Bond Vigilantes

The lesser-spotted five pound note, and some other stuff

Tue, 09 Mar 2010 10:59:00 GMT

The Bank of England is trying to boost the number of £5 notes in circulation - their chief cashier Andrew Bailey (whose signature is on every new banknote) said "our evidence suggests that the public wants more £5 notes". The general public are demanding more of the lowest denomination banknote? On our desk we have some Reserve Bank of Zimbabwe One Hundred Billion Dollar notes, and, from a trip less than a year later some One Hundred Trillion Dollar notes (100,000,000,000,000). In an inflationary environment, the public demands higher and higher denominations of banknote. In the UK we want the lowest possible denomination. This looks like a deflationary sign.

Yesterday the UK's FSA came out with this Liquidity Calibration statement. We'd thought that the authorities might try to kill two birds with one stone, and force banks to hold more in quality, liquid assets - the banks would then be more liquid in case of market turbulence, and the government would find a new, big source of demand for its neverending supply of gilts. This statement has delayed that - "the FSA believes that it would be premature to increase liquidity requirements across the industry at the current time". Given the weakness of the economic recovery, the FSA doesn't want banks to be forced sellers of risky assets (including loans to the private sector) - but this is clearly bad news for the UK's ability to find buyers for its gilt issuance.

Journalist Andrew Rawnsley put the boot into David Cameron in his Channel 4 Dispatches documentary last night, concluding that if the Conservative leader in opposition doesn't have any real guiding principles now, he will struggle badly if elected to government. The public seem to feel this way too, and additionally undecided voters in vulnerable jobs (especially in the public sector) fear the threat of higher Tory cutbacks post the election. This explains the collapse in the Tory poll lead - down to something like 2-5%, with some polls showing Labour and the Conservatives neck and neck in even the marginals, despite non-dom Lord Ashcroft's windfalls for Conservative candidates' campaigns. So a hung parliament looks more and more likely. I'm not sure it would be the end of the world however; a coalition might find it easier to sort out the public finances, as it would have safety in numbers and not have to take sole responsibility for a period of high unemployment and cuts to public services. Also, past examples of coalitions have not necessarily been disastrous - the UK's greatest moment of national crisis, World War 2, was fought under a coalition government. This paper from the Hansard Society looks at the history of such coalitions, and concludes that a hung parliament might be a great opportunity. "Parliament would be strengthened because parliamentary votes would be less predictable and therefore crucial". Buy the pound and sterling assets whatever the election result is?

If you thought Greece was bad, have you seen California lately? It's a good comparison, because both are credit-challenged nations within a single currency area. At least Greece is not terribly systemic at 2% of EU GDP, whereas California is 14% of the US economy (France is 16% of EU GDP). Too big to fail? California was badly hit by the crash in subprime housing, and tax revenues have fallen sharply. S&P just downgraded its debt to A- (Moody's is at Baa1) and its 5 year CDS trades at 250 bps versus Greece at 280 bps, and the US as a whole at 35 bps. Things have got so bad for California that it started to print its own currency last year - in July it issued IOUs to individuals and businesses who were owed tax refunds. Effectively it is trying to bypass the single currency area, by issuing parallel money - but one dollar of Californian IOU is not worth a proper dollar in any free market. Especially if you call them "revenue anticipation notes" - come on, at least a dubloon or groat would sound like proper pretend money? Some crunch dates coming up for the Californian budget - sovereign worries in Europe have faded a little in the last week or so, might the spotlight head to the US next?

And finally, a great article about Come Dine With Me, the TV competition where amateurs take it in turn to cook for each other and then are rated by their fellow competitors to try to win £1000. Economists spend a lot of time and money trying to create experiments like this (OK they just bribe some undergrads with a couple of those rare UK blue fivers). Come Dine With Me provides a closed environment where you can see that the rational economic man, beloved of all economic models, does not exist. The rational score to give your rivals is zero - that never happens. Read the article for that, and other micro-economic insights ("Regret - if Rachel had known how big an arse Stuart was she would not have scored him so highly").

UK inflation - upward pressure in the short term (though we're still comfortable longer term)

Thu, 04 Mar 2010 16:03:00 GMT

Inflation rates, at least in the non-emerging markets, remain low. US core inflation (CPI less food and energy) was negative in January, the first month on month decline since December 1982. Preliminary German CPI in February was +0.3% year on year. Japan hasn't recorded a positive year on year inflation rate since January 2009.

Things seem different in the UK. The annual UK inflation rate jumped to 3.5% in January, prompting Mervyn King to write yet another letter to Alistair Darling explaining why CPI had breached the upper limit of 3%, and prompting Darling to write yet another response.

