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French government should push for further tax and labour market reforms

France has a unique social model. It originates from the end of the Second World War, when the National Council of the Resistance (NCR) hastily put together a plan to rebuild the country after five years of Nazi occupation. Despite not having any official political affiliations, the NCR was in fact influenced by left wing individuals and the “National Front”, a communist party. The NCR’s “action plan” helped shape France in the aftermath of the war and is one of the reasons today that trade unions have such a prominent position in society and why the French are so fond of their “established social rights”.

Since then, reforming France has always been a difficult task. Given that it was announced last week that the country has experienced a second consecutive quarter of no growth, it seems obvious that some sort of change is urgently required. France has grown by only 0.1% in the past year. Despite extremely low interest rates and fiscal tightening, the government’s budget remains in structural deficit and the debt to GDP ratio has increased from 77% to 93%. More worryingly, despite French President Hollande’s very vocal claim that he would “invert the unemployment curve” by the end of 2013, the number of job seekers continues to rise at an alarming rate, hampering consumer confidence and business spending.

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So what can the Hollande government do in a country that is difficult to reform and where scope for public spending is limited?

First of all he should aim to simplify France’s highly complex tax regime, which over the years has become almost illegible. This toing-and-froing over taxes continues to hurt the French economy by creating uncertainty and hampering business investment. In the last 2 years alone, French legislators have created 84 new taxes, for a total of €60 billion Euros.

Second, the government must reduce the burden of social security contributions on the business sector. Today, France spends 17% of its GDP in social contribution taxes, the highest amount out of all of the 28 EU countries. While many people in the country believe that this is the price to pay to finance France’s generous welfare system, its financing relies too heavily on businesses.  In the rest of Europe the burden of social security payments is shared on average equally between employers and employees. In France, almost 70% of these payments are paid by employers. This has a direct effect on the cost of labour and diminishes companies’ abilities to compete in an increasingly globalised world. The French government has started to address this issue by granting a €20 billion tax credit (CICE) to all French businesses, but much more needs to be accomplished. Indeed, in order to put France on equal footing with its neighbour Germany, employer social security contributions would need to be reduced by a further €80 billion per year.

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Finally, the government should also tackle the excessive bureaucracy in the labour market. For example, many small firms today refuse to grow beyond the threshold of 50 employees because exceeding this number triggers a raft of regulatory and legal obligations. It would make sense to push this threshold to 250 employees, and bring France in line with the European norm. The French Labour Code is 3500 pages long and weighs 1.5 kilo, while the Swiss Code, where unemployment is 3% rate, is 130 pages and weighs 150 grams (anecdotally comparing unemployment rates with the number of pages of labour codes for different countries could be the subject of a future blog).  This excessive bureaucracy is partially the reason why France’s competitiveness has been declining in recent years. In its latest Global Competitiveness report, the World Economic Forum ranked France 23rd overall, but 21st in 2013 and 18th in 2012. More alarmingly, the country is ranked 116th for “labour market efficiency” (out of a total of 148 countries), 135th for “cooperation in Labour-employer relations” and 144th in “hiring and firing practices”. When asked what the most problematic factor for doing business in the country, the number 1 answer provided by respondents was “restrictive labour regulations”.

As France teeters on the brink of recession, Hollande is today in a very difficult position. A complete overhaul of the French social model would create much civil unrest and probably push the country into recession. On the other hand, doing nothing is likely to have the same effect as France would continue to lose competitiveness on a global scale. In a recent study published by “Le Monde”, 60% of respondents said they were “satisfied” with the French social model, but 64% also declared that the model should be at least partially reformed. The French government should use this as a sign that it can make some adjustments to the French tax system and labour markets, without jeopardising its chance of being re-elected in two years. With its popularity at an all-time low and unemployment at an all-time high, there is no more time to waste.

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Sprouting out: green bonds come of age

Green bonds are instruments in which proceeds are exclusively applied towards new and existing green projects – defined as activities that promote climate or other environmental sustainability purposes. They enable capital raising and investment in projects with environmental benefits. The International Capital Market Association (ICMA) set out some guidelines for issuing of green bonds in January 2014.

Originally dominated by supranational issuers (for example, European Investment Bank, World Bank and the European Bank for Construction and Redevelopment), financials and corporate issuers are increasingly tapping into this new source of funding.

Green corporate bonds, being a nascent asset class, are a place for many firsts. In October 2012, industrial gases company Air Liquide claimed they were the ‘first private company to issue bonds meeting the SRI investors’ criteria’. This bond predated the Green Bond Principles, and technically may not be a green bond, but is noteworthy in having been ‘mostly placed with Socially Responsible Investor (SRI) mandated issuers’. Since then, we’ve had French utility EDF in November 2013 announce ‘the issuance of the first corporate Green Bond’, although that title may just (by a couple of days) go to the Swedish property company Vasakronan. More recently we’ve had consumer goods company Unilever announce in March 2014 ‘Unilever’s green sustainability bond is the first green bond in the sterling market, and the first by a company in the FMCG sector’.

