Very low default rate
I am writing to offer a couple of points of clarification and amplification to your editorial of Jan. 7 titled "Stable comeback."
The S&P default study published in 2000 illustrated default rates by industry and identified the insurance/real estate industry (including not only the higher quality, more stable life companies that issue GICs but also the more volatile property casualty insurers and others) as having one of the lowest default rates of any of the 12 sectors studied. Between 1981 and 1999 (a period that included all of the GIC issuer defaults), the insurance/real estate sector experienced a default rate of only 3.3%, whereas other industry default rates ranged up to 15.63% and averaged as much as 7.99%. Separately, Moody's looked at the one-year average default rate of GICs from the period of 1989 to 1998, as compared to all other corporations. Moody's concluded that even over this shorter period encompassing all of the major GIC defaults, the dollar-weighted average one-year GIC default rate was still only 0.25% as compared to the 1.56% rate for all corporations. In other words, the one-year dollar weighted average default rate for GICs during the worst period of the asset class' history was less than one-sixth that of all corporations generally.
On a related note, we have just updated our ongoing study comparing the yield of the high five-year, $5 million, simple-interest GIC from our Rate Desk, as published in BARRON's, with the closest equivalent bond, the five-year AA1 & AA2 financial from Bloomberg. Over the 14 and a half years ended Dec. 31, the GIC offered an average yield premium of 0.4%.
The very low default rate and the significant yield premium of the GICs go a long way toward explaining why first the European and now the global medium-term note markets have exploded in recent years. These fixed-term funding agreements are simply GICs without the annuity or benefit responsive features of GICs. The wonder is they have not yet attracted more attention among domestic investors.
Peter E. Bowles
president and CIO
Troubling equity premium
The Feb. 18 Other Views commentary by Robert D. Arnott and Peter L. Bernstein ("Past and present flaws in the mantra of stocks-for-the-long-run") posits a "sensible real return for stocks ... only about one or two percentage points higher than the dividend yield," leading to a "long-term forecast of only 3% to 4% real returns." This is about three percentage points lower than the 6.5% real stock yield assumed by the Social Security Administration's actuaries in projecting benefits arising from the privatization proposals put forth by President Bush's Commission to Strengthen Social Security and would thus appear to greatly overstate those benefits. For example, the overstatement would be about 50% for someone contributing for 25 years.
The authors cite three factors that produced 90% of the return since 1802: inflation, dividends and "rising valuation levels ... rather than from growth in the underlying fundamentals of real dividends or earnings." One strong factor influencing the rising valuation levels is the increase in demand for stocks generated by the marketers of stocks.
This causes stock prices to rise, which in turn leads to greater demand and further increases in prices. Demand also has gone up with the advent of individual retirement accounts and 401(k) plans. This raises the question of how real the capital gains were in the last bull market; that is, what part was generated by growth in the underlying fundamentals of earnings and what part was the product of marketing prowess (and, I might add, accounting prowess). I hope these questions will be dealt with in the authors' upcoming paper in the Financial Analysts Journal, and I am looking forward to it.
David Langer Co.