The BoE is confident inflation will fall, and has been busy telling people to relax, it's just temporary, nothing to worry about, we said it would fall last time it was a bit high and we were right. But in August 2009, the BoE was about 95% confident that inflation would be below 3.5% in January 2010. They were wrong (see below). An ex-member of the MPC recently described the BoE's fan charts to me as being "rivers of blood", and the FT announced that it was not going to publish the fan charts any more. The market is getting worried about the accuracy of the BoE's inflation forecasts.

Why is the UK inflation rate worryingly high and what's likely to happen in future? 'Base effects' are usually given as the main reason inflation has picked up - inflation is a year on year number, the oil price was below $50 a barrel at the beginning of 2009, it's now $80, and petrol prices have therefore risen. The good news is that base effects should prove temporary, unless the prices of things like oil continue rising rapidly or we see second round effects (eg higher wages). But is this the reason the BoE has significantly underestimated the UK inflation rate? I don't think so - in August 2009, the Bank of England knew what had happened to energy prices in the first half of 2009 and would have factored this into their inflation projections. Since August, energy prices (which are admittedly a small part of the CPI basket) have barely moved, and besides, other countries don't seem to have experienced base effects to anything like the same extent as the UK. So there's clearly something else going on.

Government policies have definitely had an effect, particularly changes in VAT. The jump in UK CPI from 2.9% to 3.5% last month was partly due to the year on year numbers reflecting January's increase in VAT from 15% to 17.5%. This effect will continue to be felt through to the end of this year when the VAT increase works its way out of the annual inflation numbers. We'll probably therefore see elevated inflation levels until then, and again, this effect should be temporary. But, I think VAT is very likely to be increased to the EU average of 20% after the election, AND we may see a number of items that are not taxed (eg most food, children's clothes, gambling, lottery tickets, museum tickets, antiques, water supplied to households, funeral services,incontinence products, freight, postage, newspapers, loans) start to get taxed. We may also see an increase in the tax rate on items that carry a reduced VAT rate (eg energy, some construction). Additional VAT increases this summer would put further upwards pressure on inflation, keeping inflation elevated until at least the second half of next year.

The third commonly cited reason for higher UK inflation is the weakness of sterling. This does not mean that sterling has been weak over the past twelve months - in the year to the end of January (the period covering the last annual CPI release), sterling actually appreciated about 10% against the US dollar and was up 4% on a trade weighted basis. What matters more, as explained in Mervyn King's letter, is that we are still feeling the lagged effects of sterling weakness in 2007 and 2008. I think this lag effect is a very important point, and probably goes a long way to explaining why economists and probably the Bank of England themselves have underestimated inflation over the past year. Things like companies currency hedging, retailers setting prices months in advance and wage settlements being based on the previous year's prices mean that there's a significant lag effect between a currency rapidly depreciating (which increases the cost of imports) and these import price increases being passed onto consumers. Import price inflation peaked at more than 13% in December 2008, the highest rate since our data series began at the beginning of 1981. Michael Saunders of Citigroup has estimated that import prices lead consumer goods prices by a massive 30 months, and if this correlation between import prices and consumer good prices holds, then we could well see further upwards pressure on UK inflation through the remainder of this year and into the beginning of next year.

All these things suggest that UK inflation rate may be a lot stickier than the Bank of England expects over the next 12-18 months However, it's important to stress that these effects should be temporary, and there are a lot of deflationary pressures going on right now which should prove longer term in nature.

We've talked about these longer term influences many times before. Money supply remains extremely weak - M4 broad money supply was flat month on month in January, and only +0.9% year on year versus +3.5% in July 2009 - just think what it would have been without any QE! (Note that this figure is using the BoE's policy of stripping out the deposits of 'intermediate other financial corporations', which excludes things like counterparties and SPVs). Spare capacity is still huge, and very importantly, the enormous trimming in the budget deficit and cut in government spending that is absolutely necessary and will definitely happen will have a major negative impact on growth, meaning that spare capacity is here to stay. Bank lending remains subdued, as evidenced by a dropping away of mortgage approvals in recent months from already pretty feeble levels - the authorities' continued failure to generate meaningful demand for or supply of credit should keep inflation suppressed.

I wouldn't put it quite as strongly as the MPC's Adam Posen, who last month said that "any of you betting on high inflation in major economies, including the UK, will lose money" - there are certainly upside risks (eg sterling collapse, underestimation of the inflationary effects of QE) - but on balance there's little to suggest that we're going to have inflationary pressure beyond the next 18 months.

