May 16, 2021

Common Sense: Bearish Times for Bonds

The month of May, and this first week of June, were terrible for many fixed-income investors who have spent the last few years reaching for higher yields. If there was an index for fixed income with the household-name status of the Dow Jones industrial average or Standard Poor’s 500 index for stocks, the carnage in fixed-income markets would have been a big story and we’d all be talking about a bear market in bonds.

Consider the damage: mutual funds that invest in long-term United States Treasury bonds lost an average 6.8 percent in May, according to Morningstar, with the loss in principal wiping out years of interest payments. But that’s not the worst-hit sector. Higher-yielding bonds and fixed-income securities, to which investors have turned in droves in recent years, have suffered even more, especially mortgage-backed securities and emerging market debt, as well as just about anything that uses borrowing to boost returns.

Many individual securities and funds were hit much harder than the averages. Vanguard’s Extended Duration Treasury Index fund was down more than 6 percent in the last month. In the mortgage area, Annaly Capital management, a popular real estate investment trust that invests in mortgages, fell 8.7 percent, and an iShares mortgage exchange-traded fund lost 10.4 percent. Pimco’s Corporate Opportunity Fund, which is managed by the star analyst Bill Gross and which invests in a mix of corporate bonds and mortgage-backed securities and uses some borrowing, lost nearly 13.4 percent. Annualized, such declines are off the charts.

“There are many closed-end bond funds and mortgage finds that were just annihilated in May,” said Anthony Baruffi, a senior portfolio manager at SNW Asset Management in Seattle, which specializes in fixed-income assets.

This week, the bond markets’ jitters spilled into the stock market, with major indexes gyrating around the globe. The Dow Jones industrial average dropped more than 200 points on Wednesday, only to bounce back Thursday and Friday. High-dividend stocks, which many bond investors also looked to in their quest for income, were pummeled. Shares of Procter Gamble dropped more than 6 percent the last week in May.

The severity of the market reaction shows how skittish investors have become about ultralow interest rates. Bond prices fall when interest rates rise, with longer-maturity, higher-yielding and riskier bonds the hardest hit — the very assets that the Federal Reserve’s ultralow interest rate policy has encouraged income-seeking investors to embrace.

Fixed-income funds are where investors have traditionally looked for safety and low volatility, unlike stocks, and such precipitous moves are rare. To put this in perspective, the recent plunge in prices of fixed-income securities had analysts reaching back to 1994, when the Fed began raising rates and 10-year Treasury rates rose two and a half percentage points. That year, Orange County, Calif., had to declare bankruptcy after its bond portfolio plunged in value.

The sudden recent moves in the markets have left many experts scratching their heads, because, on the face of things, not much has changed in the overall economic outlook. This week’s employment number — American employers added 175,000 new jobs in May — was the average rate for the past year, suggesting slow but steady growth in the economy. Other measures released in May, like consumer confidence, consumer spending, and personal income, were generally positive, but nothing to suggest any imminent surge in economic growth.

“Last week’s sell-off was very indiscriminate,” said Jonathan A. Beinner, chief investment officer for global fixed income and liquidity at Goldman Sachs Asset Management. Added Mr. Baruffi, “I was surprised at how severe the market reaction was.”

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Fair Game: Finger-Pointing in the Fog

UNEARTHING the story of the financial crisis is like conducting an archaeological dig. New shards keep emerging from the dust.

Here’s an interesting find. The Securities and Exchange Commission has sued Stifel Financial, a regional brokerage firm in St. Louis, accusing it of fraud in connection with complex debt securities it recommended to five Wisconsin school districts in 2006. Rather than settle with the commission, as many firms do, Stifel is defending the matter.

The S.E.C. sued Stifel on Aug. 10 because the firm advised the school districts to buy the three ill-fated securities, which the regulator said were unsuitably risky for unsophisticated investors. David W. Noack, the firm’s sales representative, misled school district officials when he told them that the deals, involving corporate bonds and rated AA-minus, were nearly as safe as United States Treasuries, the S.E.C. said. The Wisconsin school districts lost tens of millions of dollars on a $200 million investment, most of which was borrowed.

Stifel earned $1.6 million in commissions. But it did not create the securities — and this is where the case gets murky and interesting. Royal Bank of Canada built the failed investments, using parameters set out by Stifel and secretly profiting on the deal, Stifel said. The S.E.C. has not sued the bank.

In a lawsuit against Royal Bank of Canada, Stifel points to internal bank documents indicating a $5.4 million profit on two of the Wisconsin deals. Stifel also maintains that Royal Bank of Canada hid these and the third deal’s profits and had undisclosed conflicts as the deals’ originator. As such, RBC failed to abide by the contract with the school districts requiring “complete expense and fee transparency and disclosure,” Stifel said.

