Bond Vigilantes - matthewrussell

The Hangover

Fri, 03 Sep 2010 09:04:00 GMT

It feels a little like the first half of 2008 again to me. People are asking who has it right? The bond market or the equity market? Government bond yields in the UK, US and Germany are the lowest they’ve been in recent history. Yields this low, the argument goes, imply that the bond market is expecting the dreaded double dip. The equity markets on the other hand - after a fairly positive earnings season - are trading back where they were in the mid 2000’s.

Posing this question as a simple disagreement between bond and equity investors is a touch disingenuous. Rather than being in opposition to one another maybe the two markets are actually singing the same song. One should bear in mind that - unlike Vegas - what happens in the credit markets doesn’t stay in the credit markets.

Rudimentary corporate finance theory will tell you that the optimal capital structure of a firm is one which contains an element of debt (due to the tax shield). In practice most firms do finance themselves with a combination of debt and equity. Therefore when valuing a company you should take into consideration the cost of both financing options.

There are many ways to value a firm but, if you use one of the variations on the present value of future dividend methods the cost of capital plays a huge role. Simply put, one discounts the future dividends by the cost of capital. The higher the cost of capital, the lower the value of the firm and vice versa. Here is a short worked example to show the impact of changes in the weighted average cost of capital (WACC). For simplicity I have assumed a growth rate of 0.5% and that firms in the FTSE raise their capital in equal proportions from equity and debt.

Basic Dividend Discount model;

V=    D*1+g              V: Equity value
       WACC-g            D: Dividend
                                 g: Growth rate

We can then take the following data and plug it into the model:

	Mar-09	Aug-10
BBB Yield (Cost of Debt)	12%	5.50%
FTSE 100 Forward looking Div Yield (Cost of Equity)*	4.87%	3.80%
FTSE 100	3926	5225
Implied Dividend	191	199
Growth rate	0.50%	0.50%
Debt:Equity	50:50	50:50
WACC ([cost of debt+ cost of equity]/2)	8.44%	4.65%

*Kindly provided by our friends at Evolution Securities

August 2010 – with current WACC

199*1.005 = 4,819
0.0465 - 0.005

August 2010 – with March 2009 WACC

199*1.005 = 2,519
0.0844 - 0.005

The values the model spits out are not that close to actual market levels but I think it demonstrates the sensitivity of these types of models to the cost of capital quite well.

I must admit I have no sense of the number of investors who actually take this approach to valuing equities, its pure text book theory. So let’s look at what has happened in practice. Back in 2008 when yields rose dramatically equity valuations began to drop, as you can see below. Today with yields on BBB’s (including financials) and equity prices back to where they were in the early part of the last decade one could argue valuations look somewhat justified.

Clearly these are absolute yields, they have been driven lower not by increased credit quality, but by near zero base rates and low growth/inflation assumptions. This has the effect of driving down yields on the govvies over which the corporates are benchmarked. Spreads on BBB’s are still in the 200bp region if you exclude financials, which is where they have been for a year or so now. It seems to me that we can’t necessarily take extremely low gilt yields as a sign pointing to an immediate dip in the equity market, they may actually be the reason for its buoyancy. Spreads are the real barometer of the credit markets not yields. As these haven’t changed much over the last year it’s hard to say the bond and equity markets are in opposition. It’s when credit investors disagree with equity holders that the real fun starts.

Eurozone Edging Ever Closer to Political Union

Mon, 28 Jun 2010 15:29:00 GMT

The ECB recently published a paper on its website detailing its preliminary proposals to reinforce economic governance in the euro area. The paper was split into three main sections. (1) Strengthening surveillance and greater prevention/correction of excessive deficits and debts. (2) Improving the surveillance framework and the correction of economic imbalances, and (3) a framework for crisis management in the euro area. It makes for interesting reading, and there are three main points to draw out in more depth.

Firstly, the most significant proposal is the creation of an independent fiscal surveillance agency. This will effectively be a government watchdog much like the UK’s recently created Office for Budget Responsibility. This body will be tasked with monitoring and assessing euro area countries’ fiscal policies. Once a country is deemed to have breached the ceiling of a debt to GDP ratio of 60% and/or has a deficit in excess of 3% they will be eligible to face an array of sanctions, ranging from purely financial penalties to loss of voting rights. Hopefully these penalties will be more strictly enforced than is currently the case. Remember, under the Maastrict treaty the EC already has powers to fine countries that break the stability pact (those running a deficit of more than 3%). Clearly a desire to create a larger eurozone dominated the perceived need for fiscal probity in the past, allowing countries like Greece to join the EMU that otherwise wouldn't have met the requirements.

