Markman: Why Bonds Have More Room to Go

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InvestorPlace
Investors felt a chill when Standard & Poor’s recently downgraded its outlook on the AAA-rated debt of the U.S. to “negative” from stable. Yet credit investors never blinked an eye. As one veteran debt analyst pointed out, “Stock investors panicked about the prospect of the credit boom ending, yet the people responsible for the credit boom had no reaction!” Equity investors’ concerns do have some merit, as the U.S. has created a structural budget deficit of epic proportions. But it’s already been 30 months since the government announced it would go deeply into the red to finance a stimulus. And the rating agency just noticed? Credit investors’ insouciance may be counter-intuitive, but it makes sense if you understand their role in this cycle. They are so desperate for yield that they will lever up and buy anything and everything with a coupon until they get hit with margin calls.   Since we are early in this process, according to the credit analysts I follow, margin calls are unlikely for two to five years. Bonds have progressed so much more smoothly during all the quake and North African troubles because credit investors have been chill and professional about buying steadily in all conditions, while stock investors have been manic. Chief investment officers at pension funds are focused on making 7.5% to 8% annual gains in credit, and an S&P outlook change will not stop them. Consider that just in the past several weeks, some states announced pension funding gaps of more than 25%, growing by more than $1 billion over prior estimates. Pension fund managers are responsible for hitting their marks to make sure retirees get what they are owed, and they will move heaven and earth to do it or face the loss of their jobs. Another example of what they face: The Texas teachers’ pension fund needs to earn 21% over the rest of the year just to maintain its underfunding at 20%. They would have to buy 1% bonds at a leverage of 20x to hit that mark, so you can see why an outlook change is not even on their radar. The upshot is that bond prices are going to remain firm, both in the government, investment-grade and junk realms, as funds play catch-up after their massive losses of 2007-2008. And as long as that is true, all dips in the stock market will be resolved to the upside because corporate leaders will leverage the credit market to get their stock prices up via mergers and buybacks. You can be sure that this will end badly after the credit boom has run out of steam, but probably not for another two to five years — which is much longer than most equity investors expect. Moreover, I am probably more skeptical about the quality of Standard & Poor’s work than most people after studying the organization for a long time.