Author Archives: Ben Lord

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I predict a CypRIOT: Three major implications for the European and UK banking systems

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Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.

Firstly, depositors were presumed to be guaranteed by governments up to at least  €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.

My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?

Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.

Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?

The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.

So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.

No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.

I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.

Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.

ben_lord_100

Judgement Day – RPI Damp Squib

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Today has seen the release of the decision by the National Statistician about what to do with the Retail Prices Index. We were told of the consultation in September last year, and were presented with 4 options, ranging from 1) to do nothing, to 4) to make RPI as much like CPI as possible.

Our view was always that the consultation arose as a result of the desire to correct an error made in the clothing component of RPI in January 2010 see blog. This change had seen the ‘wedge’ between RPI and CPI anomalously and erroneously increase by close to 1% following its implementation. We therefore believed that it was perfectly appropriate for the National Statistician to correct this error, and so we were expecting to see Option 2 materialise, which most closely targeted correcting this source of the wedge.

UK linkers had noticeably underperformed other markets since the announcement of the consultation. The market had initially started to price in a 30 to 50 basis point reduction in the wedge of RPI over CPI in expectation of Option 2′s intention to rectify the error.  However, as Judgement Day approached nervousness increased in the linker market as people started to worry that the more severe options could be implemented.

Were Option 4 to have been recommended today, the wedge of RPI over CPI would have been reduced by approximately 100 basis points. This would have been a severe and brutal change for the index linked bond market. All else remaining equal, this change would have seen breakevens on index-linked bonds fall by approximately 70 basis points (allowing for 30 basis points of underperformance already priced in).  To put it another way, this would have see the price of the longest index-linked gilt, the UKTi 0.375% 2062s, fall from 107.7 to about 85, a fall of 21%. Today, things really could have got nasty!

But the decision today has been Option 1. No change. Whilst highlighting that “the RPI does not meet international standards” and recommending that a new index be published, Jil Matheson “also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations”. For the release, go to this link.

All the lobbying that we – and some others – have been doing behind the scenes has been worth it. In the Financial Times today, Chris Giles (who was on the Consumer Prices Advisory Committee) stated that the ONS rejected the committee’s advice in the face of  ‘overwhelming opposition to changes in the calculation of the RPI’.  The market has recently opened, and is removing the expected reduction of 30 basis points or so from Option 2. Breakeven inflation rates at the moment are up by 37 basis points at the 10 year part of the curve and by 22 basis points at the long end. The 2062 index-linked gilt is up by 12 points in price terms, and the whole linker market is rallying in the relief that no change is being made…

…for now! We will soon see the creation of a new RPI index, called RPIJ. This effectively makes RPI equal to CPI through making the older RPI index more modern by removing arithmetic mean and replacing it with geometric mean. This will be run in parallel with the old, untouched index. But it suggests that this debate is not over forever. We could again see recommendations to move from RPI to RPIJ, but more likely, we will soon start to debate moving the index-linked corporate bond market from RPI linkage to CPI linkage.  The creation of RPIJ does seem a little irrelevant, where a new index has been created that few people will care about given that inflation linked bonds will continue to be linked to RPI and the government is clearly dedicated to linking other forms of government compensation to CPI.

Ultimately, though, even if we had seen a brutal reduction in RPI today, I still think that the strong case could be made to want to own UK index-linked bonds over the medium and long term. And changing the calculation to option 4 could have saved the Treasury a whopping £3bn per year, so while the decision to make no change has been great for inflation linked bond holders, it’s not so great for the UK’s coffers.   Finally, the strong opposition to the RPI changes gives you a good idea of how hard it will be to implement austerity measures, and if we aren’t going to get out of this debt crisis through austerity, then the likelihood of us getting out of it with the help of inflation has just increased a bit!

ben_lord_100

Panoramic: central bank regime change – inflation targeting or inflation hunting?

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Given the success that central banks have had in targeting inflation over the last decade or so, the recent increase in their powers, and the broadening of their remit to include economic growth, has been largely welcomed by the markets. But have we put too much faith in central banks abilities? And, with record levels of peacetime government deficits and the clear political incentive to tolerate higher levels of inflation, have we come to overestimate their commitment to reining in prices?

