fixed income speculation and tapering

One of the earliest attempts by technical analysts in the US to link their work to economic variables was in charting the relationship between growth in the domestic money supply and stock market advance.

This wasn’t Milton Friedman.

This was–and is–a common sense attempt to create a barometer to measure the degree of speculation inherent in the stock market.  The idea is that the economy needs a certain amount of money to grease the wheels of commerce–to keep factories humming, meet payrolls, build inventories.  Anything in excess of that amount will inevitably find its way into financial speculation in equities, real estate and commodities.  Speculation, in turn, will lead to intervention by the Fed , “to take away the punch bowl,” as William M. Martin, a former Fed Chairman put it.  (Or, in the most recent case, where the punch bowl was heavily spiked and stayed out forever, a near-meltdown of the world financial system.)  So it’s an early warning indicator of a market decline.

Although still used by at least one famous hedge fund, this simple rule has lost much of its usefulness in a globalized world with supply chain management systems, ubiquitous, but only semi-visible derivative contracts and the increased prominence of businesses based on intellectual property.

I think, however, that the Fed is using this rule, but has reversed the inference, as part of its rationale for tapering.  I think the Fed sees increasing speculative activity in fixed income markets as evidence that there’s too much money sloshing around in the world.  (I know I am.)

Three areas worry me:

pik bonds.    Pik stands for payment-in-kind.  It’s a type of junk bond where the issuer has shaky cash flows and may not be able to afford to make interest payments on its debt.  So lenders allow the firm to pay interest “in kind,” meaning issuing more junk bonds to cover the interest expense.  As is always the case in investment banking, there are variations on the theme:  the bond may be pik from inception; the issuer may have the right to convert the bonds from cash to pik, if he needs to; or the issuer may be able to “toggle” back and forth between cash and pik as he desires.

In my limited junk bond experience, pik bonds only rear their heads at bond market peaks.  And they’re here again.

contingent convertibles, or “cocos.’   The original cocos, spawned by the financial crisis, are bonds issued by financial companies that can be forcibly converted into equity–thus shoring up regulatory capital–if the issuer gets into financial trouble.  In my view, the buyer is exposed to all the downside of owning an equity with few of the rewards.

According to the Financial Times, a new variation on the coco theme has recently appeared.  The new securities are called “sudden death” or “wipeout” bonds.   Their attraction is that they pay coupons of around 8%.  The catch is that if the issuer’s regulatory capital falls below a ratio specified in the bond indenture–so far its been if a bank’s Tier One equity ratio falls below 7%–then coco holders lose all their money.  

To me, this looks like an equity put dressing it up in bond clothing so fixed income managers can buy it.

the Fragile Five.  2014 opened to a bout of bondholder angst about their positions in the debt of places like Argentina.  Argentina?   Really?  Isn’t this the same place that nationalized Repsol in 2012?   …the same place that defaulted on its sovereign debt in 2001?   …where capital flight has accelerated to the point that the government has shut down online shopping to prevent money from leaving the country?  Talk about risky.

I think these areas worry the Fed, too.  They’re why I think we’d have to see considerable economic weakness in the US before tapering comes to a halt.

there may be a real life for contingent convertibles, after all

why I don’t like co-cos…or, (more) evidence investment bankers are on the dark side

Investing is conceptually very simple but emotionally very difficult.

Under most conditions, professionals can resist the Dr. Frankenstein-like impulses of investment banks to create bizarre security hybrids.  Not at the top of the market, though.  There’s something in the air that makes portfolio managers throw away their pocket protectors and revel in the purchase of the trashiest securities.

PMs will rue these buys for the rest of their careers–which may, incidentally, be quite short periods of time if they don’t recover their senses and sell the stuff on while a market for them still exists.

One of my favorites in this genre was a convertible bond issued in 1993 by Hong Kong-based New World Development, an indifferently managed family-owned property conglomerate.  It carried no coupon and was convertible on undisclosed terms into shares of a mainland Chinese company that did not yet exist.