Kevin Foster, a Royal Bank of Canada spokesman, called Stifel’s allegations meritless and said the firm was trying to deflect blame to others for its central role in the troubled investments. “We never misrepresented our estimated profit to Stifel or the districts,” Mr. Foster said in a statement. “Stifel’s math is flat-out wrong and based on erroneous assumptions. The transactions were not profitable to RBC.”

Stifel and a lawyer for Mr. Noack declined to comment.

Here’s a short history of the transactions. In 2005, the school districts faced $400 million in unfunded health care and other non-pension guarantees for retired workers. Mr. Noack had been financial adviser to the districts for decades; he suggested they borrow money and invest in securities rated AA-minus that would generate more in yield than they had to pay in interest.

This becomes maddeningly complex: The bank from which the school districts borrowed — Depfa, of Ireland — told Stifel that it preferred collateralized debt obligations as the securities against which it would lend money to the districts. Stifel asked for proposals from banks. Royal Bank of Canada won the assignment and began to construct synthetic collateralized debt obligations linked to about 100 corporate bonds. It worked with ACA Management and UBS to select the underlying portfolios.

Depfa lent the money to the districts on a “nonrecourse” basis, meaning that the districts would not have to repay the loan if the securities bought with the borrowed funds defaulted. This arrangement, Stifel argues, shows that Depfa, a sophisticated institution, believed that the investment was not high-risk. Under the deal’s terms, Depfa could seize the collateral if the security’s asset values fell to 95 cents on the dollar and did not return to $1.01 within 30 days.

It didn’t take long for the deals to go south, and for the school districts to lose their $37 million investment. Depfa seized the underlying collateral supporting its $163 million loan. Lawsuits began flying.

Once again, we see the same toxic ingredients that have appeared repeatedly in the aftermath of the crisis: collateralized debt obligations, credit default swaps, ruinous leverage, an overreliance on credit ratings, greed and extreme naïveté.

But the case raises questions about a largely unexplored part of the collateralized debt obligation mania — whether Wall Street firms putting together these deals knew how to game the ratings agency models and profited by selecting debt issues to suit their purposes.

If, for example, a firm was designing an instrument to be used to bet against the underlying collateral — Goldman Sachs’s famous Abacus deal was created so the hedge fund manager John Paulson could short risky mortgages — a firm could assign debt issues to the deal that carried overly optimistic or misplaced ratings. Later, when reality intervened and the ratings were cut, those betting against the underlying collateral would prosper.

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Banking Sector Punished Over European Debt

The clearest signs of the anxiety are in the stock market, where shares of American banks plunged again on Wednesday. Bank of America dropped almost 11 percent. Citigroup sank 10.5 percent. Goldman Sachs fell 10 percent, while Morgan Stanley was down 9.7 percent.

All told, bank stocks have fallen more than 30 percent since the beginning of the year — and have swung wildly up and down over the last week — as the weakening economy is expected to take a toll on business and reduce earnings.

But concerns about European banks are driving the latest wave of selling. Société Générale’s share price dropped 14.7 percent on Wednesday, the most of any European bank, as its chief executive “denied all rumors” that he said caused the stock to fall.

Other European giants were alsopounded. Shares of Intesa Sanpaolo of Italy fell nearly 14 percent. Crédit Agricole and AXA Financial of France dropped more than 10 percent apiece.

Financial institutions across the Continent have huge holdings of government and corporate bonds from Italy and Spain. Doubts about the financial health of European lenders are encouraging investors to unload their shares and driving up their borrowing costs.

Those banks, in turn, trade billions daily with their counterparts on Wall Street. They also rely on billions of dollars invested by American money market mutual funds to finance loans and other investments.

That has created a vicious circle, where fears about the soundness of European banks are feeding new concerns about the stability of American financial institutions.

“The European situation is back and isn’t going away,” said Alex Roever, the head of short-term fixed income at JPMorgan Chase. “It continues to keep pressure on the market.”

Only a few months ago, American banks looked as if they had finally found their footing. Loan losses were easing. Profits and bonuses were back. Even some of the new regulations had turned out to be not as draconian as many bankers once believed.

But there has been a steady drumbeat of dismal headlines in the last few weeks. First, weak data for the housing market and the broader economy suggested that banks would find it even harder to grow. Standard Poor’s downgrade of the United States government further rattled confidence, the lifeblood of the financial system.

