Byline: 

When I spoke to Jeff Smith, Managing Director Bank of America Capital Markets, about addressing this group of global fixed income managers, I was reading William Manchester’s biography on Douglas McArthur, an American Caesar. Unfortunately, an unfavorable comparison became apparent. First of all, it took McArthur less than three years to return to the Philippines. It has taken me nearly three decades of dedicated effort in the fixed income markets to be asked to address this body. Second of all, while McArthur’s mission was to defeat the Japanese, mine is to woo them. Much of my energies are spent in soliciting the large Japanese and Chinesse surplus of savings to invest in the U.S. corporate securities. It is unbelievable that with fifty years, Japan and China have transformed themselves from vanquished nations into the world’s major creditors. Thirdly, McArthur clearly in temperament, role and public perception was a revered commander-in-chief evoking universal awe and enhancing American prestige. In contrast, I share the stigma of our profession. That is, all of us who work on Wall Street have been chastened by recent revelations. Because some very prominent investment bankers and research analysts have colluded in massive trading frauds, they have become traitors to their profession and to American business. If William Manchester wrote about them, his book’s title might read An American Brutus.

It is therefore, for me an honor to address this group because while we come from a broad spectrum of companies and countries, we share a common heritage and belief in the highest quality of business ethics.

In New York, a local radio station ran a jingle “ If you give us 22 minutes, we will give you the world.” That will be the mission of next week’s speaker. My goal, in the next 22 minutes is a more modest one. Namely, to provide some perspective of he current bond market. Giving emphasis to its size, it global diversity, and growth characteristics. Since I started trading, our country has gone from the biggest creditor to its biggest debtor. Uncle Sam, U.S. business, and the consumer do not need instruction on how to use their American Express card, for nobody leaves home without one.

I would like to give you a few statistics about the bond market. The size of these numbers might surprise you. In 2003, the total volume of domestic, new securitized debt exceeds two trillion dollars. These figures are large but are even more staggering when compared to the market 30 years ago. The United States government, corporate bond issuance, and mortgage related securities rose almost 100 times, and the volume of U.S. issuance abroad increased represents between 25-30% of our total financing.

As an active participant in the fixed income markets, we have all benefited from being in a growth industry. On the other hand, as a neutral observer of the American economy, one must be concerned that we are becoming debt addicts. Warren Buffet, possibly the preeminent investor of the twentieth century has directly admonished about our growing trade and federal deficits.

It is important to understand some of the causes of fixed income growth. One key word has to be securitization. By securtization, we have been able to take cash flow obligations and convert these IOU’s into tradable instruments. Stated differently, securitization involves the pooling and repackaging of loans into securities that are then sold to investors. This process while accelerating in recent years has been inseparable with the development of Wall Street. For a primary function of financial intermediaries is to facilitate the flow of capital from savers to borrowers. Financial institutions exist because they can do this at a lower cost than would be possible through direct financing arrangements.

This process has already transformed the mortgage lending industry. Now it is spreading to include car loans, computer and truck leases and even time charge accounts. Moreover, each year we witness new avenues for securitization with institutions such as insurance companies striving to reinvigorate their investments to leverage new opportunities.

Worldwide there is no stopping the realm of possibilities and financial opportunities. Without the process of securitization, Europe’s bond market, hereafter referred to as the Eurobond market, would not have enjoyed such explosive growth. While the Eurobond market has become more open to high yield obligations, it is still not an equal opportunity lender on the scale of the United States! Increasingly sovereign credits from throughout the globe are financing both outside and inside the United States; however, only the largest non-U.S. corporations can readily raise fixed income funds. Moreover, there remain deep-seated concerns about the sophistication of their accounting standards. Nevertheless, the trillion-dollar swap market continues to be a powerful catalyst in galvanizing funds throughout the world. Swaps have become a crucial bridge between markets, and for the first time, issuers can borrow whenever, however, and wherever they have a relative cost advantage.

Let me give you an example of the sophistication of the swap market. American Express recently issued a Euro yen swap in which they raised $50 billion yen and then swapped these yen into U.S. dollars. These dollars were then swapped into debt securities of eight different currencies, some of which were at fixed and some at floating rates.

Another significant development in the U.S. debt market has been the widespread acceptance of non-investment grade debt, commonly called “junk” bonds. As a practical matter, until the late 1970’s, only 800 companies, those with investment grade status, had access to the public bond markets. The greatest capital market in the world was a closed door to 99.9% of U.S. companies.  Since that time, the U.S. Corporate fraternity has opened our doors. In addition to the borrowers with blue blood, we now have those with yellow blood, red blood, and even some suffering from hemophilia.

