Capital Markets

Collateral Damage

Some market watchers believe a U.S. invasion of Iraq will raise borrowing costs.
Ed ZwirnDecember 17, 2002

As a general rule, instability is not great for debt markets. This is particularly true when the instability is caused by the ominous specter of war.

Certainly, months of tough talk coming from Washington — aimed at Baghdad — has not exactly calmed the nerves of U.S. lenders. Whether Saddam Hussein fully (or even partly) complies with the U.N.’s request to inspect alleged munitions factories remains to be seen. But it appears that few officials in the U.S. State Department take seriously Hussein’s pledge to cooperate with U.N. arms inspectors. Reportedly, many believe war with Iraq is inevitable.

Placing enough forces in the region could take the Department of Defense months — as evidenced by the recent slow buildup of forces in the region. while delays will likely drive borrowing costs up, any analysts believe that an invasion of Iraq — begun in earnest — would bring stability back to the debt markets. They argue that if a full-scale attack is launched by the U.N. or U.S., the end of uncertainty will lead to a tightening of spreads between most corporate bonds and Treasury notes.

To back up their claims, a good number of prognosticators point to the last war with Iraq. On July 31, 1990, just before the Aug. 2 invasion of Kuwait by Iraq, the spread of the typical high-yield corporate bond to 10-year Treasurys (as measured by the Merrill Lynch High Yield Master Index) stood at 659 basis points.

By Aug. 31, after President George H. Bush had started marshalling U.S. forces in Saudi Arabia, the spread had widened a bit, to around 710 basis points. After the coalition forces actually began its assault on Iraq, however, spreads quickly tightened.

This harkening back to the previous invasion of Iraq, although logical, misses the point. While the human toll of war with Iraq is inestimable, a number of analysts believe a full-scale offensive will actually raise the cost of capital for many corporate fund-raisers — not lower it. Says Dan Benton, head of the New York investment-grade syndicate desk at Deutsche Bank, notes: “The circumstances of 1991 were very different than they are now.”

Few Bullets

For one thing, monetary policy has changed substantially since the early Nineties. On July 31, 1990 (just days before Iraq’s invasion of Kuwait), the Federal Funds target rate stood at 8 percent. In the runup to the U.S.-led counterattack, the Fed stepped in six times over eight months, lowering its target rate by an overall 175 basis points (1.75 percent).

Most notably, the Fed lowered the Fed Funds rate by 25 basis points on Jan. 9, just prior to the actual onset of hostilities. On Feb. 1, the U.S. central bank cut its overnight target rate another 50 points.

As observers note, those moves were closely coordinated with the Bundesbank, the Bank of England, and just about every other central bank of those nations that were part of the coalition against Iraq. “Essentially, everybody else in the world was with us (in 1991), except Iraq and Jordan, and all the central banks eased at the same time on a worldwide basis,” says Martin Fridson, chief high yield strategist at Merrill Lynch. “The more reasonable expectation is that this would not happen this time.”

Further, some bankers and traders argue that there’s only so much the Fed could do to nudge markets this go-round. The markets are already “very, very volatile,” Benton points out, roiled by a seemingly endless parade of corporate scandals and restatements.

Indeed, if the U.S. invades Iraq, lenders may be more concerned with the bookkeeping and financial health of borrowers rather than how the war’s going. Ford Motor, for instance, has seen the spread levels on its debt instruments skyrocket. In fact, Ford recently issued notes with coupons that are 200 basis points over similar paper issued by DaimlerChrysler. A return of certainty to the debt markets probably won’t change that.

Other observers point out that, following last week’s Fed Fed rate cut (to a microscopic 1.25 percent), the Federal Open Market Committee has very little wiggle room left. Says Ken Hackel, chief fixed income strategist at Merrill Lynch: “The Fed has a limited number of bullets left in its gun.”

Iraqi Road

A swift victory over Iraq and the Federal Reserve Bank wouldn’t have to use its remaining ammo. “If the invasion winds up being a very quick, relatively painless event, under the rose-colored scenario the impact on interest rates would not be so great,” predicts Hackel. “The corporate bond market does very well with the lifting of uncertainty.”

And that’s the rub. It’s flat-out impossible to tell how an invasion of Iraq will play out. If the U.S. meets stiff resistance, or the war widens due to renewed terrorist attacks on American soil, or Iraq launches at Tel Aviv, all bets will be off. A regional conflict could ignite into a global conflagration.

Such a scenario would blow holes in the current market consensus that spreads on investment-grade bonds will widen only a few basis points on the initial news of a U.S. invasion, then contract. Sources in London say that over the past six months, as war news hotted up, the spread on interest rate swaps widened by as much as 10 basis points.

That bump-up gives a rough idea of the cost of war for the gilt end of the investment grade market. Obviously, lower-rated companies would have to offer even greater coupons to convince lenders to part with their capital.

The possible widening of spreads would also be bad news for some marquee investment banks. JP Morgan Chase, for example, has reportedly placed major swap market bets that spreads would narrow as growing federal deficits boost Treasury yields. “A lot of dollar swap houses have sold short because Treasury financing is increasing,” asserts Simon Boughey, analyst at, a London-based website.

With the FAS 133 requirement that derivatives be marked to market, Boughey says a pronounced decline in the value of these shorts could leave a number of investment banks with some explaining to do.

Then again, it’s well beyond the scope of either the Fed or J.P. Morgan Chase to predict the fortunes of war, and with them, the costs of war. Further domestic catastrophes like 9/11 are too unpredictable for any FOMC minutes. “The Fed can’t anticipate something else like that happening,” says one trader of mortgage-backed securities. “How much worse things can get, nobody has any idea.”