And you ask me why I’m not a fan of investment bankers.

As it turned out, the issue met with high demand despite its dubious character–a sure sign that the markets were in the grip of speculative fever.  Right afterward, I was chatting about it with a highly skilled colleague, who confessed she had actually taken part in the deal.  Her reasoning?  In her peer universe there might be a half-dozen offerings during the year that would make or break performance versus competitors.  She felt she couldn’t take the chance that the deal would not only be successful but would trade up strongly in the aftermarket.  She didn’t want to be left in the unusual (for her) position of eating competitors’ dust.

co-cos, the brokers’ latest creation

Contingent convertibles are more recent spawn of the investment banking tendency to birth nightmarish creatures.

The idea is that the vehicles, known as “co-cos,” would be issued by financial companies, especially banks, that are required to maintain minimum levels of equity capital.  They start out as bonds.  But if the issuer’s financial condition deteriorates beyond a certain level, they automatically convert into equity.  Therefore, investment banking proponents argued, they should be considered as equity by the regulators even before conversion.  (True to form, when the original idea was floated, the intention was to not specify in the offering documents what circumstances would trigger conversion.)

not a winner…

Co-cos have never taken off.

The obvious flaw, other than that no one would know what would prompt conversion, is that the buyers would be bond portfolios.  They’d be reeled in with the promise of higher-than-average coupons.

If the issuer’s capital ratios deteriorated, its stock would sag significantly.  If conversion of the co-cos followed, that would leave large amounts of stock in the hands of PMs whose client agreements don’t allow them to hold equities.  So they’d have to dump the securities right away into a depressed market, sending the issuer’s stock lower and making its problems worse.  In fact, anticipation of conversion might launch the stock of the issuer into a severe downward spiral.

Also, the Bank of International Settlements said the idea wouldn’t fly.  Finally, the co-co idea also came too close to the disastrous demise of their close cousins, hybrid bonds.

…until now

It now looks like co-cos may actually have a use, according to the Wall Street Journal.  The buyers won’t be private investors, however.  They’ll be the governments of Spain and Portugal, which will use the vehicles to inject money into ailing banks.

Why use co-cos? Three reasons:

–the injections of money will look like investments, not the bailouts they really are,

–Spain and Portugal will get securities in return for the money they pour in, so their government deficits won’t increase, at least on paper, and

–Madrid and Lisboa won’t appear to be partially nationalizing the weak banks, which is what buying equity directly would mean.

I’ve never seen this before–an instance where a crackpot, top-of-the-market, caveat emptor ploy by investment bankers to boost their bonus pool is actually useful.  It’s nothing like what the i-bankers envisioned, of course, but still…

systematically important banks: BIS says “No, no!” to co-cos

the BIS and “too big to fail”

The Bank for International Settlements, the unofficial rule setter for the world’s commercial banks, is in the process of making new guidelines to govern the behavior of systematically important (read: really big, or “too big to fail”) banks.

extra capital needed…

A couple of days ago it aired new regulations that would force the biggest banks to hold more capital to back a given loan than a smaller bank would need.  The bigger the bank, the more capital necessary.  And if a jumbo bank tried to become jumbo-er by adding net new loans, it would need even a higher level capital to back those.

The thrust of the rules is to create economic incentives for banks not to get bigger, or even to break themselves up into pieces, so that the potential failure of  one massive bank would no longer threaten to bring down a country’s entire financial system.

…through co-cos?  No, thank you.

