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Lehman and bond markets ten years on

The collapse of Lehman Brothers sent shockwaves throughout the financial system ten years ago and the panic was arguably felt most vividly in bond markets at the time. Here we reflect on the experiences of Aberdeen Standard Investments’ Global Head of Fixed Income Craig MacDonald and ask what had been learnt.

Where were you working on the day Lehman Brothers collapsed?

I was working for Standard Life Investments’ fixed-income team in Edinburgh. Lehman failed at the weekend, so it was the following Monday when the full impact was felt.

What can you remember of the day?

It was certainly dramatic. Everything else felt extremely muted in comparison. And the implications were huge. In our team, however, the shock was mixed with relief, because we didn’t own any Lehman debt.

As an investor, how did it compare to the start of the credit crunch the previous summer?

This was a much bigger deal.

Our in-house economists had become increasingly concerned about the US at the start of 2007, and so we had sold most of our US high-yield exposure that summer. But the collapse of Lehman signalled a full-blown crisis.

Did you have any sense at all that something of this scale was going to happen?

No – but we were generally underweight the US and its banks. In what banking exposure we had, we preferred broad-based banks to the pure investment banks. The latter had more proprietary-trading risk and much less liquidity, because they lacked the mainstream banks’ big deposit bases. We were also suspicious of the investment banks’ high credit ratings. That’s not to say that we predicted the demise of Bear Sterns or Lehman. But we could see that they were the weak links in the chain.

What is the biggest lesson from the way that markets behaved in the months immediately after Lehman collapsed?

It’s that correlations always rise in risk-on and risk-off periods. So most bank risk underperformed during the crisis, driven by mark-to-market accounting. But the crisis also underscored the importance of differentiation – i.e. choosing those companies that would ultimately weather the storm.

Once Lehman vanished, the concern was that the market would focus on the next in line – the likes of Morgan Stanley and Wachovia. But these were better placed than the weakest links, and, with the help of regulatory intervention, managed to survive.

Beyond the asset bubbles created by QE, has our response to the financial crisis created any troubling unintended consequences for credit markets?

Regulatory intervention was crucial in averting a far worse crisis. But the regulators may have overreached. The level of regulation in the US banking system is now high, so the pendulum probably swung too far. One adverse consequence was that small and medium-sized businesses – in many ways the beating heart of the US economy – struggled to access funding.

Only in the past couple of years have they started to breathe again, as regulations have begun to be peeled back.

There’s also the popular reaction. There’s much less trust now, with a prevailing sense of injustice over the bailing out of the bankers – even though those bailouts saved people’s jobs and savings. Understandably, though, there’s a lot of anger – and this could make an effective regulatory response to the next crisis much harder.

Thinking about the whole ten years since Lehman collapsed, what lessons have we learnt?

One of the biggest lessons was to remind everyone that when the US sneezes, the world catches cold. There was no escape, whether in the UK, Europe or emerging markets. And the same will apply next time.

But the next crisis probably won’t centre on banks. Although the banks aren’t risk-free today, the banking system has certainly improved. Ten years ago, some banks were levered up to 30 times. They had huge books of securities, but were the first sellers in a crisis, so they couldn’t provide liquidity. Today, they are less levered, more stable and have smaller proprietary trading desks.

What have we not learnt?

Although there’s less leverage in the world, there’s still a lot of debt on corporate balance sheets. We’re seeing increasing leverage in private markets too. That needs to be navigated carefully.

Another lesson that should have been learned is that while sophistication can help spread risk, it doesn’t offset bad assets or excessive debt. An overreliance on complexity was a big part of the problem last time, and it’s something to watch in future.

Did it change your attitude to running credit portfolios?

While you have to take a global view, local knowledge matters. The crisis prompted us to set up a dedicated US team in Boston, which has been a huge help since.

In the rout that followed through to March 2009, what was the best thing you bought for clients?

During the crisis, we held plenty of government bonds, which we were able to sell to ensure liquidity. That allowed us to add risk again in the immediate aftermath of the crisis. The bonds of some high-quality companies were trading at very enticing yields. Anheuser-Busch and BMW, for example, were offering an 8% coupon, which is exceptional.

Where is the biggest risk in credit markets?

Other than oil, we think that commodity-related sectors look expensive. And while we see good value in some bank risk, it’s become a consensus long, which makes us a little nervous. We think that defaults will be low next year, which should support high yield provided you don’t go too far down the risk spectrum.

Are there signs of another crash soon?

As the long as the US Federal Reserve doesn’t raise rates too fast, and as long as trade hostilities between the US and China take the form of skirmishes rather than all-out war, we expect 2019 to be reasonably benign.

Ultimately, though, it’s impossible to future-proof financial systems, companies or investment portfolios. All you can do is try to be alert to the risks. That’s what worked for us in 2008.

A version of this article was first published by Portfolio Adviser on 31 August 2018.

Aberdeen Standard Investments Global Head of Fixed Income Craig Macdonald