Centre Street Cambridge Corporation

Private Investment Counsel


April 1997

The first period of 1997 provided ample entertainment for the entire family, from “the thrill of victory, to the agony of defeat,” as the financial markets at first rose to new records in January and February, only to proceed to a series of losses, culminating in a 2% decline on the last day of March. But prior to the downturn the action had been somewhat reminiscent of that of three years ago when a small number of securities did well and held up the popular averages, while large numbers actually suffered significant declines from their previous high levels. Nervousness and fear were abroad as the fact of high valuations and the possibility of rising interest rates finally seemed to dawn on the investment world.

We can scarcely view these events in isolation, however, since it was the spirited proceedings of the previous two years that set the stage for the recent turmoil. Following a difficult 1994 when, as may be recalled, interest rates rose quite dramatically, the markets lifted off for two unusual years of double-digit gains. Consistent with historical behavior, the powerful upsurge in security prices led to “extrapolative” thinking (the expectation that things would simply continue on their merry way), complacency and high valuations, all of which, to the objective observer, spelled heightened risk. So delicate was the investment climate as we entered the new year that it was hardly surprising the markets would respond so negatively to relatively small changes in interest rates and the economic outlook.

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Typical of periods of financial hyperventilation is the tendency to belittle those who would question their legitimacy or warn of excesses. As befitting a fine historical tradition, many commentators made short shrift of Chairman Greenspan's oft-quoted “irrational exuberance” remark of last December and criticism of his cautionary statements continued, with members of Congress getting into the act as well, telling Greenspan, in so many words, to mind his own business. Remarks by Warren Buffett to the effect that stocks were overpriced seemed to be taken more seriously, presumably because people felt the markets are his business (something we suspect he would vigorously deny). In any event, it was the Federal Reserve's move to boost interest rates, despite its being widely anticipated, that finally caused many to pause and reflect. This was ironic, since, had they bothered to pause and reflect a little earlier, they would have noted that market rates had already been rising for some time.

Although his attempt to exert a dampening influence on the free-wheeling financial markets brought nasty remarks from a number of quarters, it seems to us that Mr. Greenspan knows financial history and his own place in it. There have been times when a few well-placed words from those in authority could have spared many innocents from the woe that was to beset them, or at least limit the extent of the damage (those who have read Galbraith's history and analysis of the Great Crash know whereof we speak). We also think it is important to note that Greenspan's opinions were based on concrete data and were not simply the result of his own subjective evaluation of “market psychology.” One somewhat arcane piece of data the Fed chairman referred to was the “spread” among interest rates. This is an interesting area to explore for what it can reveal about certain characteristics of fixed-income markets and, more importantly for this discussion, risk-taking behavior on the part of market participants.

First of all, there is more than one “interest rate.” The rates on mortgages, CDs or money market funds are ones most people are familiar with; others would include corporate bond rates, rates on U.S treasury securities and foreign rates, to name a few. All vary with time to maturity, issuer creditworthiness and other factors. On Wall Street, rates on debt instruments are commonly quoted in terms of their relationship to some benchmark rate, often that of a government security of similar maturity that represents a “risk-free” rate (since default on government obligations is normally considered unthinkable). The difference in rates between the bond in question and the benchmark is the “spread.” The spread is also often referred to as the amount which the bond yields “above” the comparable benchmark security (a higher yield is offered as compensation for bearing greater risk).

Over time the bond markets exhibit what might be termed “normal” spreads among securities. Corporate bond XYZ, for example, might yield two percentage points above comparable treasuries on average. But the spread varies over time. In times of financial stress, buyers tend to favor lower risk securities over those whose ownership is perceived to entail greater risk; so, the treasury yield would remain more stable as XYZ's rose (the corporate bond's price would tend to fall under selling pressure -- yield's rise as prices fall), and the spread would widen. Conversely, in good times, investors, less fearful of corporate hardship, would tend to favor the higher-yielding XYZ and the spread would narrow. Spreads are, therefore, an indicator of the relative levels of risk among fixed income securities, and they can be interpreted as an economic barometer of sorts, registering investor expectations about the course of economic activity.

Although scarcely commented upon at the time, an unusual narrowing of spreads was taking place in the fixed-income markets during 1996, reflecting widespread confidence regarding the economy. In particular, there was a dramatic decline in yields on so-called “high-yield” or “junk” securities, both in absolute terms and relative to comparable investment-grade bonds. Last May, for example, Barron's reported that high-yield/investment-grade spreads had narrowed to about 2.4 percentage points, compared to an average of about 3.5 points over the 1985-96 period, and highs of as much as 8 points during periods of economic distress in decades past. The difference between junk and treasuries would have been somewhat wider, given treasuries' lower yields, but by year-end the junk/treasury spread had declined to about 2 percentage points. Seldom had it been lower. Clearly, purchasers of low-grade paper were willing to throw caution to the wind and accept much higher risk for a meager additional return.

Although obvious from these figures alone, there was also ample anecdotal evidence to indicate that rampant speculation was afoot in the fixed-income markets, not to mention the stock market. Issuance of new junk debt reached $66 billion in 1996, short of the record $72 billion in 1993. Cash flows into high-yield mutual funds did hit a record, as retail buyers “reached” for yield in a relatively low interest rate environment. Professional money managers, in their zeal to capture the extra bit of return that will permit them to outdo their peers, were not to be left out of what was becoming a newly respectable class of investment. Among them “momentum” players, who are attracted to the most popular securities of the moment, jumped on board. Even insurance companies entered the market, hoping to offset the high cost of new financial products (not a new strategy for some insurance companies, which usually pay the price down the road when some unexpected development -- an economic slowdown is a common culprit -- raises the default rate on their portfolio of junk bonds). Some players seemed attracted to the high-yield arena simply due to a lack of excitement elsewhere: last December, the Wall Street Journal quoted one of the latter as saying “It's a range-bound, sort of boring market, and it makes sense to search for higher yield.” With talk like this, it's small wonder Mr. Greenspan concluded that the time had come to deflate some of the enthusiasm.

The denouement of our story follows a pattern so typical of Wall Street excess: the search for higher yield turns out not to have made much sense after all. Early this year, as interest rates rose and stocks dropped, interest in junk debt rapidly faded. Since March 12 about $1.6 billion has been withdrawn from mutual finds specializing in high yield securities. It just goes to show that in matters financial, it's not a good idea to do what everyone else seems to be doing.

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The buildup in speculative fervor after two years of abnormal market returns, punctured from time-to-time by nervous retreats, only to resume with renewed vigor, leaves us more convinced than ever that commitment to a long-term view, careful analysis of businesses and respect for valuations are essential to successful activities in securities at sensible levels of risk. Worrying about what the Fed will do next or ranting at “boring” markets seems, to us, to be a silly way to spend time. Treasury Secretary Rubin said of recent market volatility that it would have a “next to negligible” impact on the economy. Likewise, such short-term considerations mean very little over the course of a lifetime of investing.


Dennis Butler, MBA, CFA