So how about that bond market, huh? Surely those smart guys are getting with the idea that expectations for the economy have bottomed and everything’s going to be OK pretty soon, right? Umm, sorry. Not so much.
I checked in with ace credit analyst Brian Reynolds late last week, and he offered three pretty shocking examples of the terror that stalks the bond market lately.
Coke Enterprises (COKE), the soda bottler, issued 10-year debt in July at a spread of 169 basis points over Treasuries. By last week, the spread on those bonds had widened out to around 340 basis points, a move of historic proportions. When COKE wanted to do another deal in late October, bond investors made this consumer staples company pay a stunning 468 basis points over Treasuries. Reynolds observes that in a world where Treasuries earn 1%, it is tough for us to see how a company can profitably use money costing almost 7.5%.
Ditto for telephone giant Verizon (VZ). In April 2007 it issued 10-year debt at 95 basis points over Treasuries. In April of this year, it issued 10-year debt at a spread of 260 basis points, a historic move considering the worst previous spread for a big phone company in 2002 was 300 points. Yet last week, bond investors made Verizon pay 488 basis points over Treasuries. Reynolds wonders how the company can profitably use money costing almost 9%.
And finally, the kicker. Reynolds said bond investors was speculating that troubled MGM (MGM) would have to pay as much as 12% for a debt deal this week, but when it was priced demand was so weak they were forced to pay 15%. And it is secured by their New York New York hotel and casino in Las Vegas!
Moreover, Reynolds says the company isn’t using the proceeds for growth, but to pay down another credit facility. "In other words, loan shark bond investors are forcing them to pay through the nose and put up collateral just to keep the balls in the air," he said. It’s like a consumer who uses a credit card costing 15% a year to pay off a debt owed at 9%.
The Wall Street Journal quoted a distressed debt turnaround expert as stating that lately he felt like "an air traffic controller with five planes trying to land at once. And they are all on fire. Our greatest competition to do a deal is liquidation, getting the deal done before the bank or lender pulls the plug on the company."
Reynolds, who is unusual in that his career has spanned both equities and stocks, says his read of the bond market suggests that a crescendo of pain has not yet been reached—as smart credit investors are not swarming deals right now in a way that would be consistent with their belief that the worst is over for the economy.
Instead, he says bondholder’s actions continue to suggest that the recent action in equities amounts to little more than a bounce. "If you think the last few months were crazy, the craziness may just be beginning," he says.
Basically you can forget all the stories you’re reading in the mainstream financial media about credit thawing out. Action on those three recent bond deals shows it’s not.
It’s hard to say how long it will last, but my expectation is that bears will let stocks rise dramatically to around the 1,270 level of the S&P 500, before lowering the boom.
Meanwhile I want you to be aware of some trouble brewing in the world of banking. The good news is that banks are making a lot more commercial and industrial loans to companies than they were six months ago. While that sounds great, and will make most investors think that credit markets are thawing, Reynolds says it is actually a huge negative because the loans are involuntary and will lead to cuts in other types of lending.
C&I loans surged in a similar manner in 2000 and August 2007. And in both cases it was bad because it was triggered by the same reason as today: a freezing in money markets.
Reynolds points out that money markets have for years been the biggest buyers of commercial paper, which supply working capital to major corporations. When investors pulled out of money markets due to fears they were too risky, companies have had to look elsewhere for credit. So they drew down their standby lines of credit at banks just to remain solvent and pay the bills.
Reynolds reports that these are "horrible, risky, low-profit loans" for banks because they were granted during the bull market when credit was cheap. Banks only took a nominal fee for creating the lines, and their pre-determined terms mean they are being issued at low-margin spreads at a time when loan costs otherwise are massively higher. He says that a bank writing these lines during a bull market is like an investor selling naked puts on stock in a bull market at a time of low volatility: It produces a little income while times are good, but a bear market can be disastrous.
Since banks are not making money on these loans, they are believed to be compensating by reducing other forms of lending just as they did in years past. They will cut back on auto loans (sorry Detroit!), student loans, home equity loans and hedge fund loans (sorry Blue Mountain!).
As banks now start to receive capital injections from Congress, they will at the same time likely have to start writing off more losses. In fact, the write-offs are likely to exceed the injections, so they will likely just barely be able to tread water—not grow.
Now if the big banks’ new owners—the government—decides to come in and force them to make more loans that are uneconomic just for the sake of political correctness, you can just imagine what will result: Yes, banks could be in more danger next year than they were before the bailout.
Learn how to trade profitably in this crazy environment by reading my Trader’s Advantage newsletter.
Jon Markman is editor of Trader’s Advantage and a regular contributor to InvestorPlace.com. To get this type of actionable insight from Jon and other InvestorPlace Media experts go to www.InvestorPlace.com today.
