Just back from a day trip to Guernsey to visit clients (and now realising that I have a pocket full of non-legal tender coins to dispose of somehow – perhaps I should melt them down for their nickel content, given the 150% rally in that metal’s price over the last year). The Bank had just written its "Dear Gordon" letter after the 3.1% CPI/4.8% RPI
print, and inflation was the topic of the trip. In particular food prices came up time and time again, and they are worth a mention here. A big part of March’s upwards pressure came from food and non-alcoholic drinks, and milk in particular saw big price hikes, with the year on year rate looking huge thanks to aggressive price discounting a year ago. But other seasonal foods were also robust – and more widely people are becoming concerned about the recent rally in "soft" commodities.
It all comes down to the price of oil – in fact an old school friend who is a scientist in East Anglia for a sugar company says that the oil price is the first thing he looks at every day. This is because with petrol prices so high, it pays to convert food crops (corn, sugar beet etc) to ethanol
rather than see it end up in human or animal bellies. You can mix ethanol into petrol at a 5% level and it will work fine in your car, and in Brazil and Mexico many cars can run exclusively on the stuff. In addition large subsidies exist in the USA for ethanol production. So food producers and cattle farmers have to compete with the new ethanol producers and the price of grain has rocketed (causing riots in some poor areas of Latin America). