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When 'Risk-Free' Suddenly Isn't

Michael Herbst

Michael Herbst: I'm glad you touched down on some of the uncertainties facing the bond markets these days for two reasons. One, you had mentioned how risks in some areas, such as what we're seeing in the situation with Greece right now, could actually lead to a reconsideration or a re-pricing of other kinds of risk that may or may not be connected to that situation at all. Could you expand on that a little bit?

Steve Walsh: Yeah. One of the observations over the course of the last 18 months has been risk has performed pretty much in tandem. When risk does poorly, all risk does poorly. Very highly correlated. Stocks are down, credit is down, all spreads widen out. In a normal period you get some variation. Asset classes perform at different levels. Greece obviously widening out from 100 over at the end of the summer to as much as 450 over a few weeks ago, is obviously responding to their particular budget situation.

But it has investors going, "Wait a minute, if Greece is going to trade at 450 over, where should high yield trade? Where should investment-grade corporate bonds trade?"

I mentioned that the U.K. government trades at 100 over. So all of the sudden the U.K. government trades at 100 over and so does Berkshire-Hathaway. How do I look at those two credits?

In our adult lifetimes we never had to think about developed countries' sovereign risk. I think that's going to be a big issue that is going to confront investors over the intermediate term as we move throughout this decade.

And today, it obviously has had a ripple effect. It's caused risk assets generally to widen out, since their tights in the middle part of January.

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Herbst: Structurally speaking, though, some of those deficit concerns over the policy risks that you've talked about, obviously Greece is an acute example right now. But you've also touched on the U.K., and you could even include the U.S. in terms of some of the structural problems that it's facing.

Longer term, what's your thinking around how some of those concerns could, from a fundamental perspective, affect the bond markets?

Walsh: Sure. Again, if you look at the G20--and my statistics will be close, if not spot on--within the four years you're going to have the G20, the cumulative debt of all those countries, be over 115% of their GDP.

So, yes, it is the U.S. Yes, it is the U.K. It is the peripheral countries of Portugal, Spain, Greece, and even some of the stronger ones like Germany and France. That is an issue for the developed economies, both demographically and given the promises that have been made. That's going to be an intermediate-term issue will be significant for markets to consider.

There's a number of ways it can affect the bond market today and tomorrow, even though this is a slow-moving idea. What does it mean for economies? And typically high-debt loads tend to slow growth in economies. What does it mean for banking systems who used to hold and carry sovereign debt as if it was risk-free? That could certainly cause some challenges to the banking system.

And lastly, obviously just confidence that investors have about what previously we considered to be risk-free assets suddenly are not. And thus all assets in the fixed income market are priced off Treasuries, because they're viewed as risk-free. So everything's expressed in a spread.

We have a potential to go through an environment where that whole way of thinking about how much we're being compensated for taking risks will be evolving and changing. And I don't claim to have the answer on that. It's certainly something we're spending a great deal of time on today trying to study its implications for markets.

As I think I mentioned to you, if anything, I'm surprised that it's come about so suddenly here. This is a slow-moving idea that we knew about six months ago, that we knew about a year ago. But given what's going on in Greece, it's brought it to the forefront pretty quickly.