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Chinese housing market, not so magic – will the dragon run out of puff?

Posted on 18 January 2013 by Magnus Paterson

‘The ruin of a nation begins in the homes of its people.” – Ashanti proverb

In the last ten years, around the world, we’ve seen a series of housing led credit booms inflict heavy recessions on economies. We seem to be seeing the same thing happening today in parts of China.

Deutsche Bank’s excellent economist Torsten Slok has produced the following graph; which clearly shows how unaffordable house prices are becoming, relative to incomes, in some major Chinese cities.

While property prices in the rest of the world continue to adjust towards more fundamental valuations, China’s credit boom is allowing the opposite to happen.

Current property prices in major Chinese cities are unsustainable. Either they adjust (a bursting of the bubble) or real wages have to catch up (massive inflationary pressure).

The currently inflated dragon is unlikely to survive in its current form.

Government bond returns and “back door” QE policy

Posted on 7 September 2011 by Anthony Doyle

Journalists and financial commentators have been kept very busy this year. Market participants and investors have clamoured for information on debt ceilings, credit ratings, and restructurings. 2011 looks like a year that will go down in history as one of the most volatile on record.

With that in mind, I thought it might be useful to focus on the actual returns within government bond markets over the course of the year. The below chart represents the total return of a 7-10 year bond index compiled by Bloomberg/EFFAS in local currency terms.

We found this analysis very interesting. Looking at the member nations of the EU, the German government bond market has been the top performer with a 10.0% return, followed by Ireland and Austria with 9.1% and 7.4% respectively. Investors in Italian government bonds have made 1.0% , despite a widening in Italian 5 year CDS from 240 to 450 basis points (currently equating to a 30% probability of a default event occurring in the next 5 years).

There are a couple of factors at play here.

Firstly, all returns are local currency. Government bond yields are major drivers of currency, so the above chart could be capturing currency strength or weakness. In order to account for the currency impact, I have re-based the returns to the world’s reserve currency – the US dollar.

We now get a clear picture of a) the US dollar weakness versus most major currencies this year and b) the impact that an increase in risk aversion will have on the returns for government bonds. Clearly, Switzerland and Norway have benefitted from solid appetite for government debt and strengthening currencies versus the USD. Time will tell whether the Swiss National Bank’s intervention in currency markets will be able to be maintained without inflation becoming a concern for the SNB. Though there might be an easier way for the Swiss to benefit from a weak currency – join the euro.

Secondly, European bonds have performed very strongly this year, despite concerns over the ability of governments to fund themselves in capital markets. These returns show that Germany remains a safe haven of choice, despite concerns that it will have to backstop weaker peripheral European nations. This has resulted in Bund yields collapsing, and peripheral European sovereign bonds have benefitted from this (as they are priced off “risk-free” bunds, in a similar way that corporates are). Spreads on peripheral sovereign debt are wide, but absolute yields have fallen.

Finally, there is a big elephant in the room, and Jean-Claude Trichet is riding it. The ECB, through its Securities Markets Programme, spent €13.3bn on sovereign bond purchases last week which brought its total holding of Eurozone government bonds to €188.6bn. Having such a large buyer in the market is obviously keeping yields on European government debt lower than equilibrium levels. The big question that we are trying to digest is just how governments and policymakers can stimulate their economies without further extraordinary monetary policy measures. It looks to us like this has been a jobless recovery, consumers are hiding, and stimulatory fiscal policy can be ruled out due to heavily indebted governments.

Mike referred to QE3 in an earlier blog, and we are starting to think that the odds we might see QE10 in the US are rising. Top of the agenda at the Bank of England’s MPC meeting will be whether it should deploy more QE. As for the ECB, it may well be forced to provide “enhanced credit support” (also known as “backdoor QE” here on the M&G bond desk) for the remainder of 2011.

