matt_russell_100

It’s the taking part that counts: why Europe’s labour market might be stronger than we’d thought

We saw further evidence of the strengthening US labour market on Friday. In September, 248,000 new jobs were added and the unemployment rate fell below 6% for the first time in six years. Headline unemployment rates in Europe, by contrast, have been more dismal, with the latest numbers coming in at 11.5% across the Eurozone for August.

Less encouraging for the US was the participation rate falling to its lowest level since 1978. The participation rate measures the number of people either employed or actively looking for work as a share of the working-age population. One really has to look at both the unemployment and the participation rates together as they give a fuller feel of what’s going on. Take this, admittedly, extreme example: an economy could look like it has full employment (zero unemployment), but if its participation rate is zero, no one is actually working.

The falling US participation rate has been widely discussed as it is one of the measures that Janet Yellen, the Chair of the Federal Reserve, has consistently pointed to when answering questions on the strength of the US economy. It may be happening for a whole host of reasons, including discouraged workers giving up their job search, some opting for early retirement, or others choosing to stay in – or return to – some form of education. Participation rates in Europe however have had less airtime, so I am grateful to Erik Nielsen of Unicredit for highlighting the situation there.

So, in Europe, while unemployment numbers make for pretty sober reading, the participation rate itself has been on a generally upward trajectory. This is true for both core and peripheral Europe (see chart), so it’s not just a case of German data masking lacklustre numbers elsewhere. Again, the reasons for this are diverse, but may include a greater proportion of women joining the labour force in recent years, and an increase in the pension age in some countries.

Slide1

To assess the true situation in various countries and the relative progress each has made, we have held their participation rates constant at their 2000 levels and plotted how the subsequent unemployment data would have looked if the number of people in the workforce had remained at the same levels as at the turn of the century.

As the charts below show, the results are illuminating. Headline unemployment in Italy was running at 12.5% at the end of 2013 (the latest reading available), but once the 2000 participation rate is applied this falls to 8.7%, a fall of some 3.8 percentage points. The same is true for Spain, where the difference is a mighty 13.3%. In the US (where we have more recent data) , in sharp contrast, the current headline level of 5.9% unemployment actually rises to 12.5% when the 2000 participation rate is applied.

Slide2

Slide3

Slide4

I was rather surprised to see the extent of this divergence and that the US is actually in a worse position relative to where it was in 1999 than peripheral Europe. I remain unconvinced as to whether the Eurozone is entering a period of stronger growth or whether its economy will actually come to resemble that of Japan. But these charts definitely move me closer towards the former.

matt_russell_100

It’s the regulation, stupid: the ECB’s ABS purchase programme

The ECB is finally joining the Quantitative Easing (QE) party. Un-sterilised asset purchases have been a major policy tool in most of the developed world over the past few years but next month (as the Fed ends theirs, incidentally) the ECB will make its first foray into QE proper by embarking on an asset backed security (ABS) purchase programme.

Through this programme, focused on “simple, transparent and real” asset backed securities, the ECB hopes to stimulate lending to the real economy and so help see off the ever looming prospect of deflation. A healthy ABS market should hopefully offer banks a long-term alternative to cheap central bank funding, backed as these instruments are by loans as varied as car loans, mortgages and credit card payments.

It’s pretty clear that the market in Europe is in need of invigoration, having been all but closed for business since the financial crisis. ABS issuance in Europe in 2013 totalled just €183 billion (according to data from the Association for Financial Markets in Europe) compared to €711bn back in 2008. The US market is by contrast in far ruder health, with 2013’s total of 1.5 trillion Euro’s worth of issuance, comfortably surpassing 2008 issuance of the Euro equivalent of 934bn.

2013 issuance as a percentage of 2008 issuance

But – and there is a but – there is a very substantial obstacle currently standing in the ECB’s way. This takes the form of a regulatory barrier – namely, the treatment of securitisation under the latest version of the Solvency II proposal. Under Solvency II, as it stands, insurance companies (a large pre-crisis investor base) have to hold twice as much capital to invest in a five year AAA-rated Dutch RMBS than if they hold a covered bond of the same rating and maturity, backed by similar assets.  For peripheral eurozone issuers the situation is even starker – the capital charge on a five year A+ Spanish RMBS stands at approximately 20%, versus a charge of 7% for a similar covered bond. While this doesn’t apply for asset managers such as ourselves, it presents a very real disincentive for insurers, who must calculate that they can achieve a better return on capital elsewhere.

The idea behind these elevated capital charges is surely to protect balance sheets against the likelihood of default. But a quick look at default data makes for interesting reading. According to a Standard & Poor’s default study, default levels on European RMBS have reached a high of just 1% over the last six years. Yet in the US, where capital charges are more in line with those on corporate bonds, default levels on RMBS have been far higher – up to 28.5% in 2009, and still a little over 10% in 2013. Whilst there is some differentiation between regulatory classifications of ABS securities, in general, US capital charges are significantly lower than in Europe across all instruments.

