Understanding Credit Markets: Flight-to-Safety

When Lehman declared bankruptcy on September 15 2008, one money-market fund that had lent as much as $785 million to Lehman declared that it was unable to pay the full amount of its liabilities. It was the first time that such an event took place! Investors promptly took $40 billion out of that fund. NOW EVERY PARTICIPANT IN THE CREDIT MARKET STARTS TO FEAR ABOUT THE SOLVENCY OF EVERYBODY ELSE!!! WHO HAS LENT TO LEHMAN? WHO HAS INSURED THOSE WHO HAVE LENT? ETC. ETC. ETC.

This feeling of general distrust sets in motion a flight-to-quality episode in credit markets. Let us see how that works. Imagine one Ms. De Souza, a 37-year old hospital manager in Sao Paulo, Brazil. A mother of two, she wants to send her children to a US college. She needs to very cautious about her $400.000 nest egg! She watches the Lehman news on TV; she reads the newspapers. She starts to worry. “What if my investments in loans to companies both in Brazil and the US decline in value as banks refuse to lend to private companies? What if my investments in loans to emerging market states decline in value as global economic trade and growth falls, forcing some states to default on their debt?” She makes up her mind and calls her broker in Sao Paulo, with three very precise instructions:

1. Stop all lending to entrepreneurs, wherever they are located

2. Stop all lending to sovereign issuers from emerging markets countries

3. Invest all the available resources into loans to the US Federal government, or to the German government.

The behavior of our hypothetical Ms. De Souza is replicated worldwide. Many investors react exactly like her: in Russia (INVESTING IN GERMAN BUNDS), in Thailand, in the Netherlands, etc. Now remember the paper from Horace Brock (Session 1): INTEREST RATES CHANGE WHENEVER NEW INFORMATION ALTERS THE BEHAVIOR OF EITHER/OR THOSE WHO SUPPLY LOANABLE RESOURCES AND THOSE WHO DEMAND CREDIT. The Lehman Brothers bankruptcy IS INDEED NEW INFORMATION! Interest rates are bound to change. But how? Let us look at two different kinds of credit markets: (a) sovereign borrowers; (b) corporate borrowers. 

(a) Sovereign borrowers (national governments). They can be further divided into two categories. Some countries that feature an institutional framework that protects the performance of contracts (rule of law, stable property rights, judicial independence). That list would include: US, UK, Canada, Germany, The Netherlands, Japan, most Nordic countries, Switzerland, etc. These tend to be perceived as risk-free borrowers.

(b) Corporations (companies). Unlike sovereign issuers, private companies are unable to impose taxes; their solvency is at risk whenever the economy goes into a prolonged recession.

Note that the definition of “risk-free” is not set in stone. The USA were very risky issuers of debt between 1776 and 1783! Nowadays, some emerging-market countries have made phenomenal progress in terms of property rights protection and credit market sophistication (Brazil, Singapore and South Korea come to mind here). BUT GENERALLY SPEAKING, FLIGHT-TO-QUALITY EPISODES TEND TO END UP WITH LOANABLE RESOURCES BEING REDIRECTED TO SOVEREIGN BONDS OF COUNTRIES WITH INDEPENDENT CENTRAL BANKS, JUDICIAL INDEPENDENCE, RULEOF LAW, ETC.

[DIAGRAMS. WE PLOT CHANGES IN THREE CREDIT MARKETS]

(a) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE ENTREPRENEURS CREDIT MARKET: THE INTEREST RATE GOES UP.

(b) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE CREDIT MARKET FOR RISKY SOVEREIGN BORROWERS: THE INTEREST RATE GOES UP.

(c) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY MORE IN THE CREDIT MARKET FOR RISK-FREE SOVEREIGN BORROWERS: THE INTEREST RATE GOES DOWN.

A FLIGHT-TO-QUALITY EPISODE OCCURS WHENENVER EVENTS (a), (b) and (c) take place.
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Credit spreads

Credit spreads are important financial and economic indicators. Credit spreads are simply the difference between two interest rates, one from a risk-free credit market and the other from a risky credit market.

(a) Credit spread between entrepreneurs’ and risk-free credit markets. Example. In the USA, the so-called “junk bonds” are credit contracts issued by entrepreneurs (see here). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for entrepreneurs is 6.70% and the interest rate for US Treasury debt is 1.86% (see), then the credit spread is 6.70% minus 1.86% = 4.84% [Note: these rates change every day, every hour, every minute!]

(b) Credit spread between sovereign emerging market debtors and risk-free credit markets. Example. The average interest rate paid by risky sovereign issuers in emerging markets is currently 5.30% (see). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for risky sovereign emerging markets issuers is 5.30% and the interest rate for US Treasury debt is 1.86% (see), then the credit spread is 5.30% minus 1.86% = 3.44% [Note: these rates change every day, every hour, every minute!]

DURING A FLIGHT-TO-QUALITY EPISODE, CREDIT SPREADS TEND TO WIDEN, AS INTEREST RATES IN RISKY CREDIT MARKETS RISE, WHILE INTEREST RATES IN RISK-FREE CREDIT MARKETS DECREASES.

[CHARTS: JUNK BOND SPREADS]

NEGATIVE INTEREST RATES? ON DECEMBER 19, 2008, THE US 3-MONTH TREASURY BILL GOES NEGATIVE. WHAT DOES THAT MEAN?
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