All UK rate hike bets are off

Posted on 22 June 2011 by Mike Riddell

Pound sterling is the weakest currency in the world today and we’ve seen a pretty big gilt rally, with 10 year gilt yields rallying 7 basis points to 3.1% at the time of writing, the lowest yield in seven months. The trigger was the minutes from the last Monetary Policy Committee meeting, where the crucial sentences were ‘current weakness of demand growth was likely to persist for longer than previously thought’ and ‘further asset purchases might become warranted if the downside risks to medium-term inflation materialised.’

The markets are now pricing in a first rate hike in the UK for August 2012, which is quite incredible if you consider that back in January when I wrote this comment, the markets were pricing in three 0.25% rate hikes this year alone. The chart below shows just how violent things have been, where I’ve taken the market’s rate expectations for the month of August 2012 . Earlier this year the market was almost pricing in five rate hikes, now it’s just one. Anyone who’s been betting on a gilt sell-off or rate hikes will be in a world of pain.

On the subject of pain, and given the rain, we’re having a chuckle about Jim heading off to Glastonbury this afternoon. It turns out that Richard was at Glastonbury in 1983-1985, although he can’t quite remember who he saw or what year it was. I can empathise with what a wet Glastonbury is like, having been to one of the soggiest on record in 1997. Thankfully great music makes you soon forget about the weather though – I was lucky enough to see what’s been voted as the best gig ever, although was unlucky enough to be caught on camera doing a John Redwood, as the BBC kindly reminded me on Friday night when they aired a repeat of the gig (I’m the gormless 17 year old in yellow just after 52 mins).

NS&I Index Linked Certificates – a government subsidy for rich savers

Posted on 16 May 2011 by Jim Leaviss

Get `em while they’re hot. The new National Savings inflation linked certificates were launched on Thursday last week, to great rejoicing on the money pages of the newspapers. And rightly so – these are a gimme. Although the rate of interest (RPI + 0.5%) is lower than on the similar certificates withdrawn 10 months ago (RPI +1%), this is still attractive compared to the market rate for 5 year real yields. With the same government credit risk, the 2016 index-linked gilt yields RPI minus 0.5%, i.e. a 1% lower yield than these retail only certificates. AND the NS&I product is tax free! So for taxpayers the yields are outstanding. With the breakeven inflation rate on the 2016 linker at just 2.9% on an RPI basis, so maybe at 1.9% on a CPI basis, this implies inflation below the Bank of England target level on average over the next 5 years, the absolute level looks good too.

Why is the government offering such an attractive product? It’s giving 50% taxpayers a AAA rated, riskless investment equivalent to nearly 10% at current levels of RPI and about 7% if inflation averages 3% over the period. I can’t even find many junk bonds that pay 10% nowadays. And this is happening whilst the banks and building societies are desperate for retail funding – this is “£2 billion that the private sector won’t be able to raise and lend to first time buyers and homeowners” (says the Building Societies Association).

Well I guess the first reason is that it needs the money. The NS&I has to contribute £14 bn towards funding the deficit this financial year, and this will certainly help. But did the rate need to be so generous, and so far from the market rate? The government has talked about these certificates in terms of helping the poor savers stuck in low yielding bank accounts. But those with savings to benefit from this deal are largely the richest portion of society – many of those will be higher rate taxpayers who have been given a windfall gain. Is this a deliberate subsidy for the rich?

I’d also have thought that the government might have taken the opportunity to move to a CPI+ basis rather than continuing to use RPI. After all, that’s the BoE’s target, and pension funds are being encouraged to move to using CPI for their liabilities too. With the “wedge” between RPI and CPI high, and likely to be about 1% going forward that might have been a smart thing to have done – although there would have been some negative press headline risk in doing so.