During the discussion, the question arose as to whether the BIS would allow this “extra” capital to be supplied, not just by equity, but by  convertible securities (co-cos) as well.  The BIS said no.

why not

It didn’t supply reasons, but I think it’s easy to see why (before I go any further, I should warn you that I’m not a fan of gimmicky securities like co-cos, as you can see from this older post.  I may have gotten a little carried away when I was writing it, but I still believe what I wrote then.):

bondholders and stockholders have different points of view about the issuers of the securities they own.  The former care mostly about collecting their coupon payments and getting their principal returned at the end of the bond’s life.  Shareholders want healthy growth of the enterprise, so that they get a higher stock price and greater dividend payments.  Shareholders tend to make waves; except in extreme situations, bondholders don’t.

If the idea of the extra capital is to have more people with a strong interest in preventing aggressive expansion of the loan book, you probably want to increase the number of professional equity investors with an interest in the bank, not replace them with bond fund managers.

no one knows how contingent convertibles will work in a crisis.  In particular, if the conversion provisions of a co-co are triggered and the security becomes an equity, bond managers who own it (and whose contracts with customers doubtless bar them from holding stocks) will be forced to sell.  Having lots of stock in a troubled company being dumped on the market and forcing the price down probably won’t make the bank’s situation any better.  If it prevents the firm from raising new equity, it could make things considerably worse.

a flaw in the terms of existing co-cos has been detected. Commercial banks and their investment bankers want the co-co conversion trigger to be based, as is the Lloyds TSB issue I wrote about in my original post, on the level of equity shown in the bank’s accounting statements.  We’re currently seeing in the EU financial crisis an example of the extreme unwillingness of governments and politically connected banks to write down the value of impaired assets (in this case, Greek government bonds).  But it’s the process of loan writedown that forces the co-co conversion into new equity.

In other words, in a future crisis, governments may not permit their banks to acknowledge that their capital is impaired.  So the conversion of co-cos may never be allowed to take place–meaning that the institutions will be seen to be even more leveraged than thought.




Rabobank’s latest fundraising: Europe trying to define bondholders’ responsibility in default

the problem

To an American, one of the striking aspects of the financial crisis has been the reluctance, both of politically powerful bondholders (many of them state-controlled entities) and of country governments, to accept any impairment in the value of the debt securities of ailing financial institutions.  The prevailing thinking seems to have been that, no matter how the debt documents read, there was an implicit social promise that the negative consequences of default should fall entirely on shareholders or government.

(In the US, in contrast, it’s very clear that bondholders, too, participate in the losses from a bankruptcy–though with the quirk that the treatment a class of bonds receives is more dependent on its size and the bargaining power of its representatives than the explicit promises in the bond indenture.)

contingent convertibles

The European way of doing things has proven to put excessive strain on public finances.  One of the possible solutions being discussed to this problem is issuance of contingent convertibles or “CoCo” bonds.  Cocos would spell out in the issuing documents specific circumstances of deteriorating issuer finances that would trigger conversion of part or all of the bond capital into equity.  Conversion would simultaneously reduce the amount of debt on the balance sheet and shore up shareholders’ capital.

The idea really hasn’t gotten off the ground so far.

contingent capital bonds

However, Rabobank of the Netherlands sold a contingent capital bond last weeks that pundits are hailing as an instances of a successful CoCo bond.  The issue, $2 billion at a yield of 8.375%, was more than 3x oversubscribed.  If Rabobank’s equity falls below 8% of total capital, the value of these bonds automatically shrinks–even to zero–until Rabobank’s equity ratio reaches the 8% level again.

Although I’ll admit the issues is interesting, I’m not sure it’s a harbinger of anything.  Why?

–Perhaps least important, this isn’t really a coco at all.  Rabobank is a cooperative society.  It was formed two centuries ago by a large number of agricultural banks, which hold its ownership interests.   So there’s no publicly traded stock for the bond to convert into.  The bond principal vaporizes instead.  I’m not sure there’s a big difference, though, between getting a share of stock in a dud bank or getting nothing, other than how fast you get to recognize your loss.

–Rabobank has a AAA credit rating (although S&P has put it on watch for downgrading) and is mostly a retail bank.  So it has a very different risk profile from the troubled big universal banks of the EU.