Secondly, the level and depth of monitoring will be directly proportional to the perceived risk of an individual countries fiscal policies. The idea behind this is that it will allow policy makers to focus on the areas that need attention while applying a lighter touch to those countries with sounder fiscal positions. All well and good, but what happens when more than a handful of countries experience difficulties simultaneously?

Finally, the ECB outline a crisis management body with control of a special purpose reserve fund. This will be used to bail out failing states (one already exists) either by offering direct loans or purchasing government bonds in the market (already been done). There is also talk of minimising moral hazard. This appears like a noble but futile exercise to me as the mere existence of central banks creates moral hazard - It's what they do. Once a lender of last resort is introduced into an economy the behaviour of borrowers and lenders is influenced so as to create more risk in the economy than there otherwise would have been.

These preliminary proposals are wide-ranging and could potentially have a massive impact on European fiscal policy. One can see how the implementation of strict requirements and monitoring of fiscal policy could lead to European governments running extremely similar fiscal policies. There can not be too much of a disparity between taxes, borrowing and spending across countries if they all have the same targets for debt to GDP ratios and fiscal deficits in mind.

The idea that we won't have an effective European monetary union without a political one is the prevailing view in the market. I agree. Fiscal policy by committee is probably not the ideal way to strengthen the Euro but perhaps it is the least controversial means of getting there.

Free lecture series at the London School of Economics

Fri, 18 Jun 2010 14:01:00 GMT

Being the intellectuals that you are, we thought you might find some of the upcoming events being held at the London School of Economics (LSE) of interest. On the 30th of June they have Andrew Ross Sorkin discussing the development of the financial crisis since the publication of his book Too Big to Fail, and what he thinks the future may hold. We've mentioned his book numerous times on the blog - it's very well written, engaging and thought provoking. On the 14th of July there is a talk from Alan Beattie (the Financial Times world trade editor) on why Greece should default (we here think some form of restructuring is inevitable by the way). The LSE runs these free lectures throughout the year on various topics in the social sciences and I've enjoyed the ones I've listened to previously. If you can't make the actual events you can download podcasts a day or so later - they tend to keep me entertained while I'm ironing my shirts on a Sunday evening (Editor's note - you iron your shirts? Who'd have known?). I'm not sure if it's by design but neither of these talks clash with the World Cup. Sorkin's lecture is on a rest day before the quarter finals and the final is on the 11th July. For those England fans among you some news just in: Robert Green trained on Thursday for 3 hours and had 400 shots taken at him without conceding a single goal. Today he and Heskey will train with the rest of the squad.

Bubbles down under

Tue, 02 Mar 2010 09:45:00 GMT

Having just returned from a couple of weeks in Australia for a friend's wedding (all the best to the happy couple) I thought it might be worthwhile writing a note on what looks to me to be a bubble in the Australian property market.

On my first night out in Sydney I was fortunate enough to get chatting to a couple of the locals who were out celebrating, one of them having just completed the purchase of her second property. The other, who already has two, thought it totally normal that two girls in their mid 20’s - one an interior designer, the other a shop assistant - should be able to do this.

A couple of mornings later, I was reminded of this conversation whilst reading an article that I felt I had seen many times before. The journalist was bemoaning the state of the market – house prices ballooning, first time buyers unable to get on the ladder, demand outstripping supply…..sound familiar?

After the wedding I headed up the coast to a small beach town for a change of scenery. The train journey was made interesting (if a little irritating) by an old lady at the other end of the carriage who must have forgotten to turn her hearing aid on that morning. She spent a good half hour telling a friend and the rest of us in the carriage about her grandson who was playing the property market. Apparently he has accepted an offer on his house and then pulled out in the hope of achieving a higher price twice already, and is considering doing the same again.

Once in my beach town (and gratefully out of earshot) I counted no less than seven estate agents/mortgage brokers in the parade of about 50 shops along the beach front. If I wasn’t already thinking “bubble?” I was now. So on a rare cloudy afternoon I popped into a few banks curious of what mortgages were on offer. Mostly I just picked up the standard leaflets but in the branch of one of Australia’s big 4 banks a very helpful member of staff offered me a seat so we could talk about my “options”. Once the disappointment of not being able to sign me up had passed, she told me how busy they had been and how the majority of people signing on for new deals were opting for variable rate mortgages.

