Beware of routines…
Investor appetite for bonds is not waning and the volumes of recent debt offerings remains impressive. A few days ago, Danone launched a bond issue of more than €6 billion with tranches at maturities between 2 to 12 years. A comfortable buffer that will allow the Group’s CFO to sleep easily: a 4-year tranche paying an annual coupon rate of 0.17% and a 12-year tranche at 1.20%. More than enough to face the future! This also holds true for sovereign borrowers: Austria has taken advantage of these idyllic conditions to successfully carry out a 70-year debt sale at a rate of… 1.55%.
This focus on yields with low risk has become so routine that even those who know best now qualify this as high risk behaviour.
It might always be argued that if funds deposited with a bank are charged negative rates of -0.40%, any basis point – as long as it is positive – it is worth taking. Let us remember that this situation (of negative or zero interest rates) is an aberration which encourages increasingly dangerous behaviour as one gets accustomed such conditions. The mechanism in play indeed looks very much like the triggers of stock market bubbles: “I know that the price of this asset is absurd but as this trend will continue, I will nevertheless participate”. An attitude reminiscent of the best periods of the Internet bubble minus the enthusiasm of a stock market rush.
This debt financing extravagance is distinguished above all by the fact that it represents a trend which is “piloted” by central bankers. But is it really possible to pilot such excesses? One thing is certain: today the latter have decided to lead the market participants to a new reality by employing a mix of catchphrases and clever timing. In this way, little by little the European Central Bank (ECB) slipped out a reference to tapering(1), whereas Richard Fisher(2) stated: “Fed policymakers did not anticipate the scope of easy money on the financial service.” Or simply put, we have no doubt gone too far with monetary policies and it is time to return to reasonable interest rate levels.
The consequences of an increase in rates are key for managing bond investments – we have taken steps by considerably lowering the durations of our portfolios –, but be careful: other asset classes will be impacted, since most of them will be measured using discounting models which are extremely sensitive to fluctuations in bond markets.
The sudden recent decline of the “growth” style (negatively impacted by rate increases) in relation to the “value” style (less sensitive, or even – in the case of banks and insurers – positively impacted by this phenomena) offers a good illustration of this shift is linked to an adjustment in expectations. This is a signal to watch for, a reflection in financial markets of a message from central bankers just referred to.
Today, who is capable of saying for sure if we will witness a gradual or sudden adjustment in credit markets. The first scenario is infinitely more favourable for equity markets, though both call for renewed vigilance in our projections and future discounting. The ECB is still playing the same song, though we must not be led astray by this erry-go-round of low rates. Let us break the routine and act as if money had a price.
”Tapering”is the process by which central banks inject less money in the economy and rein in their bond purchases.
 Richard W. Fisher is the former President and CEO of the Federal Reserve Bank of Dallas.
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