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.

Are Sovereign CDS Evil?

Fri, 26 Feb 2010 14:56:00 GMT

Following on from Jim's Sovereign CDS Q&A blog (see here) I came across this chart at zerohedge.com. Whilst I can't vouch for its accuracy, the chart shows that the actual net amount of outstanding sovereign CDS contracts, relative to outstanding government debts, are actually very small. That would seem to add weight to Jim's argument that the pressures faced by governments are borne 'of fiscal imprudence and a lack of will to resolve this,' rather than the sole work of evil speculators.

Sovereign CDS Q&A

Thu, 25 Feb 2010 14:17:00 GMT

The market in sovereign credit default swaps has sprung to life over the past year as worries about the health of nations, rather than corporates, have multiplied. Problems in Dubai in December, and Greece right now, on top of a general deterioration of the developed economies' budgetary positions have seen sovereign CDS making headlines. Here's a chart of some of the latest CDS spreads on the major economies showing that fear of sovereign defaults is growing. This article is in the form of a Q&A and aims to answer some of the main questions that our clients are asking us about the sovereign CDS market.

Q: What are Sovereign CDS?

A: Credit Default Swaps (CDS) are contracts made by two market participants to either increase or reduce credit exposure to an entity - in this case a sovereign nation rather than a company. Quoted in basis points per year, a CDS price indicates the cost per year to either buy or sell exposure to the possibility of a sovereign defaulting or restructuring. Selling protection means you receive the premium every year of the contract but bear the risk of capital losses in the event of default; buying protection means that you pay the premium but will receive a payment equivalent to the losses suffered by bond holders in the event of default or restructuring. In other words sovereign CDS behave a little like insurance contracts - you can take the role of the insurer, or be insured.

Q: Why would you use Sovereign CDS?

A: You can use CDS to hedge an existing government bond position against losses it might suffer as sovereign credit worthiness deteriorates, or to take exposure to sovereign risk and receive yield in exchange for that credit risk. Like all derivatives they can be used to hedge trading positions and efficiently manage portfolios, or to take speculative or naked positions on the underlying markets. Because the instruments are mark to market, profits and losses from movements in the CDS levels occur constantly - you do not need to see an event of default to either make or lose money, just a movement in the market's perception of the risk of that default. These are OTC (over the counter) derivatives, so participants need to have legal documentation in place with counterparties, and collateral moves from one counterparty to the other to reflect movements in the profit and loss - this reduces counterparty risk.

Q: What triggers a payment?

A: The Sovereign CDS contract is triggered when a credit event occurs. There are three credit events for sovereign CDS, and they differ from corporate CDS in that "bankruptcy" is not one of them (that's a concept that only legally applies to a corporation). The credit events are:
1) Failure to pay a coupon or principal on a bond or loan.
2) Moratorium - the announcement of the intention to suspend payments of debt obligations.
3) Restructuring - changing the terms of a debt obligation in a way that disadvantages investors, for example by extending the maturity date, cutting the coupon, or changing the currency of denomination to that of a non-G7 or AAA rated OECD member.
Sometimes credit events are not clear-cut. For example, what about the UK's War Loan example that we talked about recently? Bond investors voted overwhelmingly to accept the reduced coupon payments (from 5% to 3.5%) - but was there really an alternative? So although this was a voluntary restructuring, nowadays this would probably trigger a CDS credit event. A committee of market participants sometimes has to decide whether such an event has taken place or not - obviously this is not as "clean" as you might like, and there is obviously potential for conflicts of interest to occur.

Q: What happens after a credit event has taken place?

A: The investor who has bought protection through a CDS contract needs to receive a payment equivalent to the face value of the contract that they have entered into, less any recovery on the bond. So, let's assume that Country X misses a bond coupon, and its bonds fall to 20 cents in the dollar. There are two ways of settling the contract - physically or simply as an exchange of cash. In physical settlement, I give the counterparty who sold me protection $100 nominal value of bonds for every $100 which I have insured. The counterparty gives me $100 in exchange. Thus if I own the bonds and have hedged them with CDS then although my bonds have fallen by 80%, I get my full face value back. If I have simply been speculating, then I can buy the distressed bonds in the market for 20, and sell them for 100 to my counterparty. Contracts will typically cash settle however - in this case there is an auction to set an observed market price for the distressed bonds and thus determine their recovery value. Instead of bonds changing hands, the counterpart simply transfers the difference in value between the nominal value of the bonds and their distressed price to the buyer of protection. This is neater, but there are again some issues about the fairness of the price determined at auction if participants were conflicted - in a large, liquid government bond market this is less likely to be a problem than in an auction for illiquid high yield issues.