It is apparent that corporate issuers are keen to spur the development of the green bond market as an alternative funding source and, in doing so, raise awareness of the environmental issues they face. Looking at the chart below shows that corporates are now the single largest source of green bond issuance. Whilst it’s clear that issuers and investors both earn brownie (greenie?) points in terms of enhanced reputation for their involvement and support of sustainable projects, green bonds lack a binding internationally recognised definition, they merely adhere to a voluntary set of guidelines.

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One of the structural features of green bonds is that they are often issued off existing Euro Medium Term Note (EMTN) programs and guaranteed by the parent company. Cash flows that service bonds come from the issuer, therefore benefiting from the overall cash flows of the corporate, not just the project that is being funded. It is not surprising, therefore, that the credit rating of these bonds is in line with other bonds issued by the same issuer. This dislocation does, however, mean that investors are not able to identify the cash flows from the underlying project.

Corporate bonds issuers often bracket their use of proceeds into ‘general corporate purposes’, which rarely tells investors much about how or where the proceeds are to be used. Is it, for example, for refinancing, M&A, capital expenditure or share buybacks? In contrast, one of the cornerstones of a green bond is that the use of proceeds is defined in the legal documentation of the security, which should bring a degree of transparency. I say degree because, in practice, once the proceeds are deployed the investor may have limited information on the progress of the project and the extent to which it is meeting environmental targets. For instance, are bond proceeds for the specified project leading to an identifiable reduction in greenhouse gases, water and waste?

There is a certain asymmetry in green credentials required between issuers and investors. For an entity to issue a green bond they have to abide by the principles as outlined by the ICMA. Alongside use of proceeds, these also include project evaluation and selection, reporting, as well as management of proceeds. The latter includes a suggestion to enhance the environmental integrity of the instrument through the use of an external auditor, an independent verifier or as some have called it, a Socially Responsible Investment (SRI) rating agency. Yet with so much stringency on the issuer side, there seems to be no limitation on which bonds funds are able to participate in owning such an issue. Whilst issuers are often citing a desire to diversify their funding sources and attract SRI and Environmental Social and Governance (ESG) conscious investors seeking sustainable (both from a cash flow and environmental perspective) fixed-income instruments, the investors themselves do not necessarily need to have such a green bill of health.

Indeed, even a bond issued in a ‘green wrapper’ may not satisfy certain SRI funds which may argue, rightly or wrongly, for example, that EDF is using cash flows generated through nuclear power activities to pay coupons on its green bond. Another angle on this would be to say that environmental projects are receiving credit enhancement through use of corporate cash flows to prop-up investment in green initiatives. Regardless, the burden remains with the investor to determine how green the bond is. The rating agencies have so far not waded into the argument by assigning a relative ranking of ‘greenness’.

Finally, looking at a few examples of corporate green bond issuers in the table below, it appears that the pricing of green bonds on the secondary market is in line with other (‘non-green’) issues, which to us makes sense given the structural and cash flow arguments mentioned.

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ben_lord_100

Not all change is bad: coming reforms to credit default swaps

There is a lot of analysis and conjecture about how much impact the financial crisis has had on the global economy and financial markets. There has been considerably less analysis around the impact of the crisis on bond fund managers. In a small attempt to quantify these impacts, we have dug out a few old photos of members of the M&G bond team pre and post-crisis. The photos show clearly where change has been bad.

2008-08 ben

There is, though, good change. In September there are changes taking place to bank CDS contracts that represent clearly positive progression.

The CDS rules and definitions of 2003 state that there are 3 different credit events that will trigger corporate and financial CDS contracts: 1. failure to pay 2. bankruptcy, and 3. restructuring (this means that a company can’t modify the conditions of debt obligations detrimentally as far as investors are concerned). If any of these are determined to have occurred, then buyers of protection receive par from sellers of protection (and sellers of protection pay out par minus the recovery value of the defaulted bonds, so are in the same situation as if they owned the defaulted bond). In the event of one of these events being triggered, buyers of protection are ‘insured’ against the losses incurred on the bonds.
However, whilst the above works well in most cases of corporate defaults, we have seen several examples in the last few years in terms of banks in which the outcomes have left buyers of protection in effectively defaulted bonds none the better off. For purposes of succinctness and relevance, I would like to mention two of the more recent such cases so as to bring out the flaws of the existing financial CDS contracts, and to highlight the improvements we will soon see.

In early 2013, the Dutch government expropriated the subordinated debt of SNS Bank, which had got into serious difficulties. Bondholders would therefore no longer receive coupons or principal, and so the determinations committee ruled, quite simply, that a restructuring event had occurred. However, the buyers of protection had to deliver defaulted bonds to the sellers, and there being no subordinated bonds left, had to deliver senior bonds, whose value was around 85p in the pound. This meant that they ‘owned’ bonds worth zero, and were being paid out 15p as a result of the protection they had bought!

