In Moody’s We Trust
Having recently qualified for Medicare, it occurs to me that I’ve been doing business with one bank or another for over sixty years. This began when my parents opened a savings account in my name to hold gifts I received for various occasions. Later, I deposited the earnings from my paper route and other part-time jobs into it. Savings accounts were obviously safe – you couldn’t miss the thickness of the vault doors – and also paid interest, a fascinating concept to an unsophisticated youngster.
As we are reminded every year while watching It’s a Wonderful Life, banks never have as much in the vault as their customers have on deposit since it’s loaned out to individuals and businesses. Banks do, of course, have some money on hand, as is required by their own operating principles and various regulators. But, as the market crash of 2008 proved, it’s quite possible for banks to lend too aggressively and find themselves short at just the wrong time. Various government agencies stepped in and supported some banks, forced others to merge with stronger institutions and allowed some to simply fail. Since we’ve now learned that the thickness of the vault door isn’t really a reliable indicator of a bank’s strength, where can we turn for the answer?
One place is Moody’s Corporation, a company which has been in the business of providing ratings for the bonds of a wide range of corporations, municipalities and national governments since 1909. It was founded by John Moody and was owned by Dun & Bradstreet for about forty years before being spun off to the public in 2000. It and two competitors, Standard & Poors and Fitch Group, cover just about every significant borrower in the world.
All utilize an enviable business model – most of their customers pay to get their ratings. Of course, all three assert that these payments are not a source of influence and that the ratings would be the same regardless of how the companies were compensated. Yet one has to wonder how this model affected the Aaa rating provided for what’s now known as “toxic debt”, those bonds which imploded to bring about the ’08 market crash. Warren Buffett’s Berkshire Hathaway owns more than ten percent of Moody’s. Perhaps not surprisingly, he defends their position that such ratings are simply opinions and in no way guarantee appropriateness in any specific situation.
These companies have long provided ratings for governments, including ours. Perhaps in partial penance for so seriously understating the risk associated with 2008′s Collateralized Debt Obligations, all three have been more aggressive recently regarding sovereign debt. Last August, Moody’s lowered the US government’s rating from Aaa (the highest of their twenty-one levels) to Aa (the next highest). Moody’s cited Congress’ inability to work out a budget compromise as the reason for the downgrade. Although you might think that such a public reduction in confidence would lead investors to sell, just the opposite happened. Investors were not frightened off by the change and there has been no shortage of buyers for US bonds.
As everyone knows, having more buyers than sellers pushes prices up and, as we’ve discussed, that pushes rates down. As I write this note, the return on a ten-year US Treasury bond is 1.40% and projected inflation is about twice that. Someone investing today will be losing money after allowing for inflation. As low as current rates are, they’ve been even lower a couple of times, briefly dropping below zero during the Great Depression and a few times during our current crisis. To be clear, that means that investors sometimes pay the government to keep their money instead of earning interest on it. Why would someone do that, in fact, why would billions of dollars be invested in the bonds of a country whose creditworthiness has been downgraded? The answer is that for all our apparent faults, global investors consider our dollar one of the safest currencies and our government one of the safest bond issuers in the world.
Recent headlines about European economies have made investors nervous and a two tier bond market has developed. Europe’s most solid economy, Germany, pays even less to borrow money for ten years than the US – just 1.26%, while troubled Spain now has to pay 7.44%. Why is this so? Well, individuals who own Spanish bonds are selling and few new buyers are stepping forward in spite of the seemingly attractive yields being offered.
To understand why, reflect on the plight of someone who has a savings account at a Spanish bank. That person has to consider the possibility that Spain might separate from the European Union, meaning later withdrawals might come in Pesetas instead of Euros. Should that happen, the depositor would certainly lose money, likely 25% or more. Compared to that, earning any interest seems like a good deal so withdrawals have been significant. This flight of capital has weakened Spanish banks to the point that intervention may be required. However, the stress this would put on the Spanish government has raised doubts as to whether bond owners could expect to receive full value for their investment. Many investors have simply chosen to sell rather than wait to find out; obviously they prefer German and US bonds.
Since German banks are huge holders of Spanish government bonds, I suspect that, political rhetoric notwithstanding, some sort of Euro-denominated, European Union-issued bonds will eventually be required to restore investor confidence. However stability is achieved, investors will eventually begin searching for yield again and we’ll see a reversal in bond prices. I’ve written before that an unprecedented amount of money has been flowing into bond funds as falling rates have provided unusually high returns. All that money has continued to drive rates down and here’s a chart showing the yield of the thirty-year Treasury since 1919:
When investor confidence does return, it’s pretty easy to see which way rates will go and prices will do the opposite. Although I’d prefer not to expose my clients to today’s stock market volatility, I’m much more concerned about exposing them to nearly certain losses when rates do move.