I talked to Richard Woolnough about this being a windfall giveaway for the rich – a kind of subsidy from the government. He pointed out that these certificates have been available under the last Labour government too, and we doubted that a subsidy for the rich was their explicit policy. But he also made a good point that there is another government subsidy for rich savers – the deposit protection scheme that allows a huge amount of savings to be guaranteed by HMG if you spread it around the market below the £85,000 ceiling for individual banks. This, like the huge interest on the latest inflation certificates, is a real cost to the taxpayer – as the bailout of Northern Rock showed. Another example of the baby boom generation writing itself generous promises for which the poor youth of today will end up funding?

It’s not 1993-1994 in the government bond markets. Unemployment is still way too high to provoke a Fed hike. But the Bank of England might be on the brink of a policy error…

Posted on 13 January 2011 by Jim Leaviss

Government bonds have been selling off over the past month. Since mid October the 10 year gilt yield has risen from 2.85% to 3.63%, the 10 year bund from 2.25% to 3.00%, and the 10 year US Treasury from 2.40% to 3.40%. The damage has been even greater in peripheral Europe – Spanish 10 year yields are up by nearly 150 bps over that same period. Part of this reflects the return to a “risk on” world, where equity valuations looked compelling as the economic data came in generally stronger than expected, leading to less demand for safe haven assets – especially as those safe haven assets were trading around record low yields. The other important part of the move is about a rise in inflation expectations. This had already started in mid 2010, as commodity price inflation (for example cotton, coffee, energy) had taken off, but the move was exacerbated by the US Fed’s announcement of QE2 in early November. 5 year inflation expectations as derived from TIPS yields have risen from a low of 1.13% at the end of August to 1.95% now. Add to this fears about sovereign creditworthiness (others have now joined us in worrying about the US’s AAA credit rating, and Europe faces its own default crisis) and it is no wonder that bond yields have risen. Might this be a re-run of 1993/1994, when government bonds rallied hard in 1993 before the Fed unexpectedly hiked rates in February 1994, provoking a 200 bps sell off in 10 year Treasury yields?

I went back to look at the economic environment at the time, to see how different it was to today. The thing that surprised me was that inflation had been steadily falling throughout 1993, both on a core and a headline measure. It didn’t start to pick up until the second quarter of 1994, after the Fed had hiked.

The inflation picture is similar now – the starting point is lower, but actual inflation had been coming down throughout 2010, towards record lows on the core measure. So when the Fed hiked in 1994 they were doing so in a falling inflation environment. What is different is the employment situation. In 1993 the unemployment rate was falling decisively, and was at a much lower level than it is today – i.e. the unemployment rate was falling towards 6.5%, with some estimates of full employment at just under 6%. The US currently has an unemployment rate of over 9%, and whilst it may have come off its peak, it is miles away from full employment. In fact some would argue that the unemployment rate is understated at this point thanks to a significant fall in the labour force participation rate, as discouraged workers stop looking for jobs, the young go back into education, and people retire early. Over the past couple of years the participation rate has fallen from 66% to 64.3%, compared with over 66% in `93/`94.

We think the Fed is still massively more worried about the jobs situation than it is about generating inflation. We’ve been following the chart on the left for years – it shows that the Fed’s reaction function means that they wait for unemployment to start falling on a sustained basis before they start to hike. In the last two cycles the lag was a year to twenty months from when the unemployment rate started to fall. You could argue that US unemployment did start to fall towards the end of Q1 last year, which means that the Fed might hike later this year. But in our view the level of unemployment is still way too high, and the fall in the participation rate is too severe. In any case, in the US you can rule out an early 2011 rate hike.

Is that also true in the UK? Unemployment here is sticky too, just below 8% on the ILO measure. And the public sector job cuts are yet to bite. But inflation is very sticky here and the Bank of England has missed its 2% CPI target and been at or above 3% for all of 2010. RPI inflation is at 4.7%! The 2.5% VAT hike will start feeding into retail prices from this month onwards, and utility and petrol prices are rising sharply. The money markets are already pricing in two 0.25% rate hikes in the UK this year, with a small chance that there will be a third rate hike by year end.

