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.


What is the probability of a U.S. recession in the next 12 months?

Knowing how poor the central banks have been at forecasting economic indicators, and having analysed the IMF’s wild forecasts, we think that it makes sense to take consensus views with a large grain of salt. However, there is a substantial body of empirical evidence that has emerged since the 1980s that suggests that the bond market is a pretty good predictor of real economic activity.

It has been proven that the slope of the yield curve has had a consistent negative relationship with economic activity in the U.S., with a lead time of around 1-1.5 years. By analysing the difference between 10-year and 3-month Treasury rates (also known as the treasury yield-curve spread), it is possible to calculate the probability of a recession in the U.S. in the coming 12 months. The theory goes that a monetary tightening will increase short-term rates, resulting in a flat (or inverted) yield curve as the economy slows and demand for credit falls. Additionally, inflation expectations may also fall at this time.

Research has shown that the yield curve has predicted essentially every U.S. recession since 1950 with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. This is shown in the chart below. There is also evidence that the predictive relationships exist in other countries, such as Germany and the United Kingdom.

The yield curve is a good recession predictor

Having established the predictive power of the yield curve, economists naturally wanted to assess what the yield curve was telling us about the probability of recession going forward. In 1996, economists from the Federal Reserve Bank of New York estimated the likelihood of recession based on the yield-curve spread.

Helpfully, the Federal Reserve Bank of New York updates its research on a regular basis. So what probability of recession in the next 12 months is the bond market currently pricing in? The answer is 5.38% to be precise (this is probably lower than it should be due to the Fed embarking on a record amount of quantitative easing).

5.38% chance of U.S. recession in the coming 12 months

Some economists swear by the predictive power of the yield curve. Others argue the yield curve has lost some of it predictive power due to other factors that are driving the longer end of the yield curve; such as quantitative easing, currency pegs to the U.S. dollar, and regulations. However, the simple rule of thumb that the difference between ten-year and three-month Treasury rates turns negative in advance of recessions is still reliable, with negative values observed before the 1990-1991, 2001 and 2008 recessions. Perhaps Alan Greenspan’s “conundrum” of low long-term interest rates wasn’t due to what Ben Bernanke termed as a “global savings glut”. Rather, the yield curve was telling us that the chances of recession were rising, and this is reflected in the increase in the probability of recession from 4.5% in January 2006 to 38% in January 2008.

The yield curve remains a great tool for investors. Its power to predict recessions cannot be ignored, so beware if it inverts again.

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Another year over – 2012 returns in fixed income markets

It’s been another massive year for the global economy. Europe saw LTROs, Greece got a haircut, sovereign downgrades and record high unemployment rates. The peripheral European nations attempted to implement austerity measures with limited success. The US re-elected President Obama and the focus quickly shifted to the upcoming fiscal cliff. In the UK, an Olympics induced bounce in growth was the sole bright spark for an economy which appears to be stuck in quick sand and may well lose its prized AAA rating in 2013.

The IMF, being unusually succinct, probably summed up the state of the global economy the best by entitling their latest World Economic Outlook “Coping with High Debt and Sluggish Growth”. The advanced economies account for around two-thirds of global GDP and if they are sluggish then global growth will be sluggish too.

With all this uncertainty and risk in 2012, how have fixed income markets performed? Surely government bonds will be the safe haven of choice?

In absolute and local currency terms, it’s been another great year for the markets with everything generating a positive return except UK linkers. It’s been a fall in grace for UK linkers, which were actually one of the best returning asset classes of 2011. The UK linker market was buffeted in 2012 by weak growth expectations and uncertainty surrounding proposed changes to the RPI calculation.

But looking elsewhere, investors had the opportunity to secure some excellent returns in 2012 by taking some risk. The best performing asset class of our sample was European subordinated financial debt which registered a return of 29.5%. European high yield wasn’t far behind with a return of 27.1%, followed by Sterling banks which returned 23.0%.

ECB President Mario Draghi and the ECB’s measures to support the Eurozone also had a positive effect of debt investors in peripheral Eurozone debt, with an index made up of bonds from Greece, Ireland, Italy, Portugal and Spain government bonds up 18.7%. Not a bad return for investors considering the question marks hanging over the ability of these nations to service their respective debt obligations in an environment of political uncertainty and recessionary levels of growth.

Other highlights include global high yield (up 18.7%), European peripheral financials (up 17.0%) and US high yield (up 15.6%). At the less risky end of the spectrum, European investment grade corporates returned 12.8% and US investment grade corporates returned 10.2%. Emerging market debt also did well, with EM sovereigns debt posting a fantastic return of 21.4%.

