due to government policy bumping the ceiling of feasibility and losing effectiveness. Things aren’t falling apart: it is just that the true nature of risk can’t be suppressed indefinitely.
2007 was quite a year for AAA IG. For a while, they had a negative yield spread to matched-maturity JGBs, then inflation took its toll. Policy tightening actually benefitted top-tier spreads. Until Fukushima a few months ago, Japanese AAA carried a zero spread. I conjecture this is due to the rising credit risk in JGBs offsetting the interest rate risk in AAA corporate. Another way to say this is that interest rate risk evolves into credit risk. A simple illustration of this: a JGB rate from 2% to 4% may not seem much, but it doubles the interest burden on new debt issuance. This is the essential logic of “DV01” arguments when you hear them.
The other ting to notice is that there is a strong differentiation in credit risk that develops after a banking crisis. Comparing Japan Credit Ratings, LLC (JCR) AAA and AA credit and BBB rated credits, we see big differences in volatility—huge spread blow-outs in lower credits. These are tradable but credit vol is slower moving and very dependent on monetary policy stance. Note that October 2011 bond yields look like BBB Japanese corporate bonds are rich and have nowhere to go but down on a yield basis.
Term Risk Matters: One year maturity spreads on all credits were tight most of the time. The 2008-2009 spread blow-out effect was even more pronounced at these maturities than at mid-curve, simply because people wanted shorter maturity government paper in the melt-down. Lower tier credits also haven’t recovered like five year bonds have, carrying a persistent spread premium.
Japanese 1Y Corporate Credit Spreads over JGBs, 2003-2011
Objection: Is this behavior better explained by some “Asian Characteristics” than boom and bust cycles?
It is reasonable to question if Japan is a close proxy at all: all this could be just some idiosyncratic features that make this spurious. There’s a possibility of this, but I don’t really think so. First, people are people no matter where they live, and people respond to incentives of risk and reward. There are different institutions, but there are also commonalities in central banking, demographic trends, among other things.
Second, it appears that this behavior was specific to Japan, because a country with similar institutions and even more granular similarities have credit markets that didn’t act this way at all. In Korea one observes a positive spreads for all bonds, and a consistently wide spread between AAA/AA and BBB credits, well over 200 bps over the period. There was also much stronger cointegration between top tier credits (again proxied by credit rating classes) and lower tiers credit classes: they moved together with respect to government security yields.
Have a look at the 5Y maturity. Note that this isn’t the belly of the curve in Korea, because the bulk of issuance go no further than this in term. So think of it as more like the long wing of the curve where there is some liquidity. It is true that top-tier credits were quick to recover, but that is everywhere in all times. Risk aversion in lower tier credit is more persistent in the Korean case over the whole time period.
Korean 5Y Corporate Credit Spreads over KGBs, 2003-2011
Lessons for Chimerica
A banking crisis implies easy money, ZIRP, various types of balance sheet expansion, and lower credit quality on central bank balance sheets. This acts to suppress credit risk, compressing spreads. This creates “artificiality” in credit market insofar as a central bank is not a natural buyer of higher risk securities. There will come a time when risk is moved off central books, and markets will have to learn how to re-price risk with no government support.
Another problem Japan faced in the last decade is fiscal correction. Whenever recovery began in earnest, the government went into fiscal retrenchment mode to repair its own finances. Tax hikes and the introduction of new taxes, particularly the consumption tax, made a nation of savers ever more conservative just to avoid taxes taking the economy to a standstill again. I’m not criticizing: this is just the boom and bust of the matter as government imbalances have to correct.
The combination of poor government balance sheets and good corporate balances sheets were in the driver’s seat. Households were squeezed.
So in the United States, a few years into similar financial problems took on a lot more debt to stimulate a recovery. Then the government got downgraded by one agency. And the opposition party is talking about “sensible cuts”. And the party in power has quietly been proposing a series of tax increases on people with money. Probably won’t see a consumption tax, but a higher tax on dividends or capital gains fits the MO of the party.
On top of this, next year has a big refi cliff for lower tier credits and the economy looks set to enter a slowdown. And we look set for tax increases to shore up just awful government finances. Boom and bust: as long as the tax burden doesn’t shift in a radical way to corporates, then the logic of Japanification is essentially intact.
China looks finally on the cusp of these same problems too, as their government is reaching the limits on what non-performing business and provincial assets it can take order banks to take on book without impairing their ability to finance profitable projects. Compounding this is a clear Chinese commitment to a rising Yuan policy. There is a massive manufacturing base that will be made uncompetitive as a result. Before you know it, China will have a massive banking crisis with which to contend.