Commentaries

from Rolfe Winkler:

Bond Bears: Beware of “crypto QE”

The guys at Variant Perception make a great point. Some reform plans for the banking sector (so-called "narrow banking" being the most extreme) would have banks invest more deposits in government paper in order to keep them safe. To the degree such plans get traction, that could keep a lid on yields despite rising government spending.

The following chart shows how the US 10yr yield has disconnected from the price of commodities. We believe yields are not reflecting the future risk of inflation, and the fiscal situation of many sovereign issuers. However, there are no limits to what governments may do to support their debt. In the UK, a recent ruling was announced by the FSA forcing banks to increase their holdings of government bonds. In India a similar initiative has just been announced. In Japan, already over 50% of outstanding JGBs are owned by public sector institutions. In the US, only 0.9% of commercial banks’ assets are treasuries; in 1994 it was as high as 8.7%, so there’s great scope for it to increase. Mandated purchases of government bonds by banks and other financial institutions – crypto-quantitative easing – could persist long after official QE comes to an end, keeping bond markets supported for longer than many think.

Nevertheless, we think longer-term yields will move higher. Sell rallies.

Commercial property borrowers falling short

Commercial real estate loan delinquencies are on the rise again, and September’s increase is the largest ever, according to Moody’s Investors Service’s latest tally of those loans included in CMBS deals.

Delinquencies stand at 3.64%, up from 0.54% a year ago and 0.41 percentage points higher than August. The hotel sector showed the biggest increase in late payments, up 0.79 ppt to 4.97%. The multi-family housing sector now stands at 6.09% – the highest of any property type.

In terms of region, the South has been the hardest hit followed by the Midwest.

Automatic debt-to-equity swap?

That’s what Fed Governor Daniel Tarullo seems to be advocating in his speech, which you can find here.

Here’s the graph, emphasis mine:

We must also adopt new regulatory mechanisms to counteract the systemic and too-big-to-fail problems that became so embedded in our financial system. One possible approach is a special charge–possibly a special capital requirement–that would be calibrated to the systemic importance of a firm. Needless to say, developing a metric for such a requirement is a new, and not altogether straightforward, exercise. Another proposal, which strikes me as having particular promise, is that large financial institutions be required to have specified forms of “contingent capital.” One form of this proposal would have firms regularly issue special debt instruments that would convert to equity during times of financial stress. If well devised, such instruments would not only provide an increased capital buffer at the moment when it is most needed. They would also inject an additional element of market discipline into large financial firms, since the price of those instruments would reflect market perceptions of the stability of the firm.

Yeah, who cares about the bondholder as long as the bank is OK. These are likely to be a tough sell and the banks most likely would have to pay, as they should, a hefty premium to get investors to agree to such a provision.

The EC bank smackdown

Dexia and ING’s recent decisions to call some of their subordinated debt has puzzled market observers, as they seem to fly in the face of the European Commission and its crusade on burden-sharing for banks that have received state aid.

The Commission wants junior creditors of bailed-out banks to share some of the pain along with the public sector, and wants to make sure public funds aren’t used to repay equity or junior debt if a bank can’t. Holders of some of RBS’ subordinated debt recently found this out to their horror when the bank chose not to call the bonds at the first opportunity. The Dexia and ING bondholders, by contrast, will have had a nice pay day. The Dexia upper tier 2 bond was trading below par in the mid 70s area, according to CreditSights.

It looks like the EC wasn’t too pleased with Dexia and ING’s generosity, as last night it issued a stiff press release reminding banks of its rules. That’s not good news for any bondholders who had been hoping that the Dexia and ING calls may have signalled a thawing in the EC’s stance.