RMBS default rate

This is a particularly pressing issue on two counts: not only does the ECB hope to kick off its ABS purchase programme in October, but the draft Solvency II legislation is due to be voted on at the end of September. Unless the European Commission moves swiftly to adapt the existing draft regulation, any attempts by the ECB to stimulate the market will likely be in vain. At a minimum, the ECB needs to at least equalise the capital treatment of instruments such as RMBS with that of other asset-backed products such as covered bonds.

After all, without demand from a wider client base than the ECB itself, there will be little incentive for issuers to supply these instruments. In this case, the market will continue to stagnate, and a valuable opportunity to invigorate lending to the real economy will likely be wasted.

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.

matt_russell_100

The power of duration: a contemporary example

In last year’s Panoramic: The Power of Duration, I used the experience of the US bond market in 1994 to examine the impact that duration can have in a time of sharply rising yields. By way of a quick refresher: in 1994, an improving economy spurred the Fed to increase interest rates multiple times, leading to a period that came to be known as the great bond massacre.

I frequently use this example to demonstrate the importance of managing interest rate risk in fixed income markets today. In an investment grade corporate bond fund with no currency positions, yield movements (and hence the fund’s duration) will overshadow moves in credit spreads. In other words you can be the best stock picker in the world but if you get your duration call wrong, all that good work will be undone.

We now have a contemporary example of the effects of higher yields on different fixed income asset classes. In May last year Ben Bernanke, then Chairman of the Fed, gave a speech in which he mentioned that the Bank’s Board of Governors may begin to think about reducing the level of assets it was purchasing each month through its QE programme. From this point until the end of 2013, 10 year US Treasuries and 10 year gilts both sold off by around 100bps.

US UK and German 10 year yields

How did this 1% rise in yields affect fixed income investments? Well, as the chart below shows, it really depended on the inherent duration of each asset class. Using indices as a proxy for the various asset classes, we can see that those with higher durations (represented by the orange bars) performed poorly relative to their short duration corporate counterparts, which actually delivered a positive return (represented by the green bars).

The importance of duration

While this is true for both the US dollar and sterling markets, longer dated European indices didn’t perform as poorly over the period. There’s a simple reason for this – bunds have been decoupling from gilts and Treasuries, due to the increasing likelihood that the eurozone may be looking at its own form of monetary stimulus in the months to come.  As a result, the yield on the 10-year bund rose by only 0.5% in the second half of 2013.

Whatever your view on if, when, and how sharply monetary policy will be tightened, fixed income investors should always be mindful of their exposure to duration at both a bond and fund level.

matt_russell_100

Opportunities in Spanish ABS

As fund managers it’s our job to take risk when and where we are being paid (preferably overpaid) to do so. One area where I feel that this is currently the case is European residential mortgage backed securities (RMBS), particularly Spanish RMBS.

It’s fairly easy to find senior Spanish RMBS trading as much as 100bps wide of equivalent covered bonds at the moment. The collateral in these deals was originated by the same banks as in the covereds, they return the principal over a comparable time horizon, and contain features that will be beneficial to investors if the Spanish housing market begins to weaken again.

The chart below shows this relationship nicely. Here we have plotted (minus the names of the individual bonds) short-dated covered bonds issued by three Spanish banks and what we consider to be similar quality senior RMBS. The pickup I mentioned earlier is clearly evident in the 2.5-5yr maturity/weighted-average life area:

Spanish RMBS blog

The main reason for this discrepancy is regulation. Financial regulators have deemed RMBS to be more risky than covered bonds and they therefore require banks and insurance companies to hold more capital on their balance sheets to compensate.

While I appreciate that covered bonds give investors dual recourse and that covered bond legislation in Spain is strong, I’m not sure how much the extra senior unsecured claim in a failed Spanish bank would actually be worth. Hence in general I prefer to hold a senior note in an RMBS deal where we have good visibility of the collateral, and which includes structural provisions that mean senior note holders potentially get their capital back sooner if the housing market deteriorates.

The ECB apparently takes the same view as the regulators and charges anyone wishing to use RMBS as collateral for repo transactions more than they do for covered bonds. They apply a haircut of 10% to RMBS but only 4.5-6% to covered bonds for investment grade quality instruments, assuming a five to seven year maturity. What I’m really saying is that I disagree with the regulators, and therefore see this as an opportunity to generate a higher return for a similar level of risk.

Interestingly the Bank of England applies the same haircut of 12-15% to both short-dated RMBS and covered bonds. The spread difference exists here too – albeit with both markets trading considerably tighter – which I think shows that it’s the regulation that is really skewing these markets.

