Last week Evo Morales, the Bolivian president, nationalised the Spanish-owned operator of the country’s three largest airports, with compensation yet to be determined. It was the third such expropriation in 10 months. Why, you might ask, is this a matter of any interest to readers of FTfm? Answer: it tells us a great deal about risk appetite in the markets.
Last October Bolivia, which had not made a sovereign bond issue for more than 90 years, managed to raise $500m in a 10-year dollar issue without difficulty on a yield lower than that on comparable sovereign debt of Italy and Spain. This was despite the fierce anti-capitalist rhetoric of Mr Morales, a former llama herder and coca farmer.
Investors were more interested in the harvest Bolivia had been reaping from the commodity boom and its foreign exchange reserves equivalent to 50 per cent of gross domestic product than in the president’s penchant for routinely expropriating foreign assets. The verdict of the US economist David Hale is that “we have a market which is oblivious to risk”.
Certainly, spreads on poorly rated paper have been tightening everywhere. Collateralised loan obligations, which fell into disuse after the collapse of Lehman Brothers in 2008, are back with a vengeance, with 2012 seeing the highest volume of issues ever. In fairness, the default record of CLOs through the financial crisis was far better than for non-agency mortgage-backed securities. They were nonetheless volatile and illiquid when markets were in turmoil. Now it seems there are not enough quality assets to feed investor demand for these complex instruments.
Equally striking has been investors’ enthusiasm for “sudden death” contingent capital bonds (cocos) issued by financial institutions. Last month, Belgium’s KBC Group issued $1bn of cocos on a yield of 8 per cent, carrying the risk that the bonds will be written down to zero if the tier one capital ratio falls below 7 per cent compared with a current level of 13.8 per cent. In common with a recent similar issue by Barclays, the bond is subordinated to the equity, which weirdly inverts the natural hierarchy of who is paid what in a bankruptcy.
Whether the coupon compensates for the risk is anyone’s guess. If the trigger is breached it is also anyone’s guess whether the markets will take reassurance from the addition of $1bn to the equity capital or panic because the addition might appear small in relation to the existing capital in deteriorating market conditions. As a general principle, one-off triggers, as opposed to incremental write-offs, are potentially dangerous for investor and depositor confidence. The issue was eight times oversubscribed.
This is all a victory of sorts for the central bankers who have been trying to persuade people to take on more risk in the interests of cranking up the real economy. It is a nightmare for mature pension funds that are seeking to reduce risk by diversifying away from equities. That is because equities look less overvalued than government bonds and less risky than more racy corporate bonds.
We have now reached a stage in the credit cycle where the urge to take risk is spreading to the corporate sector. Companies that have access to debt markets are responding to monetary ease not by investing in fixed assets but by doing big leveraged deals. In short order we have seen Liberty Global’s purchase of Virgin Media for $16bn; Michael Dell’s proposed $24.4bn joint buyout with Silver Lake Partners of the computer company he founded; and Berkshire Hathaway’s $28bn purchase of Heinz with Brazilian buyout group 3G.
This is a return to the era of what financial academics, in their wisdom, dubbed “efficient” balance sheets. And there will be many more such deals because stable, cash-generative companies that do not take on more leverage will find that private equity firms, which are reckoned to be sitting on around $500bn of callable capital and now have access to plenty of cheap credit, are only too keen to do it for them.
By the standards of the credit bubble, the leverage implicit in these latest transactions is not high. There is plenty of cash sitting on corporate balance sheets around the world.
Yet there are also grounds for caution since net debt on many measures is also at historically high levels. In relation to GDP, US non-financial business debt is higher than at its previous peak in 1929. And the debt is increasing because companies are shrinking their equity. Andrew Smithers of Smithers & Co points out that US non-financial companies are buying back equity at a rate of $400bn a year, or 2.6 per cent of GDP, while UK non-financial companies are buying at 3.1 per cent of GDP a year.
With interest rates low, courtesy of the distortions wrought by central bankers, this might look manageable today. Yet it leaves the corporate sector vulnerable to a future spike in interest rates. That underlines the vital importance of a smooth exit from the central banks’ unconventional measures. Alas, that cannot be guaranteed.