Bond Vigilantes

The start of another year is always a time to take stock, reflect on the last year and plan for the next. Last year was dramatic from an investment point of view, with equity markets having their biggest bear market since the great depression (and credit markets doing even worse) while government bond yields collapsed to post war lows.

All the way through this crisis we have focused on the strength of the housing market as a lead indicator of what is to come for financial markets and the broader economy. We have been joined in our observations by the policy makers, with the US Federal Reserve giving further detail last week over its plans to buy $500 billion of mortgage related debt by mid 2009.  This is designed to drive the cost of mortgage debt down, so helping the US housing market.  A similar response is being sought in the UK, where base rates have never been lower since the Bank of England was founded in 1694 (and rates are set to go lower still).

 In the UK the lead indicator we have focused on has been the level of new mortgage approvals (see previous comment here), which indicates the upcoming buying power entering the UK property market.  The latest numbers were released on the 2nd January, and the record low number continues to point to further weakness, as illustrated in the chart.

So the crisis has unfolded, a policy response is in place, but when will the economic animal spirits come back to the fore, watch this space…

Thank you very much for a bumper set of entries to our quiz this year.  The answers are shown below - with the spirit of Christmas in our hearts we allowed a small degree of ambiguity on a couple of the questions, but in the end the four people who got 19 out of 20 (and the only one they all got wrong was the impossible question 12) didn't need any charity.  Their names were drawn out of the hat and prizes have been awarded as follows:

The Winner: Nicci Dugdale of Myddleton Croft Investment Managers
Second Prize: Joe Wiggins of Principal Investment
Third Prizes go to both Chris Cowell (also Myddleton Croft) and Simon Bullock (Truestone).

Your prizes will be emailed to you shortly.  The winner of the M&G staff competition was Laura Brown with a score of 17 - booze will be on its way to you.  Congratulations everybody, and thanks for the entries.  

1) Reg Varney, star of On The Buses, achieved what banking "first" in 1967?

He was the first person to take money out of a cash machine, at the world's first ATM at a branch of Barclays in Enfield.

2) Which brand's name is derived from a phrase meaning avant-garde techniques?

TAG watches - TAG stands for Techniques Avant-Guarde.

3) Five-oh, young-`uns, Bunk.  Which city?

Baltimore - the setting for The Wire TV series.  Five-oh means police, young - `uns are the juvenile drug dealers, and Bunk is a detective.

4) What had an "e" added to it in 1967 to prevent a diplomatic incident?

Concorde.  The French insisted that the French spelling of the word was used when naming the supersonic aircraft, rather than Concord, and the UK government eventually gave in.

5) Christiano Ronaldo's fashion brand is linked, by chance, with which (will I get into trouble for saying unfashionable?) London suburb?

Thornton Heath, Croydon.  Ronaldo's fashion brand is CR7, the postcode for this part of Croydon.

6) What was the tallest building in the world at the time of the Wall Street Crash?

The Woolworth Building.  According to Selwyn Parker's book The Great Crash, the Chrysler Building become taller a few days after the days which historians generally agree marks the Wall Street Crash (October 24th, October 28th and October 29th, 1929).  Some people suggested it was the Eiffel Tower - we are going with Wikipedia as the definitive source on this one, and not counting glorified telegraph poles.

7) According to M&G Retail's Head of Institutional Sales, Neil Brown, what is the only sport that actively bans left-handed equipment (I have failed to verify this independently, but it sounds plausible)?

Neil claims the answer is hockey, where there is no such thing as a left handed stick.  Most people said polo, and apparently left-handed polo play was banned in 1975, so either answer is allowed.

8) Why did Dr. Pepper have a bad November?  What's the worst that can happen?

Dr. Pepper promised every American a can of the vile liquid if Guns N Roses ever released the long awaited Chinese Democracy album in 2008.  The record was finally released in November.

9) Data Screws Uplifted (anag.)

Credit Default Swaps.

10) What is this thing called?

Zakumi.  It is the mascot for the World Cup in South Africa, 2010.

11) When would Jim Flaherty wear brand new footwear?