Here’s the EC statement:

State aid: Commission recalls rules concerning Tier 1 and Tier 2 capital transactions for banks subject to a restructuring aid investigation

Following questions from market operators regarding the possibility  for banks which are the subject of pending European Commission investigations regarding the grant of restructuring aid to repay bonds before maturity, the Commission would like to recall that its Communication on restructuring aid to financial institutions of July 2009 (see IP/09/1180 and MEMO/09/350) sets out that “banks should not use state aid to remunerate own funds (equity and subordinated debt) when their activities do not generate sufficient profits”. In a restructuring context, measures which reduce the total amount of own funds (payments on hybrid instruments, avoidance of loss absorption, buy-backs, exercise of call options) are in principle not compatible with the objective of “burden sharing” (i.e. banks must pay a significant share of the costs of restructuring) and the “minimum necessary” requirement (i.e. the amount of state aid must not exceed the minimum necessary to allow the bank to restructure). For that reason, banks subject to a state aid investigation should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions.

Transactions such as coupon payments, buy-backs and the exercise of call-options of Tier 1 and Tier 2 capital instruments reduce the total regulatory capital of a financial institution and put into question whether granted state resources were limited to the minimum necessary. Moreover, such measures may infringe the principle of burden sharing in so far as they protect the Tier 1 and Tier 2 capital holders from their exposure to the inherent risk of the investment.

Such transactions by financial institutions subject to restructuring obligations may therefore have implications for the compatibility of the aid received. On the other hand, the Commission may accept these transactions on the basis of a case by case assessment, after balancing the above mentioned principles of burden sharing and limiting aid to the minimum against the contribution of the transaction to the refinancing capability and return to viability of the institution. For that reason, banks subject to a state aid investigation should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions.

So much for that de-leveraging

You would think it would take a little longer for hedge funds and other investors addicted to using borrowed funds to juice returns before they started loading up on high-yielding junk. But with short-term borrowing costs so low, I suppose it was just too hard to resist yields found in the depths of high-yield bond market.

CCC-rated bonds, the darlings of the current rally in corporate debt, have broken though another milestone , according to Martin Fridson of Fridson Investment Advisors. Its spread over Treasurys as measured by Merrill Lynch, fell to 12.18 percentage points this week, below it’s historical average. Meanwhile, higher-rated junk spreads are still much higher than their averages.

Fridson notes that leveraged investors have been fueling demand for the junk bond market’s junkiest debt.

Not all of them, but some, have a simple strategy:  Maximize the differential between the interest rate on borrowed money and the yield on assets in the portfolio.   If the investment strategy does not take into account the adequacy of the yield on those assets, relative to their credit risk, who is to say what constitutes an excessively tight spread?  As long as the yield exceeds the cost of funds, the trade is a money-maker…until the defaults begin.  To get the maximum “benefit” from this strategy, leveraged investors gravitate to the highest-yielding segment, the Triple-Cs.

Just as long as they don’t need to get bailed out…

Citi back for more, but sans FDIC help

It looks like Citi is on a mission to prove it doesn’t need any stinking help from the federal government. Earlier this week it tapped the bond market for $5 billion, but the notes carried the FDIC guarantee. As the FT noted in its piece yesterday, the move seemed at odds with the bank’s supposed attempts to get out from under the government’s thumb.

So today, the bank is back with five-year note offering that comes without the FDIC backstop. But it’s going to have pay for that. IFR price guidance puts the risk premium at 3.25 percentage points over Treasurys. Just for a little perspective, JP Morgan has bond maturing January 2015 trading at 1.38 percentage point over Treasurys, according to MarketAxess.

Good hybrid crack

It’s interesting to see the Irish government seems to have been keeping a close eye on the hybrid debt fiasco, as it is now embracing the securities as a way to ensure the country’s banks don’t get an easy ride offloading dud property loans to NAMA, its bad bank scheme. I guess you could call it a form of payback.

Hybrid debt has played its own special role in creating the current mess. Banks used hybrid debt to bolster their capital ratios even though the securities weren’t always very good at absorbing losses.

Investors kidded themselves that these risky capital securities were fixed income instruments that would always be supported by governments if a bank got into trouble, and so priced them as a form of debt.

But, now that banks have had to be bailed out, the European Commission is keen for hybrid investors to pay their pound of flesh by getting banks to defer coupons, not repay bonds at their expected maturity, or worse. CreditSights expects the EC to compel some Irish banks to stop paying discretionary coupons on their hybrid debt as part of the state-aid approval process.