The growing acceptance of junk bonds has coincided with a general deterioration of industrial and utility credit quality. Unfortunately, this downgrade cycle appears ominous. First of all, the erosion is not concentrated in any one sector. Secondly, the recent wave of credit downgrading has taken place during periods of both good and bad business climates. Moreover, most corporations seem comfortable with BBB ratings, the lowest investment grade.

Many credit experts are predicting massive defaults, even in historically safe sectors such as utilities. Nevertheless, the demand from pension funds, insurance companies, bank trust departments, and mutual funds seems buoyant. Moreover, there neither Congress nor labor unions seem concerned about the overall deterioration of credit quality.

As with any product, the marketplace will become the ultimate arbiter. Although regulation and investment banking resistance can contribute to slower growth rate, caveat emptor still prevails. An increased level of foreign competition or a weaker economy could become the potential Achilles heel for Junk Bonds. Let me explain what I mean by this:

A few years ago when I was on the New Issue Committee for Morgan Stanley, a single rated A issuer questioned whether his company should proceed with a proposed financing given that many economists were predicting lower borrowing costs over the next few months. Richer Fisher, the Chairman of Morgan Stanley, calmly responded “Finance when you can!” Within a few months because of asbestos problems, that company could not raise money at any price in the public markets. During my career, numerous Blue Chip companies such as Ford Motor, Union Carbide, and Citicorp have been excluded from the markets for various time periods at reasonable costs.

I would like to comment further on the increasing reliance by both the United States government and private corporations to raise money outside our borders. With our continued trade deficit, both private foreign investors and central banks have financed close to 30% of our fixed income financing needs.

When you are looking for money, do not stop at the Golden Gate Bridge or the George Washington Bridge. Keep on going east or west. For the commercial banking superpowers are now located outside the United States. These institutions have deep pockets. Fortunately, the United States has been at the forefront of welcoming the brave new world of global finance.

In myriad ways and with dazzling speed, hundreds of billions of dollars pour into one account and out of another around the world around the clock. The unending flow of money greases the machinery of international financial markets. It enables borrowers to find the cheapest funds and lenders to seek the best returns.

What makes this all possible? The answer is technology and financial engineering.

When I first started trading, communication meant yelling into a telephone. And financial wizardry required facile usage of telephone-sized books containing interest rate tables. Like Old Black Joe, those days are long gone. Today, every fixed income professional has a desktop computer and a Bloomberg machine. Even though we still yell into the telephone, we have new equipment that can in seconds transmit sophisticated information worldwide to hundreds of investors in a matter of seconds.

One of the pleasures of being today’s speaker has been sharing a historical perspective of the fixed income markets. We could not have achieved our record issuance levels without investors embracing numerous financial innovations and below investment grade credits. As with any big business, we have benefited from a supportive regulatory environment, major capital infusions, state-of-the-art technology, and skilled, aggressive manpower. As a fixed income professional, I am constantly being asked to make market predictions. Unfortunately, my crystal ball is opaque.

I recently heard the difference between a seer and a prophet in the bible. According to this source, a seer could forecast the future, while a prophet could even change the future by altering people’s attitudes and actions. By contrast a good trader’s forecasting ability is a little over 50% and is time horizon range is five minutes. All of us can understand why there are no books in the Bible named after traders.

I am therefore hesitant about making any long-term predictions. Unfortunately, the transition of our country from the Promised Land to the Land of Promises has an ominous note. The interdependence of worldwide capital to fund our debt daily tests the system. Persistent U.S. saving shortfalls, high Federal deficits, and credit deterioration require ingenious solutions. Certainly, in the future during different economic scenarios, we will experience higher interest rates, more reliance on variable short-term instruments, and an attendant increase of bank-related borrowing relative to security financing.

Today, the worldwide marketplace appears serene, and the system appears basically sound. The capital base of big banks, the system’s most important players, has been improving in recent years. An along with the risks, innovative techniques also have brought substantial benefits. They have improved the market’s liquidity and sustained the confidence so essential to the system. Over the past decade, Canada, Japan, United Kingdom, and West Germany have liberalized their bond markets. This emphasizes the importance of the international markets and how they will continue to be a locus of innovation and structured changes during the coming years. We can take comfort that the world’s financial markets will continue to adjust to market demands for global capital reallocation.

In concluding, I want to thank my host, the Bank of America, and my listeners. I would now like to open up the meeting to your questions.