He is the Finance Minister of Canada.  It is traditional for the Finance Minister to wear new shoes when delivering the Canadian budget (although respondants report that in his most recent budget Mr. Flaherty has stopped the tradition on the grounds of austerity...).

12) What is the lowest unique positive whole number that somebody will pick to reply to this question (i.e. a number that nobody else answers this question with)?

The lowest unique number was 3.

13) Which Las Vegas band is releasing a Christmas single with Elton John this year?

The Killers.

14) Where is the QE2?

Dubai, UAE - it is becoming a floating hotel.

15) What do the following companies have in common? GE, Exxon Mobil, Johnson & Johnson, Berkshire Hathaway, Toyota.

At time of writing they are the only companies rated AAA by Moodys and S&P.  We also accepted the answer that they have been Fortune magazine's "Most Respected Company of the Year", although all of the contenders for the prizes got the more bond related answer in any case.

16) Following a mix up, the writer of a nature column in a newpaper is sent to cover a war in Africa.  Which novel?

Scoop by Evelyn Waugh

17) Which artist produced this work?

Banksy.

18) According to the Handelsblatt newspaper, Germans like ones with an "X" on them, but shun those withan "S" or a "V".  What?

Euro bank notes - the X tells them that they were issued by the Bundesbank rather than by the central banks of Italy or Spain. Germans who fear the breakup of the Eurozone have been demanding only "X" rated banknotes from their banks.

19) Morrissey, Marr, Joyce, Rourke.  But who was the sometime fifth member of The Smiths?

Craig Gannon.  He toured with the Smiths in 1986 and played on "Panic" and "Ask" alongside Johnny Marr.

20) What did Liverpool FC attempt to copyright this year, to great protests?

They tried to copyright the Liverbird symbol, but had to back down after protests from Liverpudlians who pointed out that it belonged to the whole city.

Conventional wisdom says that corporate bonds have performed terribly since the credit crunch broke in July 2007.  Yes, BBB rated corporate bond spreads are now wider than they were in the Great Depression, but you may be surprised to know that thanks to falling government bond yields, the average industrial investment grade corporate bond has actually generated a positive total return over the past year and a half ('industrials' basically means anything that's not a financial or utility - about a third of the euro investment grade market and a quarter of the sterling investment grade market). 

The pain has been in the subordinated financials.  We've been banging on about subordinated bank bonds for a while now - see Ben's warning on the eve of the meltdown in September here, Richard's comment at the beginning of October here, and most recently Jim's comment on Wednesday re Deutsche Bank here. 

I thought it would be worth updating the chart Ben first used, which demonstrate the massive disparity of returns in the investment grade universe.  These two charts show just how spectacular the bank bond blow up has been (data as at end of yesterday, so includes the market's reaction to Deutsche Bank not calling its LT2 bonds this week).  The first chart shows the euro investment grade returns, breaking it down into industrials, Lower Tier 2 bank bonds (the most senior of the subordinated bank bonds), Upper Tier 2 (the next most subordinated) and Tier 1 bank bonds (super subordinated bank bonds).  While industrials are up 0.3% since the beginning of July 2007, € Tier 1 (T1) bank bonds are down almost 40%.

As this chart shows, it's a similar story in the £ market.  Industrials are up +0.5%, with T1 bank bonds down just over 30%.   The reason that T1 bank bonds have behaved more like equities than bonds is because they ARE more like equities than bonds, usually ranking level with preference shares.  A bank can stop paying coupons on T1 whenever it wants (although it can't then pay dividends to equity holders) and that's not an event of default - you have no rights to the company's assets.  In fact, although every bond varies, some banks aren't allowed to pay coupons on T1 if they don't make certain capital ratios.  We have very little of this stuff, and we'd hate to be trying to sell it right now.  Liquidity in T1 is poor - looking at a broker run from this morning, the bid-offer spread on Barclays € T1 is 33-37, which is an 11% spread - as a comparison, you're looking at 92.3-93.5 on a France Telecom € 2015 bond right now, ie a 1.3% spread.      

Finally,  a reminder - it's the last day to enter our XMAS quiz, where we have £175 worth of Amazon vouchers to give away.