Q: Are all bonds deliverable into the CDS contract?

A: No. The contract determines which bonds are deliverable - only bonds in major currencies are allowed, and bonds must be under 30 years to maturity. The concept of the cheapest-to-deliver (CTD) bond is important. The buyer of protection will want to deliver the lowest cash priced bond to the seller of protection, in order to maximise their payment. All other things being equal, this would be a long dated, low coupon bond - although in a full blown default where no coupons are being paid all bonds will tend to trade at similar cash prices in any case. Other issues to consider include whether agency bonds are deliverable into the CDS contract - some believe that KfW bonds are deliverable into a German sovereign CDS contract, while Railtrack bonds are not deliverable into a UK contract, even though both are AAA rated and government guaranteed. Lawyers love credit default swaps.

Q: What are sovereign recovery rates likely to be?

A: There has only been one example of the auction process being used to determine the recovery rate for sovereign CDS. After the last Ecuadorian default, the auction settled at a recovery rate of 31.4%. In recent sovereign defaults in the days before CDS, the observed recovery rates ranged from 6% (Russia in 1998) to 90% (Dominican Republic in 1990). The average according to Credit Suisse was 39%. Long term recovery rates may of course differ from those used in the auction process. Recoveries will tend to be based on willingness to settle, rather than asset coverage. In a corporate default, debt investors can seize physical assets or contracts from a company; with the exception of overseas embassies and property it is much more difficult to seize sovereign assets.

Q: Can I estimate probabilities of sovereign default from CDS prices?

A: Yes, with the cavaet that like all financial instruments, prices are driven by fear and greed and may not reflect the fundamentals. You need to have an assumption for a recovery rate - let's use 39% as the average. So if Greek 5 year CDS is trading at 400 bps per year, this means that in any one year you anticipate a pre-default spread of (4% x 100/(100-39)) = 6.56%, which given markets are efficient (!) must equate with the expected one year default rate. So on the back of an envelope, ignoring the impact of compounding and the expected timing of a default, the cumulative expected default rate for Greece over the next 5 years is 5 x 6.56%, or over 30%.

On today's CDS levels, the following default probabilities can be calculated:

	5 year CDS, bps	5 year implied cumulative default at 39% recovery
Germany	45	3.7%
USA	47	3.8%
France	63	5.1%
UK	91	7.5%
Italy	135	11.1%
Portugal	186	15.2%
Greece	400	32.8%

Q: If I buy protection on my gilts from a UK bank, what happens if the UK defaults?

A: It wouldn't be a good idea, and luckily it's not allowed. UK banks don't trade UK sovereign CDS (and US banks similarly don't trade US CDS). If you trade UK sovereign CDS the most liquid contract is in US dollars; you can't trade the contract in £ - this is because in the event of a sovereign default there is also likely to be a currency crisis which would significantly distort the recovery value in non-£ currencies. Because the UK only has £ obligations (there is no foreign currency debt) the recovery value will therefore be determined by auction and there will be cash settlement. This distortion of the knock-on currency devaluation is the big difference between sovereign CDS and corporate CDS (there is no currency impact in a typical corporate bond default), and a reason why the two instruments cannot be directly compared (ie. you can't automatically conclude necessarily that because an index of corporate CDS is trading at a lower spread than the UK sovereign then the corporate credit risk is lower).

Q: What is the "basis"?

A: The basis is the difference between the spread over the risk free rate on a bond issued by a government and corporate and the CDS spread. As a simple example, Greek 5 year bonds yield 440 bps over similar maturity German government bonds (risk free, hopefully), and the CDS is at 400 bps. This difference of 40 bps is the basis - it's common for the CDS level to be below the bond spread (a negative basis). The difference should be arbitragable, but issues such as liquidity, different investor preferences and uncertainty over the cheapest to deliver mean that the differences can persist. It is worth mentioning that given most assets contain an element of sovereign risk, the desire to hedge this out, especially amongst banks, has had a huge technical impact on what is still a fairly illiquid market thus distorting prices. It is not unknown in the credit markets for CDS spreads and corporate bond spreads to move in opposite directions - this can be a real pain trade for those who thought they had hedged an exposure.

Q: Are sovereign CDS evil?