The most recent example of subordinated CDS not working is still on-going, being the case of Banco Espirito Santo. This bank has seen all the good assets, deposits and senior debt transferred to a new, good, bank, and all the bad assets, subordinated debt and equity stay with the old, bad, bank. So subordinated debt will very likely get a very low recovery (the sub bonds are today trading at around 15 cents). Subordinated bank debt is now, in practical terms, able to take losses and be written down in European banks. Senior bank debt will also become write-down-able at the start of 2016, but as yet legislators and regulators are showing the continued desire to make senior good. In BES’ case, though, with all the deposits and senior debt moving to the good bank (and with a very thin layer of subordinated debt), more than 75% of the liabilities will go to the new entity. In CDS terms, this means that the contracts move to the new entity. So, again, buyers of subordinated protection in BES are left with significant losses on their bonds, but will have to deliver senior bonds which are trading close to and in some cases above par. Not the outcome that the owners of protection wanted or expected. And, frankly, not the right outcome.

So the existing rules around financial CDS are unfit for purpose. Starting in September, new rules will come into place that will vastly improve the economics of these contracts, and in simple terms will make them behave far more like senior and subordinated bonds, which after all is what they are meant to do. The major differences can be summarised into two: a new, fourth, credit event trigger called Government Intervention will be added; and the removal of the cross default provision. The Government Intervention trigger will mean that in instances such as SNS, when governmental authorities impair debt, CDS contracts will be triggered, and in the same case, owners of subordinated protection would have delivered a claim on the Dutch government that was worth zero, through the expropriation, and would have received par from sellers of protection. In terms of the second major reform to financial CDS contracts, current contracts mean that a credit event on subordinated CDS also results in a credit event on senior. This clause will be removed, meaning that in the Banco Espirito Santo on-going case, subordinated CDS contracts would travel with the subordinated bonds, and senior with senior. Unlike the changing faces of the Bond Vigilantes, the changes soon coming in CDS are ones we think are positive.

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The yield-dampeners: will interest rates inevitably rise when QE ends?

After the ‘taper tantrum’ of 2013, many commentators predict that the catalyst for a sell-off in fixed income assets could be the ending of quantitative easing by the US Federal Reserve later this year. In the latest issue of our Panoramic Outlook series, I present an alternative view to this consensus thinking, analysing a number of dynamics in bond markets that have surprised investors during this period of extraordinary monetary policy. My emphasis is on what I view as three key ‘yield-dampeners’ at work that investors should be aware of:

  • The fragility of the global economic recovery and high debt levels in the US economy make it unlikely that interest rates will return to pre-crisis levels, limiting the potential downside to bonds.
  • There are some powerful structural deflationary forces which are helping to keep inflation low.
  • A strong technical factor – the global savings glut – is likely to remain supportive to fixed income assets as is firm demand from large institutional pension funds and central banks.

Given these influences, it’s very much possible that those looking for yields to rise back to pre-crisis levels when QE ends may be disappointed. Not only are these yield-dampening forces at play in the US Treasury market, but they could also easily be applied to the UK or European government bond markets, potentially providing a useful lesson for the future path of yields. This will impact the attractiveness of other fixed income assets such as investment grade and high yield corporate bonds. Arguably, ultra-low cash rates and a stable interest rate environment for government bonds would provide a solid base for corporate bond markets as investors continue to seek positive real returns on their investments. The full analysis is located here.

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What is the collapse in the Baltic Dry shipping index telling us about global growth?

The Baltic Dry Index (BDI) is a daily priced indicator of the cost of shipping freight on various trade routes for dry bulk carriers, based on data submitted by shipbrokers to the Baltic Exchange in London. Since March this year the index has fallen by over 50%, and this has made economists worry that the fall reflects a generalized slowdown in global trade – dry bulk goods include cement, coal, ore as well as food stuffs like grain. A lot of it is the stuff that China imports to support its investment led growth model, so a collapse in demand for the ships that carry bulk dry goods to China might be telling us that China is slowing rapidly. And that obviously has significant impacts on those economies which are reliant on exporting to China for their own growth – for instance Australia, Chile, South Africa and South Korea all have between 21% and 36% of their exports going to China.

Obviously though demand for space on ships is only half of the equation. As expectations grew that the Great Financial Crisis was behind us, and as China kept publishing high single digit growth rates, there was a significant expansion in shipbuilding. Since 2010 annual growth in Dry Bulk supply has been anywhere from 5% to over 15% year on year – in most periods outstripping demand growth, and certainly depressing prices. It’s not just dry bulk, there’s also big excess supply in container ships. Shipping companies are trying to manage these supply problems – the average age of ships when scrapped has fallen from 28 years in 2011 to 21 years in Q1 2014, 4% of the fleet is “idle”, ships are “slow steaming” (going slowly to save fuel and costs of being idle at port) and shipping companies are cancelling future orders for new ships (in 2013 32% of orders were not delivered as planned and were either postponed or cancelled). But for 2014 and 2015 at least the excess supply problem gets worse, not better.