Rate hikes would kill core inflation (although remember that mortgage rates are a component of RPI, so that measure of inflation would likely rise with every rate hike) – but they would also be GDP-suicide in this fragile economy, bringing deflation risks back into play. Hopefully the Bank still feels it can target future inflation, and has the confidence to ignore those reacting to current inflation newsflow and calling for imminent rate hikes. But I don’t think that the Bank of England has much breathing room left, and with persistently high current inflation the Bank’s credibility is under attack. I think we’re only one surprisingly robust inflation print away from a UK rate hike. Let the policy errors begin…

Baltic Dry Index indicating grim growth outlook and bond rally

Posted on 10 January 2011 by Mike Riddell

The Baltic Dry Index, a measure of commodity shipping costs, is often used as an indicator of global demand, and it has a pretty good relationship with government bond markets too as we’ve discussed previously. The index has received much publicity over the past few years since it very accurately flagged the carnage of Q4 2008. One of the index’s attractions is that unlike financial markets, it’s not subject to speculation (although of course shipping rates are influenced by their own set of demand and supply factors).

Today the index fell to 1495 points, which is the lowest since April 2009, and the trend is fairly firmly downwards.

How Secure is Secured? The new trend in HY issuance

Posted on 16 November 2010 by Vladimir Jovkovic

Guest contributor Vladimir Jovkovic, Credit Analyst

Issuance in the high yield bond market in Europe this year through October has already exceeded the total issuance for the full year in 2009. The novelty since the reopening of the market in 2009 has been the fact that high yield corporates have been looking to refinance senior secured bank loans into senior secured bonds, rather than the more common unsecured bonds. As such, the proportion of secured bonds issued by high yield companies after the financial crisis has been ~40% of total issuance compared with the more muted 10-15% level before the crisis (see chart).

Part of the reason in the shift has been the recycling of loans associated with LBOs into the bond market as the primary loan market effectively shut down. As banks repair their balance sheets and restrict their lending, the public bond market is stepping in to fill the gap.

The question then arises, how will the relationship between senior secured bondholders and senior secured lenders develop? Will lenders continue to have disproportionate control on enforcement of security? Will senior secured bonds create more stability in the high yield market? The answers to these questions will no doubt emerge with time, but meanwhile and more fundamentally, how secure are secured bonds?

For a start, the ‘Senior Secured’ label is not a panacea for bullet proof security. Often the ‘Secured’ label is in fact misleading once you delve into the documentation. Secured bonds often involve pledging security on physical assets (for example plant and machinery), typically with a limit on the proportion of assets and cash flow derived from the assets covered. This in itself will partially define the security of the bond. However, some secured bonds have a security which consists of equity in subsidiaries of the issuer – for example Polish Television Holding which issued bonds secured by share pledges on its stake in TVN, a broadcaster. This is clearly not as secure as security against physical assets; and, therefore, the question then becomes whether these soft security ‘secured’ bonds are justified to have lower coupons compared with unsecured issues.

Then there is the more contentious issue of relative security in structures that contain secured bonds as well as loans. In the case where senior secured bonds partly refinance existing senior secured loans, whether the new senior secured bonds rank pari passu (equally) with the existing secured loans will depend on whether they share the same position in the capital structure and the extent to which the security package shared is the same. It appears that in recent transactions when existing bank debt is partially refinanced with senior secured bonds the loan holders retain control, whilst when both bonds and loans are refinanced together bondholders have an opportunity to share control.

It is also important to consider the inter-creditor deed, which may determine the loss sharing arrangement between creditors and their effective relative ranking on enforcement. The inter-creditor deed has not always been made available to bondholders, which has made it difficult to ascertain bondholders’ precise rights in an enforcement scenario. For example, the inter-creditor could specify that senior secured bond holders are not part of the instructing group for enforcement proceedings, leaving them in a passive position with respect to controlling negotiations, were a default to happen.

