Friday, December 01, 2006

Reality Check / bill gross pimco

good stuff from bill gross. the risk premiums are also the key to the stockmarkets. if something is hapening in this segment all the crazy lbo´s and mergers are much much harder to finance. when i read gross he thinks spreads from here on have almost only one way to go ..... up!

klasse. mit pimco hat die allianz nen guten fang gemacht. das thema risikoaufschläge ist unter anderem der schlüssel zu der weiteren entwicklung der aktienmärkte. wenn hier schwierigkeiten auftauchen werden die ganzen lbo´s oder übernahmen viel vile schwerer zu finanzieren sein. wenn ich gross richtig verstehe können die spread von hier aus nur in eine richtung gehen..... nach oben.’s hard to manufacture butter when an economy slows below the point that historically sustains profit and job growth and therefore minimizes risk......

What I would like to speak to now is the current pricing (overpricing) of certain risk assets.....

When the Fed cut interest rates to 1% in June of 2003, I could guarantee you that they could only cut them 100 basis points more. When 10-year yields on Japanese JGBs hit .35% at the same time, I could almost guarantee you that their incredible bull market run was coming to an end. NASDAQ 5,000? Easy in retrospect, but harder at the time, if only because the mathematics of value were being biased by the phantasms of hope. The floor was 5,000 points below, but the ceiling somewhere in the wild blue yonder.

Because the bond market is more mathematically oriented than riskier asset markets, it stands to reason that a quest for certainty and reality in financial markets would begin there. Fed Funds at 1%, JGBs at .35%, and ?. Where is the present day counterpart where one could claim that prices could go no higher or risk spreads compress no further? We are beginning to find such evidence in the investment grade corporate bond market, the narrowing spreads of which are displayed in Chart 1.
While a rather obvious 25 or 35 basis points to 0 analogy could quickly be advanced here, a finer, more precise analysis emanates from the quantitative dissection of a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or “constant proportion debt obligation.” more on cpdo /economist) Without too much explanation, these multibillion-dollar instruments lever investment grade indices up to 15 times ....... The increasing use of leverage, in other words, at least as applied to this particular area, appears to have run out of its magical ability to increase returns. Investment grade corporate spreads therefore are not likely to narrow further.

This is a critical analysis because if extended to other asset markets, it begins to imply that the leverage potency of recent years is reaching a peak, ..... how much leverage can be applied before the chances of losing all your money dominate the outcome? Its conclusions, under the new world assumption of today’s low volatility and narrow asset risk spreads, reinforce in general what I have offered to be the case with the CPDO in specific. There is a maximum leverage point, 7-8x in this example and eerily reflective of today’s hedge fund proclivities, beyond which returns can be maintained only with increasing and significant expectations of financial loss. We estimate that the maximum alpha an average hedge fund can generate in today’s marketplace utilizing a broad array of financial assets which average a 50 basis point risk premium, displayed in Chart 2, is 200 basis points. Any attempt to go further by levering up an already 8x levered portfolio increasingly risks significant and in some cases, total loss of principal.

And so? No gloom and doom message here. ...... But we are approaching limits. ..... But I have a strong sense that the ability to lever any or all asset returns via increasing leverage is reaching a climax and therefore, that CPDO, corporate credit spreads, and more importantly, sophomoric assumptions of future assets returns in all markets may require some future compromise, as the current masquerade of high asset returns gradually morphs from cream to skim milk.

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Blogger Chip said...

Thanks, Jan-Martin -- nice summary. Scary graphic.

1:01 PM  

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