So is the Baltic Dry Index telling us anything about global trade and growth? We started off from a position of scepticism – there used to be a good relationship (we wrote about it here in 2011), but since the massive shipping supply boom maybe it had lost its power as in indicator? But it turns out that the correlation between world trade and the BDI is EXTREMELY good. The CPB Netherlands Bureau for Economic Policy Analysis produces the monthly CPB World Trade Monitor. It’s clear from these global trade data that the volume of trade has been weakening since the end months of 2013. Trade actually fell in May, by 0.6% month on month, although due to volatility and seasonals, a rolling 3 month versus previous 3 month measure is preferred. The chart below shows that after some strong momentum in global trade in 2010 it’s fallen to a much more stagnant growth level in the past couple of years, and a brief recovery in mid 2013 has tailed away. In Q1 this year, world trade momentum turned negative. We have shown the Baltic Dry Index against this measure of world trade – it doesn’t just look like a strong relationship optically, but it has a correlation coefficient of 0.74 (strong) with a t value of 7.83 (statistically significant at an extremely high level).

Baltic Dry vs World Trade - Chart - v01 - CHART 1

When we last wrote about the Baltic Dry Index we pointed out that it appeared to be a good lead indicator for 10 year US Treasury yields, the theory being that a fall in the BDI presaged falling GDP and therefore justified lower rates. And indeed the fall in the BDI in early 2011 did nicely predict the big Treasury rally 3 months later. There is still a relationship today, but sadly for us bond fund managers the better relationship is with UST yields predicting movements in the BDI (so ship-owners please feel free to make money on the back of this). Nevertheless, over the same time period as the earlier chart there is still a decent correlation if you use the BDI as a leading indicator and push it forward by 3 months, so it does appear to have some predictive powers.

Baltic Dry as Leading Indicator for 10Y Treasury Yield - Chart - v01 - CHART 2

So we’ll keep looking at the Baltic Dry Index for the same reason that we like the Billion Prices Project for inflation. When you can find a daily priced, publically available measure or statistic that comes out a month or more ahead of official data and is a strong proxy for that data it’s very valuable.

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Falling soft commodity prices are a piece of cake

Higher agricultural commodity prices at the start of the year raised concerns about the impact these could have on retail food prices, should the trend prove persistent. Fortunately, the price of soft commodities (coffee, sugar, wheat etc) appears to have decoupled from that of hard commodities (gold, silver, platinum etc) in recent months. Indeed, data from the last seven quarters indicate that the price of many agricultural commodities have actually fallen, as the chart below shows.

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Coffee prices are now at a five month low, after fears of a shortage of coffee beans from Brazil have receded. The supply of sugar has increased year-on-year, while wheat prices have also fallen due to increased harvests and easing crop concerns.

In order to gauge the collective effect of these changing agricultural commodity prices and how they could potentially feed through into UK inflation, I have constructed a simple cake index, teaming up Global Commodity Price data with some basic recipes from the BBC Good Food website. Given that sponge and individual cakes are two of the representative items included in the CPI 2014 basket of goods – and that food and drink items make up 11.2% of the overall CPI index – combining the commodities in this way gives an indication of how future changes might affect the average consumer.

The graph below shows the results of the cake index, demonstrating the change in various cake costs (since October 2012) versus the UK CPI (yoy %). What’s interesting is the generally downward trend of all cake indices in the last seven quarters. Sponge cake and plain scones look particularly good value in recent months, owing to the high proportion of wheat in their recipes. Apple cake unsurprisingly provides a price signal for its key ingredient (the price of apples has fallen 4% YTD), while coffee cake gives a less pronounced but similar effect. The good news – particularly for lovers of chocolate cake – is that despite the persistent increase in the cost of cocoa, the price of other cake constituents such as sugar, wheat and palm oil (used as a proxy for butter) have all fallen sufficiently to offset this, bringing the price of chocolate cake lower in recent months.

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Despite the recent June increase in CPI to 1.9% yoy, due to the lag between raw commodity prices and their general price level, we should perhaps expect to see deflation feeding into cake prices and the overall food constituent of CPI in the coming months. Therefore although it is unclear who exactly was the first to declare “let them eat cake!”, this person may have been on to something. Personally, I’d recommend the (relatively cheap) scones.

Wolfgang Bauer

How to find relative value in EUR and USD investment grade credit using CDS

There is more than one way to skin a cat for credit investors. Those looking for credit exposure can do so through either owning the debt issued by an issuer or by selling credit default swap (CDS) protection for the same issuer. The differential in price between the corporate bond and CDS contract can mean the difference between outperforming and underperforming in a world of tight credit spreads and low yields. Additionally, it is possible to do this for the whole investment grade or high yield market, allowing bond investors to gain credit exposure in their preferred geographical region (for example, the U.S., Europe, or Asia). U.S. and European credit spreads have compressed substantially and are now at levels last seen before the Lehman Brothers collapse. Given this convergence, the question for global IG bond investors today is which market is relatively more attractive from a valuation perspective?

