Debt Man’s Curve: It's No Place to Play

[CrackSmokeRepublican]

Debt Man's Curve: It's No Place to Play

The 1964 top 10 hit song, "Dead Man's Curve," by Jan and Dean ended with a disastrous car crash. Now it seems that many bond issuers are beginning to flirt with their own Dead Man's Curve. Bob Prechter wrote in his best-selling book, Conquer the Crash:

    Any bond that is AAA at the start of the depression and remains AAA throughout it will be a satisfactory investment. The problem is, who can figure out which bonds those are?

A problem made more difficult, he points out, because many companies, municipalities and sovereign governments will come face-to-face with the prospect of default as the deflationary depression wears on.

The problem he poses piqued our interest, and we have devised a new way to look at the different risk levels of bonds -- the Debt Parabola (a.k.a. Debt Man's Curve).




Essentially, this configuration graphically depicts current 10-year yields from various issuers. What's special about this chart is that it shows sovereign, municipal and corporate issues on the same spectrum, so that we can see, for example, how high-yield corporate bonds compare with Greek debt. We chose a parabola to depict the situation of debt issuers because debt gets exponentially harder to repay or refinance as the interest rate rises, especially for large debtors. So problems tend to intensify exponentially the higher up the curve one goes -- just as the angle of a parabola's ascent grows steeper. Two observations:

1. Shorter duration: As we've stated many times, U.S. T-bills carry less risk than do longer-term maturities. This point is no secret to the market, which is willing to lend money to Japan, the U.S., Germany and even the UK at less than 1% as shown in "The T-Bill Zone." We agree with the market's take on this, that "shorter is better" with respect to duration. In other words, stay invested in the short end of the curve so that you can stay relatively safe and capture higher yields as rates adjust upwards, just as Conquer the Crash points out.

2. Debt-to-GDP ratio: Even though Japan's sovereign debt is at one of the highest levels in the developed world (200% of GDP), its bonds are held dear. In contrast, the market requires Greece to pay much higher rates, even though it has a lower debt-to-GDP ratio (115%). Why? It's another display of non-rational, emotion-driven markets, since it's not the actual ability to repay that matters in the near term -- it's the perception of the ability to repay.

You see, the argument is somewhat circular: Japan pays low interest rates, therefore its ability to repay its debt is high. But if Japan had a 10% rate, its massive debt load would likely be too large to carry, and it would join the ranks of Venezuela (which carries about an 80% likelihood of default over the next 10 years). In other words, Japan's low position on the parabola means near-term debt repayment is highly likely, even though its large debt means investors should be wary of exponentially larger problems in the future.

Our big-picture forecast is for a deflationary depression, commonly thought of as a perfect environment for bonds, but that does not mean that all bonds will perform well -- far from it. We anticipate various issuers reaching the "Trouble Zone" over the next few years, and although the Trouble Zone is slightly different for each issuer, it's the concept of exponentially larger trouble that's important. Also, remember that the larger the debtor, the more difficulty higher rates impose, and the greater the contagion risk. Other signals that can drive a debtor up and over Debt Man's Curve include large foreign currency–denominated debt, which often makes repayment more difficult, and having a high level of short-term debt, which increases refinancing risk.

As the market comes to grips with the deteriorating condition of the globe's debt issuers, we expect to see many yields rise. We will return to the Debt Man's Curve model in the future as investors realize that suspect issuers' debt is truly "no place to play."
Dead Man's Curve, it's no place to play.
Dead Man's Curve, you must keep away.
Dead Man's Curve, I can hear 'em say:
"Won't come back from Dead Man's Curve."
Disclosure: No positions

http://seekingalpha.com/article/222395- ... ce-to-play