A: Some people think so, and there have been rumours in the past few days that the European Commission is considering a ban of some sort as speculators have been blamed for the current Greek woes. Certainly CDS provide a method of reflecting bearish views on a nation in a way that was diffcult to do historically (most investors cannot physically short government bonds), and it's a method that produces a highly visible bellwether of a country's perceived risk. But Greece, and the other weak sovereigns, would be in trouble even if the CDS market did not exist - the problem is one of fiscal imprudence and lack of will to resolve this, and the market reflects the fundamentals rather than drives them. There is a wider, and perhaps more valid issue with CDS though, and that's the issue of moral hazard. I can't buy insurance on somebody else's house that pays out if it burns down - if I did it might produce perverse incentives for me, and even if I didn't turn into an arsonist, it might make me think twice about calling 999 if I saw smoke. Does buying protection on a company or a nation create perverse incentives to hinder a possible recovery for that entity? Is it morally right to hope for bankruptcy, or default, when it might mean hardship for employees, or indeed a whole nation? There's a debate on just this topic on the Economist website.

What is the risk free rate anyway?

Thu, 25 Feb 2010 08:46:00 GMT

The risk free rate is a concept beloved of micro-economists and bond math geeks. It's the building block of Modern Portfolio Theory and an input into option pricing models. It's supposed to represent the interest rate available in the market that is without credit risk and as such is the lowest interest rate in the market. The complete absence of risk has always been more observable in theory than in practice but in the last month or so, swap rates have fallen below gilt yields - can it be right that the lowest interest rate in the market is lower than the traditional risk free rate? Are government bonds still the right instrument with which to observe the risk free rate?

Interest rate swaps are a means of turning a floating rate cashflow into a fixed rate cashflow for a set period of time, or vice versa. If you decided to receive fixed rate payments for ten years, you would agree to pay Libor (reflecting the cost of short term money) and receive the fixed payment for the life of the contract from the bank with which you'd traded. Historically the fixed rate payment would be more than you could get by buying a gilt from Her Majesty's government. On average over the past decade it was around 0.5% more than the ten year gilt yield. This seems to make sense, as there is a risk that the bank counterparty that you have traded with disappears and can no longer service the contract, so the premium over gilts reflected credit risk.

As this chart shows however, this swap spread (the difference between the swap rate and the gilt yield) has fallen substantially since the start of 2009, and in the first couple of months of this year it has turned negative. The ten year swap spread is now -0.18%. In other words you get a lower rate of interest in receiving a fixed payment from a bank than you would from a AAA rated (still!) government bond. Does this make sense? After all, if you are a UK investor that swap might well be with a government owned bank anyway, so isn't the credit risk the same? There are two reasons why you might want to receive fixed via an interest rate swap rather than buying a gilt. Firstly, if there was a UK sovereign default you would probably lose capital if you owned a physical gilt, whereas your downside in a swap default would be limited to having to replace the counterparty at a potentially less advantageous rate of interest. More significantly though, the markets are reflecting not just the increased risk of a UK default (which in our view is much less likely than is priced into the CDS market, at about 9% over the next 5 years) but more importantly the relative supply of swaps and government bonds. Gilt issuance will be running at around a £200 billion rate for the next couple of years, but without the market's biggest investor - the Bank of England has ended its Quantitative Easing programme (although not irrevocably).

So with an implied default rate of nearly 10%, the gilt market cannot seriously be regarded as "risk free" any more, even if we do think that probability is nutty given the UK's access to the printing presses of mass destruction if we ever did get stuck for a few bob to repay our bond debts. But once the gilt supply glut is out of the way in a couple of years time (we hope), expect swap spreads to move steadily higher. The swap market has become an increasingly important yardstick for valuations however, and maybe the UK corporate bond market will begin to price in relation to swaps rather than gilts - the European corporate bond market has already been doing this for years, as has the UK population whenever we've considered a fixed rate mortgage.

LBO’s and IPO’s: have European equity investors woken up?

Wed, 17 Feb 2010 12:59:00 GMT

Back in January at our Annual Investment Forum I focussed on the changing face of the European Leveraged Finance markets - those companies financed with significant levels of debt. My belief is that the current, somewhat forced reinvention, will ultimately result in an increasingly deep and liquid European High Yield market (EHY), more akin to that of the USHY market.

This change, which is already well underway is being predominantly driven by three factors. Firstly, a need within the European leveraged loan market to re-finance a huge wall of debts maturing between 2012 & 2015 (see graph). Secondly, we have witnessed a significant rise in the number of fallen angels issuers; those high yield companies who have lost their investment grade status, the likes of Fiat and ITV. Thirdly the now significant sub financial component of the high yield universe is changing the nature of the market. Subordinate debt issued by the likes of Lloyds, RBS and ING currently comprise around 13% of the EHY universe.

