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Chapter 8

Credit

Analysis of modern bonds can quickly become off-puttingly complicated and this is not going to change in the aftermath of the 2007–09 credit crunch. Securities will become more transparent, there will be less leverage and banks will take more responsibility for their lending decisions. But securitisation, which is the process of turning pools of bank loans into marketable securities, will not disappear; nor will the huge market in credit derivatives, which is central to the management of modern bond portfolios.

However, in keeping with the back-to-basics theme of markets in the wake of the credit crunch, a useful starting point for thinking about credit is an elementary review written by John Maynard Keynes in 1925 of a study comparing long-term returns from equities with those from bonds in the United States between 1866 and 1922. The study showed a substantial outperformance of equities over bonds in periods of both deflation and inflation. Keynes found this counterintuitive, his expectation being that a period of deflation would be better for bonds than equities. He suggested a number of reasons for the inferior performance of bonds:


  

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