Let’s first take a look at EUR versus USD credit. The easiest way to do this is by using two credit default swap indices. These indices (also known as CDI) represent 125 of the most liquid five-year credit default swaps on investment grade (IG) entities in Europe (iTRAXX EUR 5Y) and North America (CDX IG 5Y). Looking at the historical performance of both indices, the differential between both index levels remained basically flat until the onset of the financial crisis in the second half of 2007. During this period, iTRAXX EUR traded around 10-15 basis points (bps) tighter than the CDX IG. During the crisis, the absolute levels of both indices increased substantially but iTRAXX EUR outperformed CDX IG, with the North American index moving up to a peak level of around 230bps in late 2008. In the following three years, with the easing of the U.S. recession and the emergence of the Eurozone crisis, CDX IG outperformed iTRAXX EUR by around 120 bps.

Starting from its minimum of -64 bps in November 2008, the index differential turned positive in May 2010 and reached its peak value of 57 bps in November 2011. With the Eurozone crisis calming down, iTRAXX EUR has once again outperformed CDX IG. Today the index differential has virtually disappeared (4 bps), and both indices have tightened to around 65bps by the end of May, a level not seen since the end of 2007. iTRAXX EUR continued to tighten in June and temporarily traded through CDX IG for the first time since March 2010.

CDS indices: EUR vs. USD IG credit

Selling CDS protection for a company creates a credit risk exposure that is essentially equivalent to buying a comparable bond of the same issuer. Hence, from a fixed income investor’s point of view, it is worth comparing the CDS spread and the credit spread of the cash bond. The difference between these two is often referred to as the CDS basis. Positive values (i.e., CDS spread > bond Z-spread) indicate a higher compensation for taking the same credit risk through the CDS of a company rather than owning the bond of a company, and vice versa for a negative basis.

Drawing a direct like-for-like comparison between CDS and corporate bond indices can be tricky. For example, it is impossible to find appropriate outstanding cash bonds for all the companies that are in the CDS indices. Furthermore, CDS indices comprise contracts with a certain maturity (e.g., five years) and roll every six months, whereas cash bonds approach a predefined maturity and are eventually redeemed, assuming they don’t default or are perpetual instruments.

We approached the problem by constructing our own equally-weighted non-financial CDS and cash bond indices, both for U.S. and Eurozone issuers. In terms of EUR issuers, we started from the current iTRAXX EUR roll, ranked the constituent entities by total debt outstanding and selected the top 20 Eurozone non-financial issuers with comparable outstanding bonds (c. five years until maturity, senior unsecured, vanilla, reasonable level of liquidity, etc.) for our CDS and bond indices. We then compared the year-to-date evolution of weekly CDS and cash bond spreads as well as the CDS basis, averaged over the 20 index members. For our USD indices we applied the same strategy, selecting a subset of 20 US non-financial issuers from the current CDX IG roll.

The chart below shows CDS spreads, bond Z-spreads and CDS bases both for our EUR and USD indices. Throughout the year, all four non-financial IG index spreads have been grinding tighter. The CDS basis for USD non-financial IG credit has been consistently negative (-19 bps on average). In absolute terms the negative USD basis has receded, moving from between -30 and -20 bps in January to -11 bps in the first week of July. In contrast, except for the first week of January which might be distorted by low trading volumes, the EUR non-financial IG CDS basis has been positive (+12 bps on average) and amounts to +11 bps for the first week of July.

CDS basis: EUR vs. USD non-financial IG credit

Several reasons have been put forward to explain the contrast between EUR and USD CDS basis values, including supply/demand imbalances within European cash bond markets adding a scarcity premium to bond prices and thus suppressing bond spreads. It has also been argued that in Europe CDS contracts were predominantly used for hedging purposes (i.e., to reduce credit exposure by buying the CDS contract) driving up CDS spreads, whereas the use of USD CDS contracts was more balanced between increasing and decreasing credit risk exposure.

In the current market environment characterised by low yields and tight credit spreads, CDS basis values do matter. The choice between a cash bond or a credit derivative is another lever fixed income investors can use to exploit relative value opportunities. By carefully selecting the financial instrument, cash bond vs. CDS contract, a spread pickup of tens of basis points can be realised for taking equivalent credit risk. A positive basis indicates that the CDS looks cheap relative to the cash bond, and vice versa for a negative basis. For instance, at the moment it often makes a lot of sense for us to get exposure to EUR IG credit risk through CDS contracts rather than through cash bonds, when we see attractive positive CDS basis values.

jim_leaviss_100

Bondfire of the Maturities: how to improve credit market liquidity

Liquidity in credit markets has been a hot topic in recent months. The Bank of England has warned about low volatility in financial markets leading to excessive reaching for yield, the FT suggested that the US authorities are considering exit fees for bond funds in case of a run on the asset class, and you’ve all seen the charts showing how assets in corporate bond funds have risen sharply just as Wall Street’s appetite for assigning capital to trade bonds has fallen. But why the worry about corporate bond market liquidity rather than that of equity markets? There are a couple of reasons. Firstly the corporate bond markets are incredibly fragmented, with companies issuing in multiple maturities, currencies and structures, unlike the stock markets where there are generally just one or two lines of shares per company. Secondly, stocks are traded on exchanges, and market makers have a commitment to buy and sell shares in all market conditions. No such commitment exists in the credit markets – after the new issue process you might see further offers or bids, but you might not – future liquidity can never be taken for granted.