The end result; nobody wins. Investors are sitting on losses, and regulators now want banks to be less reliant on hybrid debt.

Ireland, however, seems to have found a use for this kind of subordinated debt in its NAMA scheme. Ireland’s latest draft bill on NAMA suggests the agency pay banks for dodgy loans by issuing both senior and subordinated debt. If the loans perform worse than expected, the banks will bear the pain through the sub debt.    CreditSights notes:

 It is not absolutely clear how this will work, but the implication is that, in the event of a loss, the subordinated debt would not be fully repaid when NAMA is eventually wound up, while the terms of the bonds might allow NAMA to suspend interest payments as well.

A Confucian conundrum for China

The Chinese own more United States Treasury bills than can be counted in a lifetime, and as the dollar printing press roars on, the rulers of the People’s Republic are getting nervous. They would like to see another reserve currency, and quite like the idea of it being the renminbi. After all, the euro and the yen are really too small to fulfill the role, while sterling is just small change.

So China has this week decided to issue its first sovereign bonds denominated in its own currency which foreigners can buy, at least in small amounts. After all, if the world is to hold renminbi reserves, it needs a proper market in its central bank IOUs.

So far, so logical. But there’s something odd here. Buyers of the bonds must first acquire the right currency, which in practice means selling dollars to buy the renminbi. The ultimate buyers of those dollars will be the Chinese, who will then buy yet more US T-bills, making the pile even higher.

International investors will welcome a few Chinese government bonds in a diversified portfolio, but while the vast trade imbalance between China and the US persists, issuing them will do nothing to ease the upward pressure on the renminbi, or to reduce that bill mountain.

Anyone for cov-lite?

In our post-credit crunch era of avowed simplicity and rigorous credit analysis, you’d have thought that bond investors would be demanding tougher terms than ever to finance high yield companies.

Not at all, according to recent research by Moody’s on the growing European high yield bond market, where deal structures are looking rather toppy. 

Moody’s highlights recent high yield deals by issuers such as Virgin Media and Wind, noting that the deals’ structures and documentation have in common some featuers seen in top of the market covenant packages from 2006.

For example, recent documentation allows companies in some cases to add back to cashflow items such as expected cost savings from restructurings. That could enable them to take on greater amounts of debt in their leverage tests, Moody’s says. The rating firm also notes that fallen angels who have been junked have continued to issue with investment grade-style debt covenants.

Moody’s notes:

“One might think that, in the aftermath of a severe market disruption, covenant structures would tighten, but this is not the case, either for the bonds of fallen angels or those of long-time high-yield issuers.”

The strength of the European bond market in recent months has been one of the few causes for optimism in the European capital markets. Much of the demand has been driven by a hunt for yield given the poverty of current deposit rates. It looks like investors may be getting sloppy again.

The European Commission strikes back

Reeling from the humiliation of failing to stop Belgian bank KBC paying interest on some of its subordinated bonds, the European Commission has won a new victory in its bid to see bondholders share the pain of bank bailouts.

Acting as a sort-of policeman for Brussels, the UK’s Financial Services Authority has prevented the Royal Bank of Scotland from repaying four subordinated bonds at their first opportunity, causing prices to plunge by up to 15 percent. The Upper Tier 2 euro-denominated bonds fell to between 70 and 75 cents, depending on who you ask.

Behind all this lies the long arm of the European Commission, which recently launched a crusade to see banks’ subordinated bondholders share the pain of public-sector bailouts.

Brussels is very uncomfortable about the idea that banks that have accepted state funding should then use some of that money to pay discretionary dividends on, or redeem at par, bonds they have issued that are trading at a discount to face.

While it works out what to do with the banks, it doesn’t want to see them pay dividends or call bonds. In the case of the RBS, the FSA seems to be acting as its enforcer.

Coming up with a simple approach is far from easy. It’s a tricky negotiation process between the banks and the EC, made harder by the sometimes fiendishly complex nature of the debt in question, in which bondholders’ rights vary enormously depending on the instrument.

This week KBC managed to side-step the Commission, saying it would pay interest on some bonds after lawyers were able to convince Brussels that they were mandatory, not deferrable.