The dash for trash – YTD total returns in fixed income

As outlined earlier, it appears that the global economy faces some substantial fundamental headwinds. So how was it that the riskiest asset classes in fixed income have performed the best? Three little words – “whatever it takes”. Mario Draghi’s speech in late July supercharged returns for the riskiest asset classes and stimulated the “dash for trash”. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

Well Mr Draghi, the markets have certainly believed you. For example, an index of government debt issued by Greece, Ireland, Italy, Spain and Portugal had up until the speech date generated a return of around 5%. The index ended up generating a 17% return, with investors comforted by Mr Draghi’s comments.

Super Mario to the rescue

It seems to us that the Ostrich effect (the avoidance of apparently risky financial situations by pretending they do not exist) had a significant impact on markets in 2012. And in a world of ultra-low interest rates and negative real returns in cash, investors must take on risk. It is precisely what central banks are encouraging us to do. But uncertainty breeds volatility and in order to generate higher returns investors must face this volatility head on. It will be a feature of the market in 2013.

About the only thing we can say for certain is that it is unlikely that fixed income will continue to generate excellent returns across the spectrum from government bonds to high yield. For example, double-digit returns in European investment grade are not normal and has occurred only three times in the last seventeen years. On the other hand, the asset class has posted a negative return in only two of those seventeen years, with the largest loss being -3.3% in 2008. In US high yield, the consensus amongst analysts is that high yield markets will generate a return of around 4-6%, the result of coupon clipping. Analysing returns for the asset class shows that a coupon-clipping year has occurred only once in the past twenty-five years.

We posted our bond market outlook last week. It looks like the US may experience a housing induced growth spurt, Europe will eventually get round to dealing with its issues and the UK has a long way to go to secure economic growth. We like non-financial corporates, are worried about EM debt valuations and remain confident that there are still attractive investment opportunities in several areas of the fixed income universe. For an expansion of these views and more, please see here.


Jim’s outlook for 2013. Eurozone volatility, poor emerging market debt valuations and a sterling collapse. Merry Christmas!

It may not have felt like it, but 2012 has actually been a pretty good year for investors. Bond holders in particular have had a decent 12 months: the government bond bull run has continued and investment grade and high yield corporate debt appears on track to deliver some excellent returns. Major equity markets also look likely to end the year in the black.

These broad-based gains on global stock and bond markets have occurred against a still challenging macroeconomic backdrop. In fact, looking back at our last annual outlook, many of the things we were worried about then – “double dips” and rising indebtedness in developed countries and the risk of a significant policy error worldwide – have not only remained unresolved but have become, in some cases, more of a concern. But it’s not all bad news and we’re pleased to note pockets of progress in some parts of the world.

So what does 2013 have in store for financial markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And remember, there are still a couple of days left to enter the M&G Bond Vigilantes Christmas quiz for 2012.



The centaurs are back! Hybrid bond issuance in the news again

Hybrid bond issuance has started to grab headlines again. The last month has seen a few companies start to issue the centaurs of the bond world again. But are they a good investment?

We wrote about hybrid bonds back in April, suggesting that they could potentially be a good source of alpha if investors do their homework. Hybrid securities have features of both equities and bonds, and like equity they don’t mature (although some do have call features) but pay a coupon like a bond.  The legal language, bond covenants, incentives for the company to call the hybrid and rights of the bondholder in the event of a default can differ considerably from issue to issue.

Hybrid bonds are treated as debt for tax purposes, and depending on the individual structure can be treated as equity by credit rating agencies. Because the rating agencies give credit to hybrid deals for their equity features, they do not put downward pressure on a company’s credit rating like all-debt deals can. Ratings agencies like them because should a company get into financial difficulty, it could choose to simply not call the debt or stop paying coupons to hybrid bondholders. This is attractive for the issuer but if the coupon gets deferred what investor would want to hold a zero coupon bond in perpetuity?

On Monday RWE – a German utility – issued a hybrid bond at B+322bps which is a yield of 4.7%. 5yr CDS for RWE (a rough proxy for what it would cost them to issue senior 5yr paper) was trading around the 65bps mark. Not a bad yield pick-up for an investor, and the credit rating companies are happy as well. This brings us onto the potential upside for the bond investor. If you pick the right company and the right hybrid bond, you may be rewarded with an attractive yield relative to senior bonds that have been issued by the company.  

But perhaps hybrids aren’t quite the panacea they are made out to be. Are investors better off simply investing in a company’s equity and participating in potentially unlimited upside from the share price going up?

Traditionally it has been financial firms at the forefront of issuing hybrid bonds, but the uncertainty of the regulatory outlook at present has all but halted issuance from this part of the capital structure. On September 12th the Basel Committee announced that any newly issued hybrids will not receive any capital credit from financial regulators. As some of you may be aware, a rally in tier 1 and tier 2 securities has followed – the overriding sentiment in the market was that banks would start calling these instruments at the earliest possible opportunity.

So the centaurs are coming back – but be careful which horse you choose to ride as you may get bucked off.