So how can we make liquidity in corporate bond and credit markets as good as that in equity markets? First of all let’s consider fragmentation. If I type RBS corp <Go> into Bloomberg there are 1011 results. That’s 1011 different RBS bonds still outstanding. It’s 19 pages of individual bonds, in currencies ranging from the Australian dollar to the South African rand. There are floating rate notes, fixed rate bonds with coupons ranging from below 1% to above 10%, maturities from now to infinity (perpetuals), inflation-linked bonds, bonds with callability (embedded options), and there are various seniorities in the capital structure (senior, lower tier 2, upper tier 2, tier 1, prefs). Some of these issues have virtually no bonds left outstanding and others are over a billion dollars in size. Each has a prospectus of hundreds of pages detailing the exact features, protections and risks of the instrument. Pity the poor RBS capital markets interns on 3am photocopying duty. The first way we can improve liquidity in bond markets is to have a bonfire of the bond issues. One corporate issuer, one equity, one bond.

Jim blog

How would this work? Well the only way that you could have a fully fungible, endlessly repeatable bond issue is to make it perpetual. The benchmark liquid bond for each corporate would have no redemption date. If a company wanted to increase its debt burden it would issue more of the same bond, and if it wanted to retire debt it would do exactly the same as it might do with its equity capital base – make an announcement to the market that it is doing a buyback and acquire and cancel those bonds that it purchases in the open market.

What about the coupon? Well you could decide that all bonds would have, say, a 5% coupon, although that would lead to long periods where bonds are priced significantly away from par (100) if the prevailing yields were in a high or low interest rate environment. But you see the problems that this causes in the bond futures market where there is a sporadic need to change the notional coupon on the future to reflect the changing rate environment. So, for this reason – and for a purpose I’ll come on to in a while – all of these new perpetual bonds will pay a floating rate of interest. They’ll be perpetual Floating Rate Notes (FRNs). And unlike the current FRN market where each bond pays, say Libor or Euribor plus a margin (occasionally minus a margin for extremely strong issuers), all bonds would pay Libor or Euribor flat. With all corporate bonds having exactly the same (non) maturity and paying exactly the same coupon, ranking perceived creditworthiness becomes a piece of cake – the price tells you everything. Weak high yield issues would trade well below par, AAA supranationals like the World Bank, above it.

So your immediate objection is likely to be this – what if I, the end investor, don’t want perpetual floating rate cashflows? Well you can add duration (interest rate risk) in the deeply liquid government bond markets or similarly liquid bond futures market, and with corporate bonds now themselves highly liquid, a sale of the instrument would create “redemption proceeds” for an investor to fund a liability. And the real beauty of the new instruments all paying floating rates is that they can be combined with the most liquid financial derivative markets in the world, the swaps market. An investor would be able to swap floating rate cashflows for fixed rate cashflows. This happens already on a significant scale at most asset managers. Creating bigger and deeper corporate bond markets would make this even more commonplace – the swaps markets would become even more important and liquid as the one perpetual FRN for each company is transformed into the currency and duration of the end investor’s requirement (or indeed the company itself can transform its funding requirements in the same way as many do already). Investors could even create inflation linked cashflows as that CPI swaps market deepened too.

So what are the problems and objections to all of this? Well loads I’m guessing, not least from paper mills, prospectus and tombstone manufacturers (the Perspex vanity bricks handed out to everyone who helped issue a new bond). But the huge increase in swapping activity will increase the need for collateral (cash, government bonds) in the system, as well as potentially increasing systemic risks as market complexity increases. Collateralisation and the move to exchanges should reduce those systemic risks. Another issue regards taxation – junky issuers will be selling their bonds at potentially big discounts to par. Tax authorities don’t like this very much (they see it as a way of avoiding income tax) and it means that investors would have to be able to account for that pull to par to be treated as income rather than capital gain. Finally I reluctantly concede there might have to be 2 separate bond issues for banks and financials. One reflecting senior risk, and one reflecting subordinated contingent capital risk (CoCos). But if we must do this, the authorities should create a standard structure here too, with a common capital trigger and conversion. Presently there are various levels for the capital triggers, and some bonds convert into equity whilst others wipe you out entirely. There is so much complexity that it is no wonder that a recent RBS survey of bond investors showed that 90% of them rate themselves as having a higher understanding of CoCos than the market.