–According to the Financial Times, 70% of the issue was taken up by individual investors.  My guess is they don’t have much of a clue about what they’ve bought.  They see a high coupon from a conservatively managed bank–and little else.

the question of pecking order

This bond brings up another question.

Rabobank already has second contingent capital bond outstanding, this one about $1.7 billion and issued last year.  Its terms call for holders to lose 75% of their capital, and have the remainder returned to them, if Rabobank’s equity ratio falls below 7%. (By the way, Rabobank has just over $50 billion in equity, which makes up about 14% of capital).  Because the newly issued bond’s vaporization clause is triggered prior to the 2010 bond’s, it gives some protection to the latter.  That should mean an uptick in price for the 2010 issue.  The question I have is that this seems so arbitrary. Could investors in 2010 have known in advance that they would receive this extra protection?  Probably not.

On second thought, if they had an optimistic enough disposition a year ago, maybe they could.  Rabobank seems dedicated to continue to issue its coca bonds.  One would assume that the cooperative will try to make the vaporization line as high as possible.  This desire will likely be tempered by the thought that, since its retail customers may be large holders of the cocas, the line should be set at a level where there’s only the remotest possibility that the vaporization clause will be triggered.  Last year that number was 7%.  This year it’s 8%.  My guess is that as/when confidence continues to build in Europe, Rabobank will push the vaporization threshold higher.

Maybe the Rabobank cocas will become a bellwether for retail investor sentiment in the EU.  But it seems to me their success will be very little indication of prospects for other banks’ issuing cocos–particularly to institutional investors.

bondholders’ responsibility for banks: contingent convertibles and Anglo Irish Bank

Europe seems to want to change the culture of their banks and bondholders from one of “gentlemen’s understandings” that governments and equity holders will suffer all the pain in the case of bank failure to one where legal and covenant obligations will be enforced–meaning bondholders, too, will participate financially in bank restructuring.

One vehicle being pushed in the contingent convertible, an instrument that I’ve regarded as a top-of-the-market gimmick that looks good on paper but has the potential to end in tragedy.  European governments appear to be pushing it as a concept, however, because COCOs spell out explicitly what the bondholders’ obligations are in case the issuer has difficulties.  There’s no room for negotiation, no ability for a politically connected holder to put pressure on the bank regulator to take a soft stance on a certain tranche of bonds.

Europe appears to me to be taking this new attitude a giant step farther in the case of debentures of the failed Anglo Irish Bank, a property-oriented institution that proved to be a monument to opacity in lending.

The Irish government is offering to issue new, Dublin-guaranteed, bonds to holders of about €3 billion of various tranches of AIB debentures.  The rate of exchange would be: 1€ of the new issue for every 5€ of the old debt.  Holders of the affected AIB bonds, many of whom will, I think, prove to be hedge funds that bought in the secondary market after AIB failed, have squawked.  Their expectation apparently was to receive new bonds at something more favorable than a 4/1 rate.

Voting on the Dublin/AIB proposal will take place in December.

None of this is too surprising.  The rest of the government’s plan is, however.

According to the Financial Times, Dublin also wants accepting bondholders to agree to change the bonds’ covenants to provide that any holders who do not accept the offer will be forcibly redeemed at .001% of par–basically nothing.

Again, according to the FT, a result in favor of the exchange at the initial meeting requires that holders of two-thirds of the bonds vote and the 75% or more of the votes say yes.  If less than the required two-thirds attend the initial meeting, a second can be called at a lower quorum level.

Bloomberg says that investment bank Houlihan Lokey, representing a large enough proportion of the affected bondholders to defeat the proposal, intends to vote no.  The Irish legislature has also chimed in, suggesting it will pass a law allowing the exchange to occur without regard to the vote results, should bondholders reject the offer.  Houlihan Lokey apparently wants to negotiate with AIB, but the bank has refused.

This should be interesting.  Stay tuned.