In this note, which is part of our quarterly Panoramic series, we argue that we are seeing potential upside risks to inflation as central banks continue to preside over the biggest coordinated global monetary stimulus that we’ve seen in recent history. In our view, the expansion of central banks’ balance sheets signals an unspoken shift in these institutions’ remits that could have important consequences for future inflation rates. It is a phenomenon we have coined “central bank regime change”.

The Bank of England and European Central Bank seem no longer to be primarily focused on delivering price stability. Their new mandate now covers supporting domestic banking systems, offsetting the effects of government austerity measures, bolstering trade and implementing the conditions needed to generate jobs and economic growth.

With central banks’ macroeconomic responsibilities straying ever further into what was previously the state’s domain, their independence is looking increasingly fragile. The hijacking of monetary policy by politicians cannot be ruled out, especially if it enables them to inflate their way out of their growing debt burden. If we get to this stage, inflationary pressures will rise, although central banks’ credibility will be tarnished and policy responses rendered ineffective.

In our view, there are potentially plenty of reasons to expect the current period of low inflation to come to an end. Central banks are still thinking of new ways to ignite growth and they appear to be increasingly tolerant of above-target inflation. But are they moving ever closer to a major policy error that could ruin their inflation-targeting credibility? And should we all start thinking about inflation again?

To read the latest Panoramic, please follow this link.

ben_lord_100

Office of National Statistics or Office of National Savings? The Future of the UK’s RPI-CPI wedge

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There has at almost all times been a ‘wedge’ between RPI and CPI, given different calculation methodologies (arithmetic mean vs geometric mean, respectively), different items within each, and different weights of these different items. The long term difference has on average seen RPI at 0.5% to 0.8% more than CPI. Recent changes, though, saw the wedge widen in 2007 to more than 2%, and to almost 2% again in early 2010.

Differential between RPI and CPI

What are these changes? RPI is a much older index, originally conceived in the early 20th century to track the effect of price moves on workers during The Great War, using less up to date and less relevant averaging calculations and, arguably in some cases, weightings and items. CPI was not developed until much later, in 1996.

Since the coalition’s formation we know that the government has been attempting to change certain future liabilities’ (eg public sector pensions and benefits) indexing from RPI to CPI. Why? Simply, because this wedge of RPI over CPI means over the long term it is more expensive for the government to pay RPI than CPI. And given the long duration of these liabilities, the present value and so budgetary impact today of such changes are extremely powerful in terms of delivering on austerity. From a rather different perspective, that’s why there has been so much resistance to these changes on the part of public sector workers, amongst others.

The ONS is the body that is responsible for the classification, collection and measurement of these compensation indices – no mean task I hasten to add (see here for a video we did with the ONS last year). We have heard much in research notes and certain press articles in recent weeks about the ONS undertaking a project to eradicate the wedge entirely! What would this mean for us as investors? It would be less attractive to own UK linkers, as inflation as defined by RPI would be structurally lower than it has been. The breakeven rate (the rate between nominal gilt yields and index-linked gilt yields) would fall, meaning that index-linked bonds would underperform nominal bonds. This would be especially so at the long end, where the price or present value impact would be felt most.

I can think of 5 strong arguments against such an assault on the wedge:

1.To eradicate the wedge altogether would be tantamount to an event of default, especially if this is specifically to eradicate the structural difference between the two indices! We bought these securities on the basis that we would be paid RPI, which we know changes in terms of items and weightings on an annual basis, but according to changes in spending habits rather than Government policy. That’s fine! But the index is based on an arithmetic mean and always has been, and so will (almost always!) be higher than an index calculated according to a geometrically calculated mean. To change this, willingly and knowingly, with the purpose of reducing future outgoings of index-linked borrowing cashflows feels very similar to the altering of the War Loan’s coupon from 5% to 3.5% in 1932, or to the Greek PSI exercise of coercive write-downs, neither of which, arguably, were ‘defaults’.

