No strings attached

Playing with fire

They say fire is a good servant but a bad master.

They could say the same about leverage. Although it is a key component of many investment strategies, leverage has also been the smoking gun found at most financial ‘crime scenes’ in recent years. Every particular scandal has its own tale to tell, but lurking in the background of many of them is the over-zealous application of leverage in pursuit of excessive investment returns.

Ever since the technology bubble burst, corporate bond investors have focused on the degree to which companies were leveraged and fretted about their ongoing ability to service outsized amounts of debt. But as those investors step up to the plate of a new year in just a few weeks’ time, the outlook for the next 12 months will likely have them focusing even more on leverage in the financial markets.

For life in the corporate bond market in 2004 is not likely to be the cakewalk it was in 2002, when scandal and mayhem was the order of the day and headlines caused almost daily explosions in bond portfolios. Then investors were spoiled for choice when it came to buying cheap credits that eventually delivered outsized returns. It may not have felt like it at the time, but what was on offer was some of the best bond investment opportunities in a decade.

This last year has fixed all that however. The problem is that the market offers very slim pickings when it comes to value. Index OAS levels inside of 100bp don’t leave a lot to get excited about. They haven’t been there since August 1998, which coincidentally was the last time there was an excessive amount of leverage in the financial markets.

It is a fairly predictable pattern. Low yields and tight spreads eat away at investment returns, encouraging the assumption of greater risk in order to boost results. Good credits are soon offering virtually no spread (Wal-Mart’s last five-year deal delivered all of 42bp over Treasuries), hairy credits offer less than they should have to (Tyco just issued $1 billion 10-years at 165bp), and the stream of money chasing the bonds seems to have no end (2003 year-to-date corporate issuance $543 billion and counting).

The next step is for leverage to re-enter the game. Investors will survey 2004 – with its forecasts of an accommodative Fed, few inflationary pressures and a strengthening economy – and find little that will exert widening pressure on credit spreads. With the market’s strong technical base intact, driving for outperformance will require a little rocket fuel in the gas tank to build leverage in the system.

In August of 1998, Treasury yields had just rallied 250bp in 18 months to what at the time was a multi-year low. Aggregate credit spreads had traded between 50bp and 70bp over Treasuries for two years and the market was levered to the gills as it chased returns. In December 2003, Treasury yields have bounced from historic lows, but remain at unappetizing levels, and credit spreads are less than half of what they were a year ago. Experience in 1998 taught us it is possible for them to be half that in another year, and if the market’s current state is anything to go by, this seems to be on the cards.

Should we get there, it is likely that the rampant leverage of the financial markets in 1998 will be very evident again. That particular explosion was a long time in the making and currently we are far away from there.

The fascination with fire, however, seems as strong as ever.

Louise Purtle is corporate strategist at independent research provider CreditSights