Addressing the second difference between bonds and equities, the other requirement would be for the investment banks to move fully to exchange trading of credit, and to assume a market making requirement for those brokers who lead manage bond transactions. This doesn’t of course mean that bonds won’t fall in price if investors decide to sell en masse – but it does mean that there will always be a price. This greater liquidity should mean lower borrowing costs for companies, and less concern about a systemic credit crisis in the future.

matt_russell_100

UKAR – the biggest mortgage lender you’ve never heard of

U.K. Asset Resolution (UKAR) was established in late 2010 as a holding company for Bradford & Bingley (B&B) and the part of Northern Rock that was to remain in public ownership (NRAM).  Unlike other rescued institutions – RBS and Lloyds – whose progress we are kept well abreast of in the media, UKAR has flown under the radar somewhat. To give an idea of scale of the rescue; despite neither entity issuing a mortgage since 2008, UKAR is still the 7th largest mortgage lender in the UK today with a balance sheet of £74bn. About a third of assets on UKARs balance sheet are the legacy securitised RMBS deals of the two firms; B&B’s Aire Valley and the Granite complex from Northern Rock. A further 26% and 22% of assets are unencumbered mortgages and covered bonds respectively.

So, how well have they been using our tax money? And, are we likely to receive a return on our cash?

We met with management last week and they laid out their broad strategy going forward. They told us they are very focused on trying to help those able to refinance their mortgages elsewhere at a better rate. They also detailed how processes for collections and dealing with arrears have improved. This trend can be observed below, as the number of borrowers in the two securitised deals who haven’t made a mortgage payment for over 3 months has decreased significantly.

UKAR – borrowers in 3+ months arrears have declined significantly

More specifically, UKAR has a three pronged strategy for dealing with each of the three groups of assets (RMBS, unencumbered mortgages and covered bonds):

  • RMBS deals – has a strategy of tendering for notes that represent expensive financing
  • Unencumbered mortgages – sell off loan portfolios to third parties who wish to securitise them
  • Covered bonds – shortening the maturities through liability management exercises

Along with lowering arrears, UKAR has been successful in achieving these objectives whilst turning a decent profit. Clearly this profit is where we as tax payers (or the government) extracts value. Unlike the cases of RBS and Lloyds in which the government took an equity position, here they fully nationalised the institutions and extended a loan. Last tax year UKAR paid back £5.1bn of debt and £1.1bn in interest, fees and taxes to the government.

One further, slightly more technical point to note is the RMBS structures have hit a non-asset trigger. The trigger specifies that the notes issued out of UKAR have to be paid back sequentially – in order of seniority – until the whole deal is paid off. At this point there will be a slice of equity that will become available to the Treasury, roughly £8bn in total.

So, yes, I do think that they are doing a good job of looking after the tax payers’ investment. I also think commercial liability management exercises and portfolio whole loan sales will continue to maximise value. And of course, helping to keep people in their houses is a pretty good deal as well.

mike_riddell_100

Stamping down on foreign flows into UK property could be sterling suicide

So now we know what the Bank of England intends to do about the UK’s housing market, a market that Governor Carney has previously referred to as the biggest risk to financial stability and therefore to the economic expansion (the IMF and the EC had similar warnings).The answer, in short, is not much at the moment – while Carney is not “happy” with the buoyant UK housing market, he is willing to “tolerate” it.

Before wondering what to do – and what not to do – about the housing market, it’s worth asking whether the UK housing market is in a bubble. It’s not as crazy a question as you might think – in real terms (i.e. adjusting for inflation), UK house prices rose by just +1.2% per annum from 1974 to the end of 2013, and by 2.2% per annum from 1974 to the end of 2007. It was the early noughties when things got crazy, as UK real house prices saw double digit returns in four consecutive years from 2001-2004 – strip out these years, and UK real house price growth has actually been negative in the last four decades*. But even including 2001-04, if you consider that the UK’s productivity growth since the mid 1970s has averaged about 1% per annum, and that UK population growth has averaged 0.3% per annum over this period, then small positive real house price growth doesn’t appear hugely alarming.

That said, 40 year average price changes don’t tell the whole story. The performance of the housing market in the past year is remarkable – UK house prices were up 11.1% in nominal terms in the year to May according to Nationwide, which is still a long way short of the 2001-04 bubble years, but is the fastest pace since then. Meanwhile data from the ONS shows that nominal London house prices rocketed 18.7% in the year to April. These rates of growth are well in excess of inflation, and well in excess of wage growth.

What is causing the recent jump higher in house prices? By definition the answer is an excess demand versus a lack of supply, although almost all commentary on the UK housing market seems to focus primarily on the latter rather than the former. Public debate about UK housing has been strongly influenced by then MPC member Kate Barker’s government commissioned 2004 review of housing supply, where she argued that ‘the long-term upward trend in house prices and recent problems of affordability are the clearest manifestations of a housing shortage in the UK’, and that the UK needed to build up to 260,000 new homes per year to meet demand. In the decade since the report was published, less than half this figure has been built, suggesting a shortfall of 1 million houses has accumulated.

But is the spike in house prices really all down to supply? As Fathom Consulting have pointed out, if there was a housing shortage then why haven’t real rent costs jumped higher? The chart below plots nominal wage growth versus UK rent costs back to 2001 – rent costs were actually increasing at a slower pace than wages pre-2008, and have only been running fractionally above wage growth more recently. If there was a supply shortage, then we would expect to see real rent costs increasing quite sharply as people become forced to spend more on housing as a percentage of their income, but this isn’t the case.