2. The Statistics and Registration Service Act that covers changes to RPI states that any changes to the index must be carried out in consultation with the Bank of England as to whether the changes are fundamental and materially detrimental to holders. If the BoE decides that both of these conditions are met, then the changes to RPI cannot go ahead without prior approval of the Chancellor. Well, given the changes Mr Osborne has been trying to make elsewhere in his search for austerity, might he simply approve the changes in the index? Well this would not be without significant risks, electorally, and it would have a fundamentally and materially detrimental impact on the ability of the DMO to borrow through the linker market, which we will touch on in a moment. But perhaps it would be open to legal challenge? Consideration of this last issue involves looking into the contractual protections embedded within the old-style 8 month index-linked gilt prospectuses. It turns out that these documents state that if both the conditions of a change to the index above are met in the opinion of the BoE, HMT will inform bond holders of this, and offer them the right to redeem their stock. So the next issue for holders is: at what price can I put my bonds? The prospectuses state that “the amount of principal due on repayment and of any interest which has accrued will be calculated on the basis of the index ratio applicable to the month in which repayment takes place”. Thus, in current markets, with substantial negative real yields, the protection provided in these old style bonds is not sufficient to compensate holders fully, as it only pays accrued inflation. As a result of this, holders are going to be very sensitive to any chatter about substantial changes to the index. And this will have pretty major consequences. For instance, looking at the 4.125% gilt linker of 2030, the current price of the bond (given by current accrued RPI relative to RPI at the date of issue, along with future assumed inflation of 3% per year, positive real coupons, and negative real yields) is 316.5. To take this bond and assume we put the bond in the event of a change to the RPI, we multiply par (100) by the index today (242.5) over the base RPI at issue (135.1) to arrive at a price of 179.5. A holder would be set to lose 137 points, or 43% of the bond’s current value!

3. It would also serve to ruin the RPI linker market, at least for a long while. The uncertainty from recent headlines cannot be helping sentiment among the linker buyer base at the moment, and this has been an extremely important source of funding for our high levels of borrowing in the UK in recent years. It would be unwise to annoy these buyers, as it will only serve to increase the costs of issuance (through demanding higher real yields), irrespective of the final outcome of the ONS’ project to lower the paid level of inflation. Indeed, this begs the question as to whether to make the change to linkers from the perspective of our financing position would be to shoot ourselves in the foot?

4. The ONS states on its website under its ‘Vision and Values‘ that: “Our mission is to improve understanding of life in the United Kingdom and enable informed decisions through trusted, relevant, and independent statistics and analysis” (my emphasis added). To target the structural and total eradication of the RPI-CPI wedge would in my opinion clearly be an impeachment of its independence, and would see huge criticism about the political motivations of such a change in the index. This could perhaps lead to legal challenge.

5. Could this not be interpreted as an attempt to specifically and deliberately conceal high levels of headline inflation, Argentina style? Or, if not, to artificially and deliberately manage UK inflation down? It is not just pensions and benefits that are linked to inflation, but wages and commercial contracts, which all have significant impacts on the economy’s overall level of inflation. To change the major index underlying all these contracts from RPI to CPI (the logical equivalent of making RPI CPI) would be to manage inflation down, at a time when so many are concerned about stubborn inflation in recent years, as well as the effects of super-accommodative monetary policy on future inflation. What would this tell us about our politicians’ and policymakers’ inflation targeting attitudes and indeed capabilities?

As a result of these arguments, I personally find it difficult to believe that this is the intention of the ONS or of its project to examine the wedge. I believe instead that the review is targeted at removing some of the anomalous sources of the wedge, which resulted, in no insignificant part, from a change in measurement that took place in 2010 that particularly impacted the wedge between RPI’s clothing price level and CPI’s clothing price level.

Year-on-Year RPI vs. CPI clothing and footwear

Indeed, the clothing and footwear components of RPI and CPI alone represented 60% of the total wedge between the two indices! This kind of change would be justifiable in my opinion. Anything else would at best be ill-advised, and at worst would be mismanagement on a major scale.

ben_lord_100

Bail-ins: Damned if we do; damned if we don’t

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We have written on numerous occasions about the hitherto inseparable links between sovereigns and banks, and we have also written about the benefits of writing down bonds to create capital  (see The New Era for Bank Bonds: Send In The Clowns? and Equitisation of bank capital bonds) . In 2007 the global markets woke up to the fact that the US subprime market was blowing up, and in 2008 realised that due to financial engineering and securitisation, both of which were preposterously known at the time as ‘risk dissemination and minimisation’, banks the world over had major solvency issues as vast quantities of investments plummeted in value. This, in turn, led to a liquidity crisis as the investment markets shunned investment in banks and the interbank market froze over.