On my first point, the consensus has held that a mixture of trade sales, secondary LBOs, IPOs, restructuring and re-financings will offer a solution to the circa €200 bn worth of European leverage loans coming due. However, the recent decision to abandon attempts to IPO Travelport, and delay those for New Look and Merlin, has brought the spotlight firmly on the IPO market asking questions of its willingness to participate in future. (See FT article here)

The European equity market has arguably learnt some harsh lessons over the last few years. The relisting of Debenhams back in 2006 was followed by three profit warnings in quick succession with its stock price predictably suffering. (See Times article here) Gartmore and Smurfitt Kappa’s IPOs are other examples of sponsor owned businesses that come to mind whose stock prices have underperformed the market since relisting. Had much, if not all of the low hanging fruit already been extracted by the sponsor?

In today’s volatile environment the ability of private equity to hit their IRR targets may be hampered by the scepticism pervading the European equity markets. The reality is that there will always be an equity market interest in backing companies with good prospects and strong track records, sensible debt levels and an alignment of sponsor/equity market interests. But the lack of willingness to underwrite the IPO’s of highly levered, cyclical businesses poses further questions for the European leveraged finance market. If the European equity market is unwilling to play its part in re-financing the excesses of previous years, then the implications are likely negative for both private equity returns and certain European leveraged finance investments.

Breakfast with Nobel laureate Joseph Stiglitz, plus competition time

Thu, 11 Feb 2010 12:24:00 GMT

On Tuesday morning, I attended a breakfast with Joseph Stiglitz that was both fascinating and gloomy. Stiglitz, who was formerly the senior adviser to Bill Clinton, Chief Economist at the World Bank, and was awarded the Nobel prize for Economics in 2001, shared his views on the state of the US and global economy and discussed some of the key themes in his new book Freefall. Stiglitz's views are mentioned in brief below;

Consumption forms the majority of economic growth in the US, and a sustainable recovery needs consumers to spend. However consumers can't consume if they're saddled with too much debt. There are three solutions to this:

1) Bankruptcy. Defaulting on outstanding debts would reduce the burden, thus allowing spending to rise. However banks clearly don't want that, and most certainly can't afford it.
2) Inflation. This is also not likely, as central banks won't allow it. Plus, in practice, inflating your way out of debt problems doesn't really work - countries typically have a lot of short term debt, and as soon as markets get a whiff of an inflationary policy, short term bond yields will rise, thus making the cost of debt more expensive. In fact the worst thing for central banks is if markets believe that there's a risk of inflation even if the central bank has no desire to inflate its way out of a debt problem, since this results in the cost of debt rising without the accompanying benefit of inflation (no wonder, therefore, that US policy makers continue to stress the downside risk to inflation, whether they actually believe it or not)
3) Muddle through. This is the most likely outcome, is what the authorities seem to be doing now, and the implications are a low growth rate for a prolonged period.

In his view, the US unemployment rate is likely to remain elevated. The budget office doesn't expect unemployment to return to normal levels until at least the middle of this decade, and that's based on what some might argue is an overly optimistic real growth rate of 3% per annum. In addition, the official unemployment rate is underestimating the 'true' figure - if you add in all the Americans who actually want a job but can't get one, the number is almost 20%. Furthermore, about 40% of people in the US have been unemployed for more than six months, which is something that Europe's used to, but hasn't been experienced in the US in modern times. The effects of the labour market crisis are likely to be exacerbated and long lasting because this financial crisis has come at a time when US labour is at a particularly vulnerable phase. Just as in the Great Depression, when the US economy was transitioning from one based on agriculture to one based on manufacturing, this crisis has hit as the US economy is transforming from one based on manufacturing to one based on the service industry.

Labour market aside, he believes that the US economy is facing two huge underlying macroeconomic problems, the first being a weakness in global aggregate demand brought about by a very high saving rate in the emerging countries, and the second being mounting inequality between the rich and the poor. The apparent solution to the latter problem was to encourage people on low incomes to spend more and save less, resulting in an unsustainable savings rate of zero, and which has clearly now backfired.

Stiglitz also touched on exit strategies. Something that's very important but hasn't yet received sufficient attention is the effect of Federal Reserve ending its purchase of mortgages. The Fed's balance sheet has swelled from $800bn to about $2tn, and it has bought almost all mortgages issued in the US over the past year. The Fed will go from buying almost the whole market to buying none, and surely this will result in mortgage rates rising, which is clearly bad news for the housing market and for the already depressed commercial real estate market. The most likely outcome for the US economy is a 'double dip' - not necessarily one that returns the economy to recession outright, but a slowdown in US growth.