Slide1

The next chart suggests that the pick-up in house prices that began last year is much more likely (as always) to have had more to do with demand, namely lower mortgage rates and easy mortgage availability. The left hand chart is from the Bank of England’s recent Financial Stability Report, and shows the loan to income ratio on new mortgages advanced for house purchase. Around 10% of new mortgagees are now borrowing at a loan to income ratio at or in excess of 4.5 times income. Over half of home buyers are now having to borrow at 3+ times income, which is a ratio about 5 times higher than immediately before the UK housing market crash of the early 1990s. It’s striking how closely correlated loan to income ratios (left chart) are with house prices (right chart). It suggests that limiting loan to income ratios will also serve to limit house price appreciation, although the correlation doesn’t necessarily imply causation. It could be that a jump higher in house prices forces buyers to take on more debt, since only additional debt will make it possible to get onto the bottom rung of the housing ladder**.

Slide2

The other growing source of demand for UK property is likely to be overseas investors. When sterling collapsed post the 2008 crisis, the assumption was that the UK would see an export-led recovery thanks to a huge improvement in its competitive position. Unfortunately, this didn’t really happen, because the UK’s big export – financial services – was in little demand post crisis. UK exports did initially pick up, but today are only 10% higher than at their peak in 2008, and have moved sideways since 2011. Spain’s exports, in contrast, are almost 30% above 2008 levels in euro terms, despite the euro strengthening against sterling over the period.

Sterling depreciation may not have resulted in a surge in exports of UK goods and services, but it does appear to have led to a pick-up in a new kind of export – London’s housing stock. Savills, an estate agent, estimates that overseas equity into just prime London residential property was above £7bn in 2012, and presumably it was higher still in 2013. Overseas buyers have always been involved in London property thanks to market transparency, liquidity, political stability, a clear rule of law, decent education, and low taxes versus countries such as France or Spain, but the 2012 inflows were twice the amount seen in 2008 or 2009, and about a third higher than in 2006.

It’s easy to see why overseas buyers have taken a shine to UK property from the chart below. British houses feel far from cheap in local currency terms, but they look considerably cheaper from the perspective of all the traditional foreign buyers, with the exception of Russians. From the perspective of Chinese investors, London house prices are still 17.5% below their 2007 highs when measured in Chinese Yuan.

Slide3

The Bank of England’s strategy for reducing domestic demand for UK housing via macro-prudential measures such as limiting loan-to-income ratios should be the primary way to tackle the destabilising effects of housing related indebtedness, and the Bank of England arguably could have done more. Stemming foreign flows into the UK housing market is much more attractive politically, but could be very unwise.

Data from last week showed that the UK’s current account deficit improved slightly in Q1 2014, but Q4 2013 was downwardly revised to 5.7% of GDP and Q3 2013 to 5.9%, a worrying new record. Of the so-called ‘Fragile 5’ emerging market countries, only Turkey had a bigger deficit in Q4.

A current account deficit is a broader measure of a country’s trade balance. The UK’s large deficit can be attributed to various factors (e.g. a sustained trade deficit, a deteriorating income balance which may partly reflect an increase in foreign companies taking over British companies, and sustained budget deficits), but generally speaking a chronic current account deficit is indicative of competitiveness problems. The chart below shows that a large and deteriorating UK current account balance has historically preceded a sterling crisis, where a sharp depreciation in sterling subsequently restored the UK’s competitiveness, and hence its current account balance. If you consider that foreigners buying new build houses in London is little different to foreigners mass buying Scotch Whiskey in terms of its effects on the national accounts, then proposals to tax foreign buyers of London property is the equivalent to taxing your own exports! Not a very clever thing to do with such a precarious current account balance. Note that taxing exports is considerably worse than protectionism, which typically involves taxing imports.

Slide4

Macro prudential controls are a positive step and should help curb some of the local mortgage excess that has built up over the last couple of years. However, those pointing to supply-side factors as the primary reason for higher prices aren’t viewing the whole picture. UK property is cheap from an overseas perspective and will likely remain in demand to foreign buyers looking for solid returns in a low-yielding world. And beware the clamour of calls to stem foreign inflows into the UK housing market, which is turning into one of the UKs most in-demand exports. Of course, if macro prudential measures fail to take some of the heat out of the market, the Bank of England could always raise interest rates (if only they could remember how to….)

*This is calculated using UK RPI and the UK Nationwide House Price Index. Given there are methodological issues with both RPI and Nationwide data, it’s worth treating the calculation slightly cautiously – for example, UK RPI has averaged 0.9% higher than UK CPI since 1989, so real house prices appreciation is an additional 0.9% p.a. on a CPI basis.

**The recent nudge higher in both house prices and the move higher in first time buyer loan to income ratios is likely to have been assisted by the help to buy scheme (or the ‘help to sell scheme’, as we called it at the time), although given that as at the end of May, only 7313 houses were sold under the scheme with the total value of mortgages supported by the scheme at £1bn, there are other forces at play.

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