The crisis we are in today is the same crisis we were in 5 years ago. Sovereigns had to step in to guarantee their banking systems, so as to enable debt to be rolled over and confidence to return. In the short term the most important thing was to provide liquidity, which we saw through government guaranteed debt issuance and secured funding directly with central banks in the UK, US and more recently Europe. Next, sovereigns had to buy huge volumes of illiquid assets from their banks (US), or provide direct capital injections to support their solvency (US and UK), as the perception dawned that the liquidity crisis was caused by a solvency crisis.

All this time, the inevitable link between sovereigns and banks was becoming more and more deeply intertwined. And whilst it may feel that the Great Recession has metamorphosed from a banking crisis to a sovereign one, it hasn’t really: sovereigns took on increased liabilities to protect their banking systems and now find themselves in the ‘limelight’. It’s the same crisis, with a different focus.

Many European banks, though, remain substantially undercapitalised. Hence, the system is still overwhelmingly dependent on central banks to provide them with liquidity at an affordable cost. All the time the sovereigns providing liquidity are becoming more and more tied to the health or otherwise of their banks and the assets they are taking from them as collateral.

Has the time come for this cycle to end? Might the severance of this link bring the beginning of the end of the sovereign crisis? Many European banks are still on 24 hour life support, saddled by enormous levels of liabilities that are cutting off new lending and suffocating new investment through the multi-year crisis in confidence in lending to and investing in banks.

So how will this occur? Well my sense is that there’s abundant liquidity at the moment after all the LTROs, inter-central bank funding lines, secured lending facilities and covered bond new issuance. The problem is far more one of solvency and capital adequacy in Europe, where the very worst of the banking crisis continues today. For sovereigns to provide their national banks with the recapitalisations they need, via wholesale nationalisations, would only see a worsening of the sovereign debt crisis, as the funds would have to come from somewhere. So this approach doesn’t really work. And is it really desirable from the perspective of the taxpayer?

The solution? We need new capital, in substantial scale, and fast. The time may have come to sever a significant part of the link between a sovereign and its banks. Unsecured bank bonds in peripheral Europe where the sovereigns are struggling under high borrowing costs, and so where the cost of providing guarantees and funds to their banks are painful, should now be written down in certain cases. Both subordinated debt and senior unsecured bonds would see defaults, in some cases even to zero. This would generate huge amounts of capital (which writing down only subordinated debt would not achieve on its own), and does not involve the troubled sovereign having to borrow more from the markets or seeing debt / GDP levels spiralling. Yes this is painful for investors and to risk-taking savers who are exposed to bank bonds in their pensions and so who suffer losses there. But the write downs are taken. Capital is generated. Deleveraging of the system occurs quickly and substantially (at last!). And the severance of this part of the sovereign-bank link (deposit guarantees must remain in place)  means that the banks might just stop dragging the sovereigns down with them.

Policymakers and politicians must be aware (and I’m assuming they are already) of the benefits of this first step towards cleansing the system. If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time. But this situation of creeping nationalisation where taxpayers provide 24 hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered. Could now be the time for bank bondholders to see defaults, where they are needed? There are countries where these dramatic measures aren’t needed, as well as individual banks where they won’t be needed within troubled systems. The process will be painful for bearers of risk (investors and savers), but it might, more importantly, provide the capital the system so needs to start restoring confidence in the banks, and the sovereigns would benefit from cutting the tie with the non-deposit banking system. So policymakers have to work out whether society overall would be better off with this new approach than the current one. They may very well conclude that the present situation of taxpayers being subordinate to bank bond holders, rather than vice versa, is a morally repugnant system.

Some of us are damned if we change tack and take this approach. All of us are damned if we don’t.

ben_lord_100

Markets start to think about inflation again

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Over the last few weeks we have witnessed a meaningful bounce in inflation breakevens in the UK, Europe and the US. When breakevens are rising, it is a signal that the fixed income market is anticipating higher inflation than has been priced in. It also means that index linked bonds are outperforming conventional bonds. In the UK, the linker gilt of 2016 has outperformed the conventional gilt by 45 to 50 basis points in yield terms since the start of this year.

Inflation expectations are rising

Why have the bond markets started to price in higher levels of inflation?