With at least a 20% deposit on a property worth A$250,000 or more, the lowest variable rate one can achieve is 5.79% and 6.49% fixed for a year at this particular bank. Encouragingly there were no deals I could find that were offering an LTV of greater than 95%. However there was a decent amount of literature on re-financing existing deals and suggestions on how this cash could be used. Rather scarily one of these was to invest in the capital markets - and yes, you can trade on margin.

My helpful mortgage advisor also mentioned that a lot of re-financing took place last year when rates were at their lowest for some time. With every passing minute spent talking to her the bubble in my mind's eye was growing larger.

Mortgage repayments increased by an average of 25% in Sydney in the 4th quarter of 2009, and if the experiences of this mortgage advisor are representative of Australia as a whole, last night's rate rise from the RBA (of 0.25% to 4%) together with the further anticipated hikes that may be necessary to tame inflation could lead to tough times for mortgage holders further down the road.

An Alternative View on the World

Fri, 02 Oct 2009 13:27:00 GMT

Practically every newspaper article or research note I have read on the global economy over the past couple of years hasn’t failed to mention the huge pool of potential demand for goods and services that lies in the emerging middle classes of China and India. I think this map gives us some sense of perspective when reading the huge numbers the journalists and analysts have been talking about. The map re-sizes a country by population rather than by area. It also leaves me with a sense of how insignificant we in the West could become if these trends continue.

I got this from www.worldmapper.org. There are loads of other maps on there if, like me you find this sort of thing interesting.

Jim and Richard are in China this week so no doubt we will be hearing their thoughts on it in due course.

Mervyn loses his Talons

Wed, 19 Aug 2009 14:08:00 GMT

The Minutes from the Bank of England's Monetary Policy Committee meeting of two weeks ago were released earlier today. They show that the motion to increase the Quantitative Easing program by £50bn was carried with a vote of six to three. Interestingly, Governor Mervyn King was one of the dissenters. Not too long ago one would have assumed that this would have been due to him worrying that inflation is about to pick up and that he would therefore be reluctant to increase the monetary stimulus further. In fact quite the opposite is true. King and the other two dissenters (Beasley and Miles) actually voted against the £50bn, as they wanted to increase it by £75bn (which would have taken the total programme to £200bn). This is a quite a departure from the previously hawkish Governor, who, it was reported in the New Statesman, opposed the 1.5% rate cuts of late last year. I guess it remains to be seen if once again he’s a little late to the party or he has now managed to get himself ahead of the curve. Bear in mind however that the increase in QE was announced before the unexpectedly sticky UK inflation data...

QE or not QE? That is the question

Fri, 08 May 2009 13:48:00 GMT

Whether you want to call it quantitative easing, credit easing, printing money or “enhanced credit support” as Jean Claude Trichet prefers, the ECB yesterday took a step in that direction. At the post rate decision press conference, Trichet announced that they had agreed in principle to purchase up to €60bn of euro-denominatedcovered bonds, which is roughly 10% of the public market. He said that they had decided on covered bonds as that market has been particularly badly affected by the “financial turbulence”. The announcement is good news for banks in Germany, France and Spain as they are the heaviest users of these instruments (a blog with a bit more detail on covered bonds is on its way). Regardless of how you label it, a foray into the credit markets is a clear signal that the opinions of the doves are becoming increasingly influential.

Trichet also announced a 25bp cut in the key rate to 1% and emphasised that it had not been decided that 1% was their floor. We were told that the current 6 month maturity on the loans offered to banks would be increased to a year and that the European Investment Bank (EIB) would be permitted to participate in the ECB’s re-financing operations from the 8th July. I find this a particularly clever manoeuvre as it potentially transfers the decision of which firms to lend to from the ECB to the EIB, and any criticism that may come with further interventions in debt markets.

Trichet made clear that all the decisions were made unanimously, a step no doubt designed as a show of unity after the recent bickering which came to a head with him asking members not to comment publicly on non-standard measures (see previous blog). Even though the argument appears to be swinging a little in favour of the doves it is clear the hawks are still strongly defending their corner. The weak first quarter economic data may have led one to think that more substantial policy may have been announced, I'm sure if the economy continues to weaken we will be seeing the doves in the ascendance and the hawks marginalised.

ECB - let's get ready to rumble!

Thu, 16 Apr 2009 13:22:00 GMT

It’s all getting rather interesting at the ECB. Facing a rapidly deteriorating economy and the prospect of deflation, the governing council are at odds on the best way to deal with the crisis.