I’m not arguing that investing in the Spanish mortgage market is without risk. But I do believe that investors who, like us, don’t repo their bonds or need to hold capital against them can and should take advantage of these kinds of unintended regulatory consequences.

matt_russell_100

Technical support for Euro IG; around 4% of the market set to mature this month

Benjamin Franklin said that death and taxes were the only inevitabilities in life. I’d like to add the discussion of the January effect to his list. Every year I receive at least one piece of commentary telling me that January is always a good month for risk assets (we’re far from innocent ourselves – see here).

Basing investment decisions purely on seasonal anomalies isn’t a particularly reliable investment process and the sensible investor should take other, more robust information into account when making changes to their portfolio.

The improving economic outlook for Europe and the general lack of pessimism should help the European credit market rally this month. So too should the fact that about €64bn worth of investment grade bonds are set to have matured by the end of the month. I think it rather unlikely that we’ll see enough supply to offset the bonds that are maturing. J.P. Morgan recently publishing a research piece pointing out that gross European investment grade issuance has only ever been higher than €64bn a month on four occasions in the past, and all were prior to 2008.

2014-01 matt blog

J.P. Morgan also point out that January has been on average the month when most issuance takes place throughout the year. The primary market has been true to form since 2014 began but it will need to maintain the pace of the roughly €16bn that was issued in the first week of the year to give investors with maturing bonds somewhere to put their cash.

If net issuance turns out to be negative in January it will be a key technical support that could see Euro investment grade spreads continue to tighten further. It will also give us all another nice data point to talk about come next January.

matt_russell_100

A new source of supply in the ABS market

One of the features of the ABS market this year has been the lower levels of primary issuance. That, coupled with increased comfort in the asset class and higher risk/yield appetite has caused spreads to tighten.

Slide1

We have had a few new deals, but 10 months in and new issuance volume is only about half the amount seen in 2012, and just a third of 2011 issuance.

Slide2

What we’ve seen of late, despite the subdued new issuance, is an increase in the number of these securities available in the market. In the not-so-distant past, banks would structure a securitised deal, place some with the market and keep some to pledge to their central bank as collateral for cheap cash.

Now spreads have tightened, and the market feels healthier, some of these issuers are taking the opportunity to wean themselves off the emergency central bank liquidity and are offering the previously retained securities to the public market.

Another dynamic in ABS at the moment is that ratings agency Standard and Poor’s is considering changing its rating methodology for structured securities in the periphery. S&P is considering tightening the six notch universal ratings cap – countries rated AA or above will not be affected, but bonds issued from countries with a rating below AA could be downgraded as they won’t be allowed to be rated as many notches above their sovereign as they were before.

The implication is that securities that get downgraded will become less attractive for banks to pledge as collateral because of the haircuts central banks apply to more risky (lower rated) securities. Our thinking is that southern European issuers will be hit hardest by this change. So unless the ECB loosens its collateral criteria (which it can and has done previously), one would expect to see more of those previously retained deals coming to the market as well.

So whilst we haven’t seen too much in the way of new issuance, it looks like we could be about to see an increasing number of opportunities in the secondary market.

 

matt_russell_100

Long term interest rates – the neglected tool in the monetary policy toolbox

I was recently fortunate enough to see a presentation by Phillip Turner from the Bank for International Settlements (BIS) on a paper he published earlier this year. ‘Benign neglect of the long term interest rate’ is a highly informative and interesting piece. In it he argues that after decades of the market determining long term interest rates the “large scale purchases of government bonds have made the long term interest rate key in the monetary policy debate”, and that a policy framework should be implemented around long term rates.

The use of central bank balance sheets isn’t as novel a concept as one might think when they hear (as I did repeatedly over 4 days of conferences and seminars in conjunction with the IMF/world bank annual meetings) QE described as unconventional monetary policy. In fact Keynes argued that central banks should stand ready to buy and sell government bonds as a means of affecting the price of money (the interest rate) from as early as the 1930s. Furthermore, the Thatcher government engaged in “quantitative tightening” as recently as the early 1980s by issuing more long dated gilts than were required to finance government spending. The rationale was that issuing more gilts would drain liquidity, curtail broad money growth and slow inflation more effectively than just increasing the Bank Rate.

Setting policy for longer term interest rates may be new territory for today’s generation of policy makers however it shouldn’t be for some. It’s often forgotten that the Fed actually has a triple, not dual mandate. Along with maximising employment and promoting stable prices they are also charged with providing moderate long term interest rates.

What constitutes a moderate long term interest rate is a matter for debate but the paper makes clear that adjusting the short term rate is not necessarily an effective measure in influencing the 10yr yield.

Turner argues that it may be more efficient to alter the average maturity of the outstanding government bonds – those not held by the central bank – through open market operations. The BIS has calculated that shortening the average maturity by one year will lead to a 1% reduction in the yield on a 10 year note. Essentially the message is that the longer the average maturity of the outstanding debt the tighter the policy.