Perhaps there is an element of geo-political risk affecting the oil price, which feeds into the inflation baskets in a plethora of forms? Yes, but I don’t think oil is the major culprit here, although in the US, where oil is taxed far less than in the UK or Europe, inflation is far more sensitive to changes in the oil price. See Jim’s blog here.

Perhaps rising breakevens owe to fears around money creation? In Europe, at the end of 2011 the interbank market was completely disfunctional, and we were entering a deflationary spiral. But the long term repurchase operations (LTRO) have added somewhere in the region of €1 trillion euros to banks over the last few months, the interbank market has been showing signs of being slightly less disfunctional, and the risks of deflation feel for the moment substantially reduced. In the UK, the mechanism of quantitative easing boosted the prices of conventional gilts more than index linked gilts, as the Bank of England did not purchase linkers directly. This artificially suppressed the relationship between the conventional gilt and the linker (the breakeven), at exactly the moment when money creation ought, in my opinion, to have seen higher inflation risk premia priced in. The strong performance of index linked gilts in the UK either owes to a fear that improved economic data means we are closer to the end of QE than the beginning, so the artificial source of demand for gilts is not going to be in the market for much longer (a relative call), or owes to the market’s deciding that we are not going into a disinflationary or deflationary economy, and are more likely to see on target inflation or higher.

It is worth thinking about the levels of 5 year breakevens in the chart, a relative valuation measure. In the UK the bond market is expecting inflation to average 2.8% a year for the next five years. Remember though that this is RPI inflation, which historically has averaged 0.8% more than CPI. If we assume this historical relationship holds, then this 5 year breakeven implies CPI will be bang on the Bank’s target of 2%. So on this basis the breakeven does not make inflation protection look expensive at all. Considering the 5 year breakeven in Europe, which is currently 1.6%, this is still pricing in inflation being below the 1.8% (ish) target on average for the next 5 years. With aggressive money creation (at last!), surely the risks are skewed to the upside? In fact, only the US market is pricing in inflation to be above target for the next 5 years. I think that this is the correct side of the inflation target for linkers to be valued at, and I believe there is a good chance the UK and European markets start to move towards this US dynamic.

Why? Firstly because of the ultra low interest rates and ultra accommodative monetary stance at the ECB, BoE and Fed. And also because of the large scale money creation we have seen in all three markets and have discussed briefly above. But most importantly to me is the fact that at this moment in time, the three central banks in question all have a clear and visible inflationary bias. They would rather have inflation than deflation (rightly). But now they are showing a propensity to favour above-target inflation over below-target inflation. This is tantamount to a (temporary or permanent, we do not yet know) change in the inflation targets. And this must, in my opinion, see higher inflation risk premia. How do we show this clear inflationary bias? Inflation is significantly above target in all three economies, and yet policy is not only not being tightened, the taps are still very much on!

ben_lord_100

Beware the wealth tax movement

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I saw a very interesting article in this weekend’s Financial Times discussing the London property market. Ed Hammond cited data showing that Greek and Italian citizens have accounted for more than 10% of London property purchases so far in 2011. In fact, Greeks and Italians have so far this year spent more than £400m on prime London property, up from £245m in 2010. Much of this has been into the most exclusive parts of London such as Mayfair and Knightsbridge. It looks like there is a real urgency amongst rich southern European citizens to protect their wealth in this environment of soaring government bond yields.

It struck me that it was, though, a strange situation. Two countries that are on their knees, unable to finance at sustainable rates, that at the same time find themselves very high up the global wealth league tables. Italy, for instance, in 2010, sat in the top 10 of countries with the highest average wealth per adult (according to Credit Suisse). In another study, the Human Development Report 2011, Italy comes out as the 24th wealthiest country in the world while Greece sits at 29th. The UK came just above Greece, at 28th, for purposes of context. Norway and Australia come first and second, respectively.

In these markets that are being totally dominated by what we call the sovereign debt crisis, the market has become fixated on debt to GDP ratios, as corporate bond investors have always paid close attention to companies’ net debt to EBITDA ratios (an income statement approximation to cash earnings). Both ratios very simply look at the level of debt relative to earnings, and thus give some indication of how easily a country or company can service their debts.