Then, in a sign of how grim things had become, the Federal Reserve took the unprecedented step of pledging to keep interest rates near zero for the next two years. That may prevent the economy from slipping into another recession, but it will squeeze lending profits that make up the bulk of banks’ income.

And that comes as demand is already slowing for all kinds of loans and a wave of deal making has been shelved.

“Everyone is going to be lowering their estimates,” said David Ellison, the chief investment officer of two FBR mutual funds that invest in financial companies. “You are going to have lower loan growth and lower margins; we are in a new era.”

If that were not enough, there are lingering worries about the legal hangover from the housing bust. Bank of America, which faces potentially tens of billions of dollars in investor claims, held an unusual conference call on Wednesday to reassure shareholders it could cope with all settlements, among other concerns. Its shares fell to $6.77 on Wednesday, after reaching a postcrisis high of almost $20 in April 2010.

Now, as Europe’s fiscal troubles spread to core trading partners like France, there are renewed fears of contagion. The links between French and American institutions, after all, are orders of magnitude larger than they are between American banks and say, Greek, or even Spanish ones.

For example, according to the Bank for International Settlements, French banks owed American institutions more than $160 billion at the end of 2010.  Spanish banks owed less than $20 billion. And that’s not counting the billions of dollars that big American banks lend directly to overseas companies or any European government debt they hold as investments.

Nowhere is that nervousness greater than in the short-term financing markets, where European banks turn to American money funds each day for tens of billions of dollars in funding.

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When Havens Fight Back

TOKYO — As global investors flee the dollar and euro for refuge in stronger currencies, those havens have started to send out a message: enough.

Demand for currencies like the Japanese yen and Swiss franc, seen as relatively safe assets to hold in turbulent times, have surged in recent weeks, driving up their value as investors have dumped dollars and euros as a result of debt worries in the United States and Europe.

A strong currency might sound like a validation of investor confidence in the performance of an economy. But for trade-dependent Japan and Switzerland, a sudden jump in the value of their currencies can wreak havoc by making their exports uncompetitive.

Declaring the yen’s rise to be a threat to the economy, Japan’s Ministry of Finance moved on Thursday to reverse the trend, intervening in the foreign exchange market and preparing to pump money into the country’s financial system. The maneuver came a day after the typically sedentary Swiss bank unexpectedly cut interest rates in an attempt to weaken the franc.

“The recent rise in the yen in currency markets has been one-sided and unbalanced,” Finance Minister Yoshiko Noda said on Thursday as he announced the start of the intervention. “If this trend were to continue, it would harm the Japanese economy, even as we do all we can to recover from our natural disasters.”

Japanese authorities delivered a one-two punch to markets. First, the Finance Ministry said it had begun selling yen and buying dollars. Then the Bank of Japan announced that it had further expanded its program to purchase government and corporate bonds, a form of monetary easing aimed at increasing liquidity and helping to dilute the value of the yen.

The yen weakened steadily throughout the day, from 77.15 yen to the dollar to about 80 yen on Thursday evening in Tokyo. Earlier this week, the yen came close to a record high of near 76.25 yen to the dollar.

“We judged that rises in the yen have economic costs, including the risk of damaging corporate sentiment and encouraging companies to shift production overseas,” the governor of the Bank of Japan, Masaaki Shirakawa, said at a press conference.

Japan, which had taken a laissez-faire approach to currency policy from about the middle of the last decade, has over the last year become more willing to intervene. Last Sept. 15, with concerns over the American economy mounting, it spent 2.1 trillion yen in its biggest one-day intervention ever.

On March 18, a week after an earthquake, tsunami and subsequent nuclear crisis, the Group of 7 industrialized economies came to Japan’s aid by staging a joint intervention, coordinating efforts to sell the Japanese yen on global currency markets. Traders had attributed the yen’s surge to Japanese companies repatriating funds to finance recovery back home.

But since then, the dollar has again slumped against the yen, falling 5 percent in the last month as investors wary of the debt impasse in the United States fled to other currencies. Even after lawmakers in Washington struck a deal on Tuesday to avert a default or downgrade of United States debt, fresh concerns over the economy again weighed on the dollar.

Japan did not disclose the size of its intervention on Thursday, but traders estimated that the government spent more than a trillion yen on the maneuver, according to Reuters. Asian central banks, Japanese retail investors and exporters bought into the dollar’s rally, helping to buoy the American currency, Reuters said.

The central bank followed with its announcement that it would seek to raise liquidity by increasing its asset purchase program, including Japanese government and corporate bonds, to 15 trillion yen from 10 trillion yen announced previously.