Fighting out of the blue corner, the German duo of Axel Webber and Jurgen Stark argue that cutting rates further and/or embarking on quantitative easing (QE) in a US/UK style would have little positive impact. Yesterday, Webber said in a speech that he would be critical of lowering the key rate to below 1% and that “direct interventions in the capital markets should take a backseat”. Stark's philosophy is more hawkish; in a speech he gave last month, he effectively ruled out involvement in the capital markets by stating “the health of the financial system cannot be made the ECB’s responsibility” (he didn’t offer any suggestions as to whose responsibility it is, but one assumes he is looking to individual governments). He also feels that cutting rates further could exacerbate the problem by weakening “the incentives for banks to clean up their balance sheets…and monitor their credit risk carefully”. The solution coming from these two seems to be to keep calm and carry on. They suggest continuing with the policy of offering banks unlimited loans, and Webber has also suggested lengthening the loans from the current six months to a year.

And in the Red corner, representing Greece, Cyprus, Italy and Austria we have Provopoulos, Orphanides, Smaghi and Nowotny. Provopoulos has indicated that he may support a rate lower than 1% if necessary, and would also be in favour of involvement in the capital markets. Orphanides went further in January, saying it is "dangerous" to take the view that monetary policy becomes ineffective as rates approach zero. Smaghi is a little less dovish, favouring an interest rate of zero if it’s justified, but would prefer the ECB committing to maintain a low rate of interest for a “prolonged period of time”. Nowotny agrees with the Germans to an extent as he thinks lengthening the maturities of the bank loans is the fastest option but has also recently said that “the purchase of commercial paper, corporate bonds and similar things” would be “sensible”.

The referee for the fight will be Jean-Claude Trichet. He has been non-committal as ever on “non standard measures”, although he did signal that the rate is likely to be cut to 1% at next week's ECB meeting. None of the QE advocates have yet described how the process of purchasing government bonds (let alone corporate bonds) would work. This will be a major hurdle to intervening in capital markets, as the process will inevitably become extremely politicised. Hopefully next week both parties will add more colour to their arguments. I for one would like to have a ringside seat.

If you're interested in watching how the fight unfolds, you can read ECB speeches as they occur here.

The Further Demise of ‘Supersub’ Bank Bonds

Wed, 14 Jan 2009 10:46:00 GMT

As our regular readers will know, we have been tracking Tier 1 (T1) capital’s fall from grace since last August. Unfortunately for these bank bond holders, the picture has not improved this week, with S&P and Fitch widening the notching between senior and hybrid debt on a number of European banks. This is because in their view (which has also been the long held view of our analysts) the risk/reward characteristics of these securities are becoming more akin to those of equity than debt. It feels as though the wider market is coming round to our way of thinking. This is significant because any further credit rating downgrades on T1 bank bonds will cause these bonds to drop out of investment grade indices, leading to more investors becoming forced sellers, and driving prices even lower.

Here is an update of the chart Richard used in his October 3rd blog. It shows that T1 has fallen even further since Deutsche Bank’s decision not to call a Lower Tier 2 bond in December; the average T1 bank bond is now down over 32% since July ’07. If more banks’ T1/UT2 ratings are cut things could get even gloomier.

If you would like more information on hybrid debt, or Deutsche not calling its LT2 bond, it is worth taking a look at last month’s blogs by Mike here and from Jim here.

Credit markets - cracks in the ice?

Wed, 03 Dec 2008 15:54:00 GMT

For all the talk of frozen credit markets, the figures showing new issuance may come as a bit of a surprise to some. November has been the most successful month for new non-financial deals this year (see graph on left). Companies have managed to issue new debt in spite of extreme risk aversion, risk aversion that can be seen in the huge sell off in equities and credit spreads hitting all time wides.

One of the main factors behind November's issuance levels was desperation, and we've seen that companies must offer a considerable discount to attract new capital. BMW for example, which is A rated, printed a €750m 5yr deal and had to offer investors a yield that was 6% in excess of 5 year government bonds. (Incidentally we thought this offered good value and bought some for a few of our funds).

What's been interesting to see is that levels of demand for the new issuance have been very strong, and the prices of the new deals have tended to trend higher in the secondary market - of the 23 substantial issues that were €500m or larger, 21 are trading at tighter spreads. And whilst the majority of paper has come from well regarded, less cyclical sectors such as utilities and telecoms, some less favoured sectors (as the example of BMW showed) have also been able to issue. What was very much a sellers market only 18 months ago is now a very different place - and we're saying that on a day that the iTraxx Crossover index hit a record high of over 1000 bps, implying default rates of over 50% over the next 5 years in riskier credits.