Going into this crisis, countries (not companies) were paying out more in spending than they were taking in tax revenues. And as the bond markets have become not just concerned, but obsessed with starting to reduce debt levels relative to GDP, we have seen austerity budgets passed all over Europe (not the US, but that is something we will all worry about at a-not-that-much later date). These are a direct attempt to bring primary budgets back into balance, where spending is financed through tax revenues rather than increased borrowings. A secondary aim of this is to start to bring down the all-important debt to GDP ratio.

But governments are finding it very difficult to bring in the necessary budgetary reforms due to political unrest. And now, the few reforms that have been brought in to cut spending have met with what looks like being a global slowdown. Perhaps even a global recession. So governments are not only struggling to bring the primary budget back into balance, but are now seeing GDP growth fall, whether by coincidence, or by actually contributing to the decline in growth (more likely). And if GDP starts to fall, then debt to GDP ratios deteriorate unless total debt levels are being reduced by a faster amount. You won’t find many, if any, examples of states that are actually cutting their total debt levels in Europe yet.

It is worth observing, in passing, that there are several countries that have pretty terrible debt to GDP ratios that also have historically low interest rates (witness the US, the UK and Germany, amongst others). The implicit message here is that debt to GDP is not the be-all and end-all in terms of the cost of that debt.

So what is needed, if growth continues to slow and the threat of renewed recession spreads across these over-indebted nations?

The evidence of the Greeks and the Italians coming and spending such large sums of money on prime London property suggests that these people fear a new wave of fiscal approach to this crisis. As growth in both these states continues to plummet, thereby worsening traditional debt to GDP ratios (bar a haircut or default, both synonymous as far as we’re concerned) a new approach by policymakers may start to take hold. Austerity isn’t going to help in this environment. Perhaps even the opposite. What is needed is an ability to stimulate the economy, so as to generate jobs and growth. And what is all too clear from the last couple of years is that the bond markets will no longer lend to finance these budgets aimed at growth. So the resource needs to come from somewhere else. Is it time for Robin Hood to come to the rescue in the form of a wealth tax? It appears that many citizens of peripheral Europe are starting to fear exactly that.

ben_lord_100

What is risk off?

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Recent selling of risk assets into traditional haven government bonds has taken their yields back near their all time lows. Will people continue to buy them in a risk off trade? We are almost certainly nearer the beginning than the end of a western world sovereign debt crisis. That means quite clearly that Gilts, Bunds and Treasuries are not the ‘risk free’ investments they once were. In relative terms, their risks are low and perhaps falling. But in absolute terms, their risks are high and rising. The US was just downgraded from AAA by S&P, and yet their yields are still rallying, contrary to the expectations of many and contrary to traditional theory. If greater fiscal union is the final solution to the peripheral European sovereign debt crisis, then the transfer of wealth from Germany and other strong EU states to the weaker ones will see Bunds, amongst others, sell off dramatically. Yet if fiscal union is unacceptable to some EU states and it fails to get parliamentary approval, then surely Bunds will remain firmly within the very top echelon of government bonds in the world, with yields potentially less than 1%? Perhaps the austerity plan which has been so important in supporting Gilt yields and the AAA rating in recent times sees UK borrowings become the last true safe haven in the Western world? Yet the low economic growth consequences of this approach could also scupper the plans and have just the opposite effect. As you can see, in each case traditional economic views and expectations about these ‘risk free’ safe havens could prevail, or could be utterly wrong. That doesn’t sound to me to be very risk free at all!

So, to where do we retreat in a new paradigm in which traditional safe havens are no longer such? Given the recent widening in credit spreads, I believe that some of the high quality investment grade credit now looks good value again. Maybe, just maybe, the new safe haven could become the high quality, low beta, internationally exposed, lowly geared, corporate bond universe?

ben_lord_100

The economy continues to lead credit

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Two months ago I questioned whether the decoupling between credit spreads and economic fundamentals could continue for much longer. I felt at the time that at some stage the weakening economic data would start to drag credit spreads wider, at least relative to government bonds. I also asked whether we might enter an environment in which high quality investment grade credit could see a flight to quality rally, whilst some of the lower quality, higher beta credit could sell off. Let’s see how government bonds and credit have fared since this blog was posted.

