Equity market duration and the Wizard of Oz
Last week, Bank of America Corp.’s head of U.S. equity and quantitative strategy, Savita Subramanian, said something very interesting about the S&P 500:
“The S&P 500 has essentially turned into a 36-year, zero-coupon bond,” Subramanian said in an interview on Bloomberg TV’s Surveillance. “If you look at the duration of the market today, it’s basically longer duration than it’s ever been. This is what scares me.”
While we are not exactly sure how Bank of America comes up with “36-year zero-coupon bonds” (we assume it is some sort of beta analysis), it appears that Ms. Subramanian is telling us many companies are leveraged to the hilt and a move up in interest rates and a widening of credit spreads will compress margins, increase the cost of capital, reduce earnings, and ultimately equity valuations. This very insightful observation not only sheds a bright light on the fragility of equity valuations but should also send chills down the spine of investors’ heavily leveraged loans and high-yield bonds.
In these markets, there are many companies that cannot generate enough cash to meet debt service, let alone have some cash flow left over after they service their debt. We continue to point out that about $400 billion leveraged loans reside in open-end mutual funds that promise timely liquidity to investors upon request. There’s also plenty of investor capital in high-yield bond funds. We saw what was going to happen to that market when the music stopped and liquidity evaporated last March. Actually, we didn’t see it because the Fed and Treasury bailed everyone out before it happened! Last March, the Fed saw (amongst other things), that the multi-trillion, high-yield corporate debt market’s liquidity went to zero and perhaps finally realized there is indeed a problem that threatens the financial system.
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