With the rise in issuance of senior secured bonds and their greater enforcement rights compared to the more traditional unsecured bonds, making the inter-creditor available to high yield bonds holders makes sense. It appears, at least for now, with recent high yield issuers such as Exova (testing and advisory services), R&R (ice cream) and Polypipe (pipes for construction) that the tide is shifting in favour of higher disclosure. Greater transparency in the market will carry the benefits of improved liquidity and depth of market as bond holders become better equipped to answer the question ‘How secure is secured?’.

Four handles? Fork handles? Four candles?

Posted on 31 August 2010 by Richard Woolnough

In all financial and commodity markets the big figure (the first part of the price) is referred to as the handle. This allows verbally quicker and more accurate trading (see this classic Two Ronnies sketch) as the handle does not need to be mentioned in every transaction. In the bond markets the handle from a yield perspective is the first big figure, so when the yield on a security is 4.5%, the handle would be 4. The ongoing bull market in the UK means there are currently no conventional gilts outstanding with a yield greater than, and therefore with a handle of, 4.

Like the stock market’s focus on the Dow 10,000 level, bond investors also focus on significant round number levels. The psychology of hitting new lows in yields takes time for the market to get its head round, while the financial implications for issuers and investors can be enormous. The loss of the 4 handle in long dated conventional UK bonds has been replicated by the loss of the 4 , 3, and 2 handles of long dated US, German, and Japanese government bonds respectively over the last three months.

The implications of these new low yields is substantial. For an investor such as a pension fund that is short longer dated liabilities, the funding gap increases, putting it under pressure to buy more bonds at a lower yield and higher price due to the mismatch of assets and liabilities. While for issuers like the government it means they are better able to service their debt, and will need to issue less to meet their funding needs. Thus the psychology of the shift below 4 percent is compounded in favour of bulls versus bears by the realities of market positioning.

Beautiful Game, Ugly Investment

Posted on 17 August 2010 by Stefan Isaacs

Travelling back from Sunday’s draw between Liverpool & Arsenal (it was never a sending off), I noted Liverpool Football Club had again made the business pages for all of the wrong reasons (see here).

The current battle between RBS, the principal creditor to LFC, and its owners Tom Hicks and George Gillett continues to highlight the dangers of utilising leverage to buyout companies in certain industries.

LFC was bought by the American pair for £219 million in 2007, including debt. Back in April of this year, and unable to re-finance the current £237 million of bank debt, Hicks & Gillett effectively defaulted and ceded management control to an independent Martin Broughton, as a condition of that re-financing. According to the Sunday press, a six month re-financing comes due on October 6th, along with a £60m penalty, at which point it is alleged RBS would take control of the club. No doubt potential suitors are well aware of the impending date and are biding their time, hoping to buy the club for the value of its debt alone. The most likely outcome, absent an earlier credible bid, is that RBS will again roll the loan in October, before finally selling the club later this year/early 2011.

So what has gone so spectacularly wrong off the pitch? Clearly the recession of 2008 proved a huge challenge to industry, although football, with a strong global support base actually weathered the storm comparatively well. Liverpool’s problems lie in the unsuitable debt load and subsequent demands placed on the club post the 2007 acquisition.

As potential debt investors in LBOs (see here) (typically through high yield bonds that are issued to help fund the transaction) we favour those industries and companies with stable and recurring cash flows. We also look for hard assets that we can fall back on if things were to go wrong (higher recoveries), as well as an ability to recognise synergies and operational improvements – leading to improving cash flow and profitability.

Sadly for the fans of clubs with spiralling debts, football fails to tick the boxes. The fixed nature of players’ contracts, an ever increasing wage/revenue ratio, and the ongoing pressure to compete with ‘trophy’ signings make the cash flow generation required to service interest costs a real challenge. Deloitte’s Annual Review of Football Finance 2010 (see here) makes interesting reading. Over each of the last three years the wage bills of Premier League clubs have grown in double digit percentage terms. ‘With wages growth outpacing revenue growth in 2008/2009, the Premier League’s wages/revenue ratio increased to 67% – a record high.’ The report goes on ‘[in] a classic example of competitive game theory, clubs are continually driven to maximise wages rather than profitability.’ Despite increasing income streams ‘the vast majority of those revenues will quickly flow into the hands of players and their agents.’ Clearly operational achievements will be massively hampered in any industry operating under said conditions.