There were numerous additional pieces of information that warrant a mention. I wasn't aware that (according to Stiglitz) Paul Volcker was fired by Ronald Reagan. Despite Volcker's excellent track record in bringing inflation under control in the 1980s, the bankers wanted someone to repeal Glass-Steagall and ultimately the bankers had their way. Reagan turned to Alan Greenspan as someone who strongly believed in deregulation. Greenspan succeeded in controlling inflation, although in Stiglitz's view it wasn't particularly due to Greenspan's policies - the main credit goes to China. Greenspan has been blamed for a lot of what has happened over the past couple of years, but it's not solely Greenspan's fault - if it hadn't been Alan Greenspan, it would have been anyone else who believed in deregulation to meet the political will at the time when Greenspan was appointed.

Stiglitz also discussed a favourite topic of his, on how a lack of regulation led to inappropriate incentive structures in banks, which led to bad behaviour. The banks' job is to efficiently allocate capital, manage risk, and reduce transaction costs, thus resulting in higher productivity. But 40% of corporate profits went to banks at a time when real wage growth was flat for a whole decade - banks stopped being the 'means', and became the 'end'. Banks were allowed to become not only too big to fail, but too correlated to fail. Saving the banks has been a social cost, but a private gain. This isn't acceptable - the cost should be carried by the financial sector.

So radical reforms are necessary, and greater stimulus is needed, not least to support the labour market. If you are keen to read more of Joseph Stiglitz's thoughts, then I have a signed copy of his book Freefall. The person who is closest to guessing where Greece 5y CDS is at the close of Monday 15th February wins (we're taking the GCDS page on Bloomberg). To give you a guide, it started this year at 283, mounting credit concerns meant that it closed at 426bps on Monday this week, before rumours of a bail out saw it close at 375 on Tuesday 9th February.

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What happened the last time the UK defaulted?

Tue, 02 Feb 2010 14:31:00 GMT

Britain has run debt to income ratios way in excess of current levels at several points in its history. Around the times of the Napoleonic War, and both the First and Second World Wars the debt to income level exceeded 200% - levels that today would be regarded as crippling and would lead the markets to expect imminent default. Click chart to the left. Yet there has never been a formal default, and much was made about the UK paying off the last of 50 instalments of World War 2 debt to the US and Canada in 2006.

But it cannot be said to be true that the UK's credit record is unblemished. In their brilliant book, This Time Is Different (we've plugged it before), Reinhart and Rogoff do not have Britain in their very short list of six nations that have never defaulted (New Zealand, Australia, Thailand, Denmark, Canada and the USA). There are (at least?) two instances of the UK defaulting. In 1932, in the grip of the Great Depression, Britain (and France) defaulted on First World War debt to the United States - the so-called inter-allied debt. Britain had linked its ending of paying of these debts to the premature end of German reparation payments earlier in the year - academics therefore have termed this an "excusable default" where Germany was the real defaulter. The Americans didn't seem to be especially cross about it in any case, although it was done without consent.

Another event that I would classify as a default was the changing coupon on the gilt known as War Loan. Issued in 1917 ("If you cannot fight, you can help your country by investing all you can in 5 percent Exchequer bonds. Unlike the soldier, the investor runs no risk", the adverts said), the bond's coupon was reduced from 5% to 3.5% in 1932. You can read Chancellor Neville Chamberlain's speech announcing his plan in Hansard, here. This was a voluntary conversion - you could have had your money back - but the moral screws were on. Chamberlain ends his speech saying "For the response we must trust, and I am certain we shall not trust in vain, to the good sense and patriotism of the 3,000,000 holders to whom we shall appeal". 92% of holders accepted the new, lower coupon (probably not just for patriotic reason, but because 3.5% was still a better rate of interest than was available elsewhere in those deflationary times). Today, we have seen the ratings agencies classify similar events as defaults, even if such disadvantageous changes were consensual.

Perhaps just as interesting is the question - why didn't the UK default more often? A paper called Sustainability of High Public Debt: What the Historical Record Shows by Albrecht Ritschl suggests that it isn't obvious why it didn't. Post WW1, growth was disappointing, in contrast with expectations of a peace dividend. Yet even during the deflationary years between the wars (1926 to 1933) the conservative establishment view was to run budget surpluses, and to go onto the Gold Standard (until 1931), which didn't allow a devaluation and thus help boost UK exports. Why the UK decided to beggar itself rather than default was in part due to the culture in the Treasury (the "treasury view" was hardline), and also due to the emergence of the United States as a rival economic power and financial centre. Post WW2, Ritschl argues that Marshall Aid was effectively a "rescue operation" that prevented a default. So reputation is extremely important in preventing default, the competitive threat from other financial centres matters, and having allies with deep-pockets (Germany or the IMF in the case of Greece?) can also prevent defaults. Remember the golden rule - willingness to pay is as important as ability to pay. Britain was willing to accept austerity in the 1930s to maintain its reputation; Ecuador has defaulted with a debt to GDP ratio of under 20%.

