Taking Stock / Credit Where It Isn't Due

Were you astonished by the 70 per cent leap in the TA-100 index over the last year? Are you left gasping by the hundreds of percentage points Israeli stocks have gained on Wall Street? Well, we have news for you. Turn your attention to bonds and you'll find nothing less than a revolution.

Yields on government and corporate bonds have sunk by an eye-popping degree, generally speaking. And those yields are the primary day-to-day manifestation of how the market evaluates the risk associated with the issuer, as well as the prevailing interest rates.

This is the news - corporate risk seems to have evaporated. To judge by the bonds, almost all companies have reached safe harbor, they're in great financial shape and there's almost no danger they'll default on their debts.

As for government bonds, part of the drop in yields is due to the steep slide in long-term and short-term interest rates. A year ago, Israeli government long-term bonds tied to the consumer price index were trading at yields of about 6 percent. Today that figure is below 4 percent. Yields on Shahars were about 10 percent and have slumped to 6-7 percent.

Yields on government bonds sank because geopolitical changes in the region slashed the risk premium associated with Israel - the conquest of Iraq, the U.S. resolution to back Israel in deed and with $9 billion worth of loan guarantees, the treasury's economic program that restored fiscal discipline to government, and the drop in Bank of Israel lending rates.

The clearest sign that Israel's risk premium had dropped was the narrowing spread between yields on Israeli and U.S. treasury bonds in the international marketplace. That spread has dropped from 200 base points (2 percent) to 70 (0.7 percent) in the space of a year.

What risk?

Back to corporate bonds - Israel's shrinking risk premium and interest rates, and the improved mood, affected spreads far more dramatically. A long list of companies whose real costs of capital had ranged from 8 percent to 14 percent saw yields on their bonds plunge to three, four, five percent, namely below the yields on Israeli government bonds just a year ago.

Vanishing yields have created tremendous capital gains for anybody who bet on bonds a year or two ago. More importantly it created a benchmark for companies to raise capital through bonds at very low interest that had been but a dream just months ago.

Indeed, in the last few months, we've seen a stampede of companies stressed by the credit crunch and tempted by the low interest rates to issue bonds linked to the CPI. This has had a most interesting side-effect.

Banks were first to notice the transformation, of course. After two years of tightening their fists and turning a cold shoulder to their biggest borrowers, and constantly widening their financial spreads, they found that now it was the customers turning the cold shoulder, having found a new source of financing.

As a manager at one of the big banks told us this week: "Something we haven't seen for three years is happening. Customers are threatening that unless we grant them credit or narrow our spreads, they'll turn to the bond market. And some of the banks are starting to lower the cost of credit in order to compete with the low prices at which the market is willing to lend."

"But," we asked, "surely you learned the lessons of the credit bubble, and won't succumb to the temptation of narrowing spreads too far and lending at unreasonable rates?"

We didn't get the expected answer we were expecting. "It's temporary. At the moment we're keeping to the rules we set ourselves in the last two years because of the lessons from the bubble. But it's probably just a matter of time. If the boom on the capital market continues, competition between the banks will be stronger than the rules and we'll start chasing the customers again."