Football clubs also tend to be asset-light businesses, with those assets that they do own proving difficult to value. What is Anfield worth if football isn’t being played there for example? How much is Wayne Rooney worth should he break a leg?

Beyond that, how willing or able would a lender be to enforce their rights in an event of default? Indeed, this no doubt partly explains RBS’s previous willingness to afford Liverpool’s owners extra time to find a buyer. Huge reputational issues aside, a punitive administration regime requiring a ten point deduction by the FA makes it a less than palatable option. Finally there is the issue of the super creditors rule, which places players, managers, the FA and other football clubs as preferential creditors in administration. The recent case of Portsmouth demonstrated that under these rules wealthy footballers are made whole ahead of HMRC. (see here)

The current underperformance of the high yield bonds issued by Manchester United in January 2010 (currently trading at 96% of face value to yield 9.6%) despite (sadly) strong performance both on and off the pitch, suggests other investors share our concerns. Whilst certain companies within industries such as cable and healthcare & packaging have proven themselves successful LBO candidates, most football clubs remain a far from attractive proposition for most debt investors.

Speculative thoughts

Posted on 7 April 2010 by Richard Woolnough

Democratic governments are designed and exist to promote and protect the interests of their population. Thus they tend to be described as “good”. Capitalists are seen to be out for themselves and therefore acting in their own selfish interests. They are often described as “bad”. However, in order to have a prosperous society one has to combine the socialism and fairness of democracy with the efficiency and ruthlessness of capitalism.

These two forces come together in the government bond market. On one side is the collective need to borrow to provide for your citizens needs (health, education, defence, etc) and on the other are capitalists who provide the finance for government spending. These capitalists can be described as either investors or speculators.

Investors are generally seen as good capitalists, while speculators are seen as bad capitalists. This line of thinking has once again come to prominence with the market’s attempts to value Greek debt, with holders of the debt who think it is undervalued described as benevolent investors, while economic agents who think the debt is overvalued (expressing their view through credit default swaps) described as devilish speculators.

European governments are now looking to see how they can regulate speculative investors who have used CDS to express a negative view on Greece’s ability to pay its debts. They argue that Greek government bondholders might actually want to see Greece default on its debt due to their holding of CDSs. It has been noted that CDS holders might be incentivised into pushing for Greece to enter default. Additionally – because the CDS market is over-the-counter – there is no way of finding out who the protection buyers and sellers are, adding to uncertainty and volatility in markets. The investment community counters these arguments by saying it should have the right through CDS to promote the efficient allocation of capital.

Putting the various arguments aside, let’s assume the governments win – after all, they regulate the market and can determine what contracts are legal. This banning of CDS would eliminate the tool of CDS for speculators to express a negative view, but would also eliminate the potential for speculators (investors) to express a positive view. If it is seen that the banning of negative CDS trades is a net positive for governments and society then governments could then move a step further and seek to ban the shorting of government bonds physically or through the use of the futures market. If that works then governments could progress to stop the shorting of national currencies as that position is the most aggressive step capitalists can take against a nation state. If that works then governments could stop criticism of their national finances. If that works… I think you know where we would end up!

This is the essential conflict between the state and the individual; are you an individual/speculator who is up to no good, or are you an individual/speculator who challenges the status quo for good? Should CDS on governments be transparent and not abused? Yes. Should it be banned? No. The CDS market should be a fair and level playing field. If governments think that CDS are mispriced then they should take the same response as they do in the FX market i.e. behave responsibly, influence the debate verbally, and then strongly intervene with the only medicine speculative capitalists respect, real money.