Summer is usually a tranquil time in the financial world, but this summer has been anything but uneventful.
Europe is in crisis. Bickering politicians in Washington pushed the United States to the brink of default, leading to a downgrade of U.S. debt for the first time in history. And above all, markets have gone through a period of unprecedented volatility.
Chances are these financial woes will be with us long after the weather cools and the leaves fall. That means the confusing and unsettling financial speak we've heard in business news of late will also stick around, so there's no time like the present to brush up a little on your market intelligence.
What's in a rating?
Let's start with ratings agencies: Moody's, Fitch and Standard & Poor's (S&P). It's somewhat amazing these institutions have credibility after the 2008 meltdown. They were once trusted to assess corporations' and governments' ability to pay their debts. But they soiled the bed in the last decade, failing to accurately rate U.S. mortgage-backed securities, says Jafer Naqvi, a senior associate with investment firm PIMCO Canada.
"They had a lot of that paper rated AAA and it proved to be anything but."
As we all know, these investments were chock full of subprime mortgages.
Surprisingly, the rating agencies still have enough authority to give markets a good shake as S&P demonstrated, recently downgrading U.S. debt from AAA, its highest rating, to AA+, the second highest credit rating.
The downgrade really means nothing in terms of default risk, says James Hymas, president of Hymas Investment Management, Inc., a Toronto-based fixed income investment firm.
"The chance of default has increased from 0.01 per cent to 0.015 per cent," he says. "The difference between AAA and AA+ is something that's more a matter of perception than something that can actually be measured."
Call it a shot across the bow of U.S. lawmakers.
While many fretted about the downgrade and, arguably, it sparked turmoil in North American stock markets for a couple of days, a curious thing happened to the value of U.S. debt. But before we get to that, a short bond 101 might prove helpful.
The unyielding power of bond yields
Under normal circumstances, a debt downgrade would increase two things: the yields on existing bonds and the cost of issuing new bonds. And these two outcomes are related. Bonds are financial instruments that allow companies and nations to borrow money. The yield is the return on a bond relative to its market value. The higher the yield, the lower the market value of the bond. Here's an example: A bank buys a $100 bond from a government that pays an interest — or coupon — rate of four per cent annually for 10 years. Halfway through the term, the government gets into economic trouble and it's uncertain whether it will pay back the $100. As a result, the bank wants to sell the bond before it matures, but a buyer will only pay $65 instead of the bond's original $100 face value. At this discounted rate, the new owner receives a higher return on that bond.
The four per cent coupon payment on $100 is more like a 14 per cent payment on $65. The higher return isn't guaranteed. The government might default on its debt and not pay back the $100 at maturity.
And because of this uncertainty, the bond has a yield of 14 per cent. "Greece is the poster child for investors not having a lot of confidence," said Stuart Graham, president of PIMCO Canada. "If you were looking at a 10-year Greek bond, that's coming with a yield of about 14 per cent."
High yields can affect a government's ability to issue new bonds because new issues must pay a coupon rate to match the current yields on its existing bonds in the market. This has a domino effect, creating more hardship. Investors infer that because the government is having a hard time making good on its $100 debt that pays five per cent over 10 years, it's likely going to have an even harder time paying a higher rate on new bond issues.
As a result, the government might not be able to find buyers of new debt, which increases the likelihood of default on existing debt, unless the government cuts spending and/or raises taxes to find money to service its existing and future debts.
The U.S. exception to the rule
One would assume U.S. bonds (called treasuries) would decrease in value and their yields would increase because of the S&P downgrade. After all, its fiscal situation is getting worse, not better. Yet the opposite happened. U.S. treasury yields decreased and their market value increased.
"For a brief moment, U.S. treasuries were at a record low of about two per cent, which means people were willing to spend money for 10 years at essentially two per cent," Graham says.
The reason is that the U.S. dollar remains the world's reserve currency (though many market watchers argue its status is eroding and gold is again becoming the world's reserve currency).
"Investors are actually going to go to those instruments that have the highest quality or safety factor," Graham says. "That highest safety factor is still U.S. treasuries, along with the debt of other major countries."
