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Exactly a month ago, physicists at the University of Copenhagen revealed a breakthrough of mind-boggling importance for the future of mankind. I have to admit it passed me by, as I was leading a personal war against dry January.
The researchers worked out how to control two quantum light beams, rather than the usual one. Why does this matter? Because we can now create at will something called quantum mechanical entanglement. These lights can influence each other instantly and across huge distances.
This is a big deal for computing, apparently. And because the resulting quantum bits can be 1 and 0 simultaneously, chips millions of times more powerful than today’s are coming. Also announced this week, Google says it can make them less error prone.
Nope, I haven’t a clue either. Then again, if you think you understand quantum physics, as Richard Feynman or maybe Niels Bohr once said, you don’t understand it. I am reminded, however, of a similar investment phenomenon — and equally misunderstood.
Take a recent FT headline: “Investors pour record sums into high-grade corporate bonds”. It would be just as true if it read: “Investors ditch record sums of high-grade corporate bonds”. Two opposing states of the world existing at the same time.
How come? Because in secondary markets, such as equities or credit, there must be a buyer for every seller and vice versa. There is a fixed stock of securities which can only change hands — cash does not flow in and out, as commonly said.
Hence phrases such as “money on the sidelines” or “record purchases of Chinese stocks” are nonsense. Any cash on the sidelines will be replaced by cash belonging to whoever sold. Likewise, investors do not flee a market in meltdown. Someone is buying — just at a much lower price.
So what is actually happening when investors get excited by a particular asset class, such as corporate bonds? The latter makes me nervous at the moment because my portfolio doesn’t have any. Should it? More on that later.
Investors can shift money from an equity fund to a credit fund — sure they can. And if they are bullish they will bid up prices of the underlying bonds. Sellers, on the other hand — and there have to be just as many — are taking an opposing view at these prices. That’s how markets work.
The amount of money which is mistakenly seen as flowing into corporate bond “markets”, therefore, is either fund-level data, or the increase in the value of the market. No bad thing of course. Unless you were an early seller.
A small caveat, though: bonds and equity markets are not completely sealed. The former have a finite life. Many are rolled over. For example, fresh capital into US credits last year was equivalent to a tenth of the total value of bonds outstanding. In emerging markets it can be higher.
With equities, however, the flow of money in and out is tiny compared with the size of the stock market overall. Last year in the US, to compare, initial and follow-on public offerings were worth 0.01 per cent of the S&P 500 capitalisation. Buybacks — when cash is returned to investors — amounted to 0.03 per cent.
Now we understand that money isn’t pouring into corporate bonds, although the prices at which buyers and sellers are happy to trade are rising. Or they were. The rally since October last year is having a pause this month. US investment grade credit is down 3 per cent. European junk bonds are a percentage point lower.
Why is that? And does the recent weakness alter my ambivalence to the asset class? I wrote in December that my fixed income preference was government bonds over credit.
First, let’s remind ourselves what corporate bonds are, and what makes them move. Credit securities are essentially a form of debt funding, where a company pays you a coupon in return for having your money for a set period of time.
Yields are determined by a number of things. The two important ones are the risk-free rate of borrowing (what an investor would be paid if they lent to the government instead) and the probability a company goes bust. How long until the bond is repaid also affects its price.
You can see the fact that government bond yields have begun to rise again since mid-January does not help credit (remember that prices move in the opposite direction to yields because bonds pay a fixed coupon).
It is also true that credit markets don’t like uncertainty. As well as going up, government bond yields have become more volatile of late, as investors try to work out whether inflation is here to stay or not, and how much central banks care.
The risk-free component of credit prices is not the only worry. Some investors are focused on the possibility of rising defaults. Business indicators in the US, for example, such as domestic non-financial profits growth and capacity utilisation, are dropping fast. Deutsche Bank also points to a spike in credit card and loan delinquencies, which suggest the post-Covid credit boom may be over.
And this is what has always bugged me about corporate bonds. Unlike returns on equity or profit margins, which move up and down around a long-run mean, credit default rates always seem to always go more like: zero, zero, zero, zero, zero, ka-boom!
I exaggerate only a bit. Worse, the clever bond analysts I have worked with over the decades never seem able to predict when the explosion is going to happen. Who knows when the next one is. But given the extra yield one receives to compensate for default risk is currently small, why bother waiting to find out?
The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__
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