Bunds, Gilts and Treasuries have had a fantastic couple of months as shown in the chart below, with 10 year benchmark returns of 7%, 5.25% and 5%, respectively. However, this did not happen solely because economic data turned so horribly south, although it clearly did. These government bonds were boosted because of the peripheral sovereign debt concerns in Europe, and debt ceiling negotiations almost bringing about a technical default in the US. The markets panicked and sold risk and bought traditional, relative safe havens.

It’s been a great couple of months for treasuries, bunds and gilts

How has credit performed over the same period? The broad European, Sterling and US investment grade indices’ spreads have widened over the last two months. European spreads have risen from an average of +143 basis points to +172 (20% spread widening), Sterling spreads have risen from +193 to +218 basis points (13% spread widening), and US spreads have risen from +162 to +173 basis points (7% spread widening). Credit default swap spreads paint a similar picture of rising credit premia and rising risk aversion in the last two months, although the extent of the credit spread sell off has been greater in this market than in cash, largely due to far superior liquidity and therefore activity. The index of the 125 investment grade names in Europe has risen from a weighted average spread of 104 to 134.5, or a 29% spread widening, and the equivalent US index has risen from 96 basis points to 105 basis points, a widening in spreads of 9%.

Market participants in all risk assets have reacted typically: selling higher risk assets for perceived lower risk ones. In fixed income, we have observed this both in the cash market and in the CDS market.

Riskier corporate bond spreads have widened

The CDS market has also widened

However, in June I expected to see this as a result of a fundamental worsening in the economic data and environment, rather than as a result of a global panic in risk that has actually transpired. But the panic sell off in all types of risk has seen all sorts of participants sell whatever they can and buy anything traditionally perceived as risk free. Assets of all classes have been sold into higher quality government bonds.

ben_lord_100

Corporate credit: might now be a good time to revisit exposures?

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Don’t get me wrong, I am not sounding the death knell of the post QE (1) credit rally. But a couple of pretty important and recent developments have got me asking: should I be chipping away at some of the higher beta corporate bonds I own?

Let’s start with the good news. Companies broadly are in fantastic fundamental positions, having responded to the crisis by cutting costs and debt and building up cash, and then subsequently by taking advantage of ultra low interest rates by borrowing for the long term. These strong fundamentals have not only led to very low default rates, but also augur for continued low default rates in the future, on account of the very low financing costs many of them have for the next 5, 10 or even 30 years. (I am not, here, talking about banks!)

Along with the above strength in companies’ balance sheets though, we have witnessed unprecedented amounts of monetary and fiscal policy stimulus. Both of these combined have served deliberately, substantially and artificially to support aggregate demand and consumption. And let’s not forget that consumption still makes up close to a 70% share of our western economies. So, with companies in strong financial health, and with consumption supported by unheralded levels of low interest rates, tax breaks and handouts, it is little surprise that the result has been nothing short of a nirvana for corporate credit.

But is this set to change? Austerity measures are starting to bite here in the UK. And in Europe interest rates have begun their upward trajectory (and there looks, from where I’m sitting, to be a pretty good chance of another hike in July, or not long thereafter). All over the West the extraordinary policy stimulus is starting to be withdrawn, albeit rightly at an incredibly tentative pace. And even though we are only a few months into this process, economic data has turned negative, fast (see Mike’s blog). Government bond markets in the US, Europe and the UK have watched this data in horror, and have started to rally again as the growth picture worsens.

Corporate credit, though, has remained remarkably resilient, only moving a few basis points wider whilst the data has turned negatively, and whilst the government bond markets have rallied substantially. This is illustrated in the following chart, which maps the economic surprises index Mike blogged about recently over broad investment grade credit spread performance.

Credit has performed well despite macro headwinds

*our thanks go to Hans Lorenzen at Citi Investment Research and Analysis for this slide.

If, as I do, you worry about the macroeconomic picture in a world where interest rate rises, government spending cuts and higher taxes are all detrimentally impacting consumption and economic growth, then perhaps there is a good chance that investment grade credit has to start to react to the change in the economic releases? But which way? If credit is still too cheap and spreads too wide, then a worsening macroeconomic picture could see a flight to quality out of higher credit risk names into relative safe havens in the investment grade universe. However, if credit is not too cheap, there is a good chance a more bleak world order could see investment grade spreads sell off. In other words, it might not matter how strong companies are fundamentally, if people are not spending their money on their products or services anymore.

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