Canada, Norway and Australia are examples of other nations with bonds that are perceived as safe, but they don't issue enough debt to meet the global demand and aren't perceived as liquid (easily tradeable) as U.S. treasuries.
"What this all says about the investor psyche is we're just really worried and we're more concerned about return of our money than a return on our money," he says.
As a result, the S&P downgrade of U.S. debt may have ruffled the feathers of equity investors, but it sent them running toward the very investment S&P has called into question.
Europe's problems are everyone's business
The U.S. debt downgrade was only a side dish to the main course of financial worries that have driven markets over the past few weeks, Hymas says.
"The real story was the debt crisis in Europe with the European Central Bank starting purchases of Spanish and Italian bonds," he says. "That had the effect of forcing people to focus their attention on the bond portfolios and to a large extent they decided that Europe was getting too risky for them and they wanted to hold the U.S. debt."
And it's the European Union members' debt problems that will likely continue to fuel volatility in all markets for the foreseeable future. It's reached the point that even rumours of problems — like concerns about French banks' creditworthiness — can send investors rushing for safety.
European policy-makers are trying to stem the spread of contagion from Greece, Portugal and Ireland — their bond yields are more than or near 10 per cent — to Spain and Italy, two of the largest economies in Europe.
To combat this threat, the European Central Bank (ECB) is buying Italian and Spanish bonds.
The ECB's buying spree is an effort to control bond yields, Naqvi says. "They don't want the market to think the risk in Spain and Italy is excessive, so they're trying to keep the yields down to keep the cost of financing down to control that situation," he says.
"The analogy we would use is they're trying to build a bridge to such a time that sovereign debt can be financed by the private marketplace."
At the moment, the market is selling these bonds, not buying them. European banks and other large investors have these bonds on their books and want to unload them. The ECB is stepping in to buy up the unwanted bonds to help stabilize the European banks because just the prospect of default on Spanish and Italian bonds affects their ability to do business, Hymas says.
"A big piece of the puzzle is liquidity because a bank keeps a liquid reserve of investments and in the course of its business it might need to borrow $100 million for a short term and it might want those bonds as collateral to get a loan from another institution," he says.
"The trouble is, what if you own Greek bonds, for instance, and your usual counterparties aren't accepting those as collateral?"
And liquidity is important to banks. Greek bond defaults are one thing, but default worries about Italy and Spain's bonds — much larger fish — are another. If financial institutions become worried enough about one another's investment books, liquidity in markets can dry up — as we saw in 2008.
But Hymas says while the problems are real, they don't necessarily lead to a major calamity until there's a major shift in perception all at once. It's a 'Wile E. Coyote moment' — to quote New York Times financial columnist and economist Paul Krugman.
"You'll remember from the cartoons that Wile E. Coyote is always running off cliffs, but he doesn't start falling until he looks down," he says. "The way crises finally come to light is when investors as a group suddenly look down."
Volatility... investor friend or foe?
Arguably, we have been having those moments every other day in the markets of late, Hymas says. This has led to volatility in both the bond and stock markets.
"We have this daily risk on and risk off in the marketplace," Graham says.
Stock indices can be up 500 points one day — the risk is on — and down 400 points the next — the risk is off.
And in amongst the uncertainty are bargains, says Don Reed, president of Franklin Templeton Investments in Canada. "We know the European banks are struggling and so on, but generally speaking, many corporations are in great shape." In the U.S., for instance, many corporations listed on the S&P 500 have reported earnings higher than analyst forecasts.
"Cash on the balance sheets of U.S. corporations is at an all-time high," he says, adding many Canadian corporations' balances sheets are equally as healthy. Besides being flush with cash, look for companies that pay steady dividends, have good management, low debt, sustainable earnings growth and a global presence, he says. Better yet, look to invest in emerging markets like China, Brazil and India with growing middle classes to service.
And investors shouldn't fret about the bad market days and volatility — so long as they have a longer time horizon until they need the capital.
"Investors are focused too much on day-to-day things that are happening, and that's causing some to be hurt financially because the market goes down and they sell, which is precisely the wrong thing to do."