So to the present day. This weekend the papers were full of headlines about Conservative leader David Cameron postponing austerity for the UK. Today, in what looks like a different view, his Shadow Chancellor George Osborne has committed his party to maintain the UK's AAA credit rating: "Judge us in the first few months of a Conservative government on whether we're able to protect our credit rating". I'd have thought that as a result, the UK's 5 year CDS spread would have narrowed a little, but it's stuck at 85 bps (we've written protection on Her Majesty's Government because although fiscally we face a crisis, we don't believe this will result in a default). Perhaps the market fears that the Conservatives are going to have a Devon Loch moment; the latest polls point to the forecast overall majority having slipped away, and a hung parliament is in prospect. With the UK economy at least growing again, albeit it only just, the chances of Osborne getting his chance to be Mr Austerity are slightly lower.

Exploding Myths

Thu, 28 Jan 2010 14:28:00 GMT

According to many market commentators, the UK debt market is looking sick and is at a critical juncture. It is amongst the most unloved government markets in the developed world, which is understandable given the British inability to save in the boom times. Now there is justifiable scepticism that markets will not be able to absorb the forthcoming huge government debt issuance once the Bank of England stops providing life support to the gilt market when it ends the quantitative easing program.

This consensus view is typified in PIMCO's monthly investment outlook in which the UK bond market is singled out as a market that must be avoided. In their opinion, the gilt market is resting on a bed of nitroglycerin. PIMCO point to the UK's relatively high level of government debt, potential for sterling to fall and domestic accounting standards that have driven real yields on long dated inflation linked bonds to exceptionally low levels.

We agree these are issues that face the UK economy and have commented on these points previously. However, like any consensus, it makes sense to investigate if this is correct, priced in, and when it might come to an end.

Firstly, the IMF forecasts that for 2009 that the UK government will have a relatively large annual deficit of -11.5% of GDP, which is below that of the USA (-12.5%) but almost triple Germany’s government deficit (-4.2%). However the UK’s total outstanding gross debt stands at 68.7% of GDP, which compares favourably with the USA (84.8%) and Germany (78.7%). The UK government has responded in aggressive Keynesian fashion to the downturn, if this medicine works then the action will be short term in its nature and will not leave the UK with a permanent debt burden, or the increase in debt could alternately be curtailed by the arrival of a more fiscally stringent government in this year’s election. The UK has very little foreign debt and has been prudent by having the longest maturity debt profile in the G7. Outstanding debt and re-financing needs would therefore appear relatively manageable on an international basis. Not all outcomes will be bad.

Secondly, with regard to fears that our exchange rate could fall, the exchange rate has already collapsed by 22% on a trade weighted basis since 31 July 07. So a lot of the necessary adjustment has already taken place. This adjustment process is very beneficial for an open economy such as the UK, especially when many of our trading partners are locked into using the relatively strong Euro currency. By having a flexible currency and control over domestic interest rates, the UK is arguably in as good a position as anyone to grow our way out of our debt problem.

Finally, accounting standards have indeed distorted gilt yields as we have previously mentioned here. However, this accounting standard is designed to improve company accounts in terms of disclosing assets and liabilities of company pension schemes and this is surely a good accounting standard that should be adopted by many other regulators. The fact that better pension regulation in the UK results in lower long term rates makes long dated bonds - especially UK linkers - look dear internationally. But this dampening influence on gilt yields is a distortion that is likely to persist unless the regulation and the accounting oversight of this significant employee benefit are changed.

The view that the UK gilt market is one to avoid has some punch in the short term, but the consensus is exaggerating the risks the UK gilt market faces. Even if one agrees with the consensus, it is important to see if this view is priced into markets and when this will eventually come to an end. I agree with the direction of the consensus, absorbing that much new supply will be negative for gilts in the short term. However in the longer term the UK has the chance to adjust to the crisis through fiscal stimulus, financial reform and a falling exchange rate that might well provide the medicine required. The consensus that a bed of nitroglycerin is a dangerous place to rest like any consensus view should be challenged. Don't forget, a bed of nitroglycerin could be exactly what the sick UK economy needs as it is one of the oldest and most useful drugs for restoring patients with heart disease back to good health!