If Evel Knievel Were a Banker

If Evel Knievel Were a Banker

“Mind the gap” was a phrase first used on the London Underground to warn metro rail passengers to be cautious of the space between the station platform and the train door.

For anyone that has ever ridden a subway this spacial awareness comes second nature thanks to our primal sense of self-preservation that warns us of placing our bodies in precarious positions where we could fall. Some of us, however, are born with a different sense of space and the normal risk the general population would assign it. Few legends embody risk-taking like stuntman Evel Knievel.

Most of us would have the hair on the back of our necks stand up jumping a motorcycle over a small pile of dirt but for Evel Knievel, he didn’t get excited unless he was jumping his Harley Davidson over 50 stacked cars as he did in Los Angeles in 1973.

I’m pretty sure that had Evel Knievel worked on Wall Street he would have found himself right at home.

Wall Street like Knievel loves risk-taking. On Wall Street, the best place to see a motorcycle jump a stack of cars is by looking at credit spreads. A credit spread is a difference in yield, usually expressed in basis points, between two different fixed income securities.

As an example, we might look at the spread between investment grade corporate bonds and junk bonds or between 10yr U.S. government bonds and 10yr Colombian government bonds. The theory goes that the smaller the spread the less the risk and the wider the spread the greater the risk. In Evel Knievel parlance the wider the spread the bigger the jump and if the spread is really, really, really big then it’s like jumping the Grand Canyon a feat that Knievel hoped to accomplish by strapping himself to his Harley.

Well, strap on your rockets folks because spreads are about to get really, really, really big!

In a market filled with complacency since the last financial crisis, and fueled with a further debt binge with the cheapest rates in human history, things are about to unwind. And we should have seen this coming.

 

Spread between U.S. investment-grade bonds and U.S. junk bonds is at very low levels that were only lower leading up the last financial crisis.

Italy’s 10yr government debt yields over 3% more than German 10yr debt. It has tripled its risk spread just this year.

Here’s the thing about risk that Knievel and markets all seem to learn the hard way. Risk that is seen and obvious is not the real danger. When Knievel wanted to jump 50 cars that was measurable and clear. When a credit spread is wide the price is clear.

The real danger is the unseen.

Knievel had to rely on his personal skill and gut instincts that were often not measurable. He was also subjected to the exponential impact of small things that could go wrong. As an example not hitting the ramp at the right speed or having a tire blow out could kill him.

Credit markets are the same. The embedded risk was always there despite the narrow spreads. Traders and investors bought in without “minding the gap” that they knew or should have known could quickly widen mid-jump. The cumulative accidents that Knievel suffered gave him a Guinness Book of World Records title for the most broken bones, 433 to be exact, without dying.  What we are currently witnessing in markets right now is Knievel jumping the Grand Canyon and unfortunately, he’s not going to make it.

If you or your portfolio manager doesn’t know how to properly manage risk then you should expect lots of broken bones.

Be safe out there and ride responsibly!

 

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