The inherent irony of lowering long term rates to stimulate the economy is that it reduces the incentives for banks to perform their socially useful function of maturity transformation – borrowing short and lending long. The lower long term interest rates the less of an incentive banks have to lend further out along the yield curve. The graph below shows that the term premium in the US 10yr has been negative for a large part of this decade.

Negative term premium is a disincentive to lending

However I believe that tougher regulation (larger capital buffers), increased litigation costs and a general de-levering of the economy will restrict the level of bank lending regardless of how steep the yield curve is.

This chart shows the maturity distribution of bonds held by the Fed.

Maturity distribution of Fed Treasury holdings

I’ve calculated that the average maturity of all Treasuries in issue is roughly 6 years, whilst the average of those on the Fed’s balance sheet is about 10 years. Operation Twist was a conscious effort by the fed to lower long run yields and they are still buying bonds at the long end. Given that factors other than the steepness of the yield curve are driving bank lending perhaps the Fed should be buying fewer Treasuries with 7-10 years to maturity in favour of even more longer dated ones. Also if and when they decide to sell their holdings they should consider this (and the on-going) analysis on the wider implications of altering the average maturity of the Treasury free float.

There are plenty of other interesting observations and questions raised in the paper so I recommend reading the whole thing…..especially if your job involves managing a central bank balance sheet.

matt_russell_100

Panoramic: The Power of Duration

The early summer surge in bond yields will have focused the minds of many investors on the allocation of assets in their portfolios, particularly their fixed income holdings.

The largest risk to a domestic currency fixed income portfolio is duration. When investors discuss duration they are more often than not referring to a bond or portfolio’s sensitivity to changes in interest rates. Corporate bonds however also carry credit spread duration – the sensitivity of prices to moves in credit spreads (the market price of default risk).

Exposure to interest rate risk and credit risk should be considered independently within a portfolio. Clearly the desirable proportion of each depends heavily on the economic environment and future expectations of moves in interest rates.

I believe that the US economy and, to a lesser extent, the UK economy are improving and at some point interest rates will begin to move closer to their (significantly higher) long-term averages. We may still be a way off from central banks tightening monetary policy, but they will when they believe their economies are healthy enough to withstand it. Since a healthier economy increases the probability of tightening sooner, and is positive for the corporate sector, one should endeavour to gain exposure to credit risk premiums while limiting exposure to higher future interest rates.

In the latest version of our Panoramic series I examine the US bond market sell-off of 1994 to see what we can learn from the historical experience. Additionally, I analyse the power of duration and its importance to fixed income investors during a bond market sell-off.

matt_russell_100

Higher mortgage delinquencies not necessarily bad for all RMBS

Moody’s, the credit rating agency, published a report a few days ago on the asset backed securities market. One section of the report has attracted some media attention – it details the agency’s thoughts on UK interest-only residential mortgage-backed securities (RMBS).

Moody’s reaches the fairly unsurprising conclusion that when interest rates start rising in the UK delinquencies on interest-only mortgages will pick up. They go on to say that this effect will be greater in the non-conforming sector than in the prime segment of the market. This makes sense, as borrowers who have an impaired credit history usually fall into the non-conforming bucket and are therefore, on average, more likely to have trouble paying their mortgages than those who qualify as prime borrowers.

This isn’t as bad for RMBS deals that are backed by interest-only mortgages as one might think. A large proportion of RMBS deals are structured with features that protect investors in the more senior notes to the detriment of those who own the more junior ones. A variety of trigger levels are usually built into the deals which amongst other things reference delinquencies and credit enhancement. If these triggers are hit, cash flows are diverted to the most senior tranche of notes, bringing forward their maturity date and increasing their yield.

A deal I have been looking at recently is 95% backed by interest-only mortgages and has a trigger when 7.5% or more of the mortgages are more than three months in arrears. Delinquencies are currently much lower than that but if they did breach the 7.5% level the deal would switch from paying pro-rata to sequential. This means that any excess cash that is generated through repossessions or borrowers re-mortgaging will all be paid to the lenders at the top of the stack instead of being shared by all the note holders. An increase in interest rates and delinquencies would in this instance clearly be of benefit to the senior notes.

Another dynamic to be aware of is when the mortgages backing the deal were originated. Mortgages taken out closer to the peak of the credit bubble in 2007 are generally of a lower quality because lending standards were weaker and borrowers generally have less equity in their property. As a result, these mortgagees have less of an incentive to keep paying their mortgage each month.

Holders of junior notes in later vintage deals should definitely be worried by the prospect of higher interest rates in the future. Senior note holders – whilst remaining attentive to movements in the market – should be fairly comfortable with the credit quality of their bonds, even in a climate of higher interest rates.

Page 1 of 41234