The bank said it would also expand its credit facility — its pool of funds available to buy up assets from banks and other businesses — to 35 trillion yen from 30 trillion yen. The bank also kept its benchmark interest rate near zero.

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Worries Grow About Breadth of Debt Crisis

The worry is that the worst case, a Greek debt default, would lead to damaging losses for European banks and spur a global panic, replaying the events of September 2008. Then, investors fled all but the safest government debt, unloading everything from corporate bonds to American and emerging country stocks. Global markets froze.

As European officials headed into a long weekend of critical talks, the European Union and the International Monetary Fund said that they were confident of a deal to secure a vital 12 billion euros ($17 billion) in outside aid needed to stave off an imminent Greek default.

The comments, reflecting belated advances in negotiations that have been going on for weeks, were aimed at calming anxious financial markets. But so far, the deepening concerns are stopping short of transferring forcefully to the United States. For the time being at least, investors seem to believe enough shock absorbers have been built in to comfortably withstand any default by Greece or other highly debt-ridden nation.

The interest rate on United States 10-year Treasury bonds remains below 3 percent. In contrast, Spanish bond yields rose to an 11-year high of 5.74 percent as anxious investors fretted that it could be next in the firing line after Greece.

“U.S. financial institutions are very cash-rich, so that means a liquidity crisis would have to be extraordinary before it affects them,” said Guy LeBas, the chief fixed-income strategist for Janney Montgomery Scott.

After a 179-point sell-off on Wednesday, American markets stabilized, with all the main United States indexes closing higher.

But the cost to investors of insuring their holdings of Greek government debt, to make sure they recoup their money in the event of a default, registered its single biggest one-day move.

An investor now has to pay about $2 million annually to insure $10 million of Greek debt over five years, compared with about $50,000 on the same amount of United States government debt, according to Markit.

Insurance rates on the debt of Irish and Portuguese governments, as measured by rates in the market for credit-default swaps, also climbed to record highs. In addition, Spain struggled to kindle investor interest on its auction of bonds, selling 2.8 billion euros ($4 billion), missing its top target and with average yields creeping up again. The fear is that a Greek default could threaten the integrity of the euro zone, require European countries to bail out banks that lent heavily to Greece and other deeply indebted countries, and spread panic across global markets.

The European Union’s top economic official, Olli Rehn, said he had reached a deal with the International Monetary Fund to avoid a Greek default through at least the fall.

But he warned politicians they must agree to new austerity measures or the program would be worthless.

The mood in the markets was made more nervous when Michael Noonan, finance minister of Ireland, said on Wednesday that the Irish government was ready to impose losses on senior unsecured bondholders of Anglo Irish Bank and the Irish Nationwide Building Society if the European Central Bank agreed. That added to fears that countries beyond Greece might be involved in a broader restructuring.

Also, some well-regarded economists say that a Greek default is almost inevitable. The chances of Greece defaulting are “so high that you almost have to say there’s no way out,” Alan Greenspan, the former chairman of the Federal Reserve, said on a “Charlie Rose” broadcast, shown on Bloomberg TV on Thursday night. He added that as a result, some American banks may be “up against the wall.”

The financial markets are watching nervously as the Greek government tries to push through austerity measures required to secure more international aid.

Greece “needs to better inform the markets as well as the Greek people that what’s being done is actually achieving results, which will help restore confidence,” said Claude Giorno, the senior economist for Greece at the Organization for Economic Cooperation and Development, based in Paris.

But the United States, for the time being, appeared insulated from the problems, and American assets remain a destination for anxious global investors, with the dollar and Treasuries rising.

The Standard Poor’s 500-stock index rose 2.22 points, or 0.18 percent, to 1,267.64. The Dow Jones industrial average closed up 64.25 points, or 0.54 percent, to 11,961.52. The Nasdaq composite index fell 7.76 points, or 0.29 percent, to 2,623.70.

Still, two Deutsche Bank strategists, Jim Reid and Colin Tan, warned in a report on Thursday that this Greek crisis had echoes of the collapse of the Lehman Brothers investment bank in September 2008, an event that plunged the financial system into chaos and required the commitment of trillions of dollars in government support to stave off another Great Depression.

“Everyone in every corner of global financial markets should be keeping a very close eye on upcoming Greek events,” they wrote. “The period is resembling the buildup to the Lehman collapse where, although markets were increasingly nervous, virtually everyone expected a last-minute buyer.”

One ugly scene that some analysts are imagining involves a default by Greece leading to losses inflicted on banks in other European countries that own large amounts of Greek debt. The European Central Bank, too, is a big holder of debt, and analysts said in the event of a default it might need to be recapitalized, another blow to confidence.

Those losses could then cascade to the United States because the American and European banking systems are so interlocked, lending billions of dollars to each other every day.

American banks and insurance companies may also be liable for the biggest share of default insurance payments to European institutions if Greece or other countries fail. And the trillion-dollar money market fund industry could also suffer.

About 44.3 percent of money-market fund assets are European bank debt, according to Fitch Ratings, although they may be a little insulated because they have sold much of their Spanish, Portuguese and Irish debt. The funds have never held Greek bank debt, which rarely met the funds’ credit rating standards. The markets are keenly watching for signs that contagion is spreading through the global financial system.

The renewed volatility in the markets has again trained a spotlight on the Chicago Board Options Exchange Volatility Index. The VIX, as it is known, measures the implied volatility of options on the Standard Poor’s 500-stock index. It rose to settle above 21 on Thursday for the first time since March.

Another pressure gauge under scrutiny is the overnight interbank lending rate. As of Monday, investors’ expectations for three months from now of the overnight interbank lending rate showed an increase of about 10 basis points to nearly twice its current levels.

Still, increases in those two measures so far pale in comparison to the spikes in both during last year’s flare-up in Europe.

Contributing reporting were Eric Dash, Stephen Castle, Matthew Saltmarsh and Liz Alderman.

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Japanese Central Bank Cuts Growth Forecast

HONG KONG — The Bank of Japan slashed its economic growth forecast Thursday in the aftermath of the natural disasters that hit the country last month but refrained from announcing fresh steps to stimulate the economy — a sign that the central bank expects rebuilding activity to lead to solid growth again later this year.

The bank said it now expected the Japanese economy, the world’s third-largest, after those of the United States and China, to expand only 0.6 percent in the current business year, which ends March 31, 2012. That is down from the rate of 1.6 percent the bank had forecast in January.

“As a result of the disaster, the economy will inevitably continue to face strong downward pressure for the time being,” the bank said.

Corporate profits are likely to fall significantly, and private consumption and business investment will remain weak for some time, the bank added.

Bleak data published separately Thursday underlined the economic weakness created by the March 11 earthquake and tsunami and the nuclear crisis and supply chain disruptions that followed. Industrial output in March fell a record 15.3 percent from the previous month, according to the trade ministry.

“Today’s data releases provide another powerful reminder of the devastating effect of Japan’s recent disaster,” Frederic Neumann, a regional economist at HSBC in Hong Kong, commented in a research note. “While data will look better from here on, the Bank of Japan will still need to announce additional monetary easing measures this quarter to abet the recovery.”

In a bid to calm a near panic in the financial markets immediately after the earthquake, the Bank of Japan flooded the markets with liquidity and expanded a program to purchase government and corporate bonds.

This month, the bank announced a loan program totaling ¥1 trillion, or $12.2 billion, to help financial institutions in the disaster area extend reconstruction-related loans.

On Thursday, the central bank left its key interest rate at zero to 0.1 percent, as had been widely expected, in a bid to help the recovery. But it announced no additional measures, saying it wanted to assess the effect of its previous steps before taking more action.

“The B.O.J. took the decisive step of increasing asset buying in March, and actual purchases have only just begun,” Masaaki Shirakawa, the central bank governor, said, according to Reuters. “It’s important to examine the effects of the move for the time being.”

The bank also struck a positive note on the prospects for recovery later this year and raised its forecasts for growth during the financial year that starts in April 2012 to 2.9 percent, from an earlier forecast of 2 percent.

Like other forecasters, the bank expects the Japanese economy to rebound once rebuilding gets under way in earnest and power supplies and the flow of components and spare parts in the manufacturing sector get back to normal. Unlike the situation during the global financial crisis, economies elsewhere are growing, meaning that international demand for Japanese goods remains solid.

“From the beginning of autumn 2011, supply-side constraints are likely to ease,” the central bank wrote. “Moreover, efforts to restore capital stock damaged by the earthquake disaster are projected to gradually provide a boost to Japan’s economy.”

Still, the government and the central bank will need to provide support to affected areas, and the Japanese economy as a whole, for months to come.

Hampered by an aging population, high government debt and intermittent deflation, the Japanese economy is unlikely to expand much more than 1 percent per year in the medium term, even as the effects of the March disasters wane, the ratings agency Standard Poor’s said Wednesday.

That makes Japan one of the slowest-growing developed countries in the world.

Japan is also a laggard within Asia, where developing nations like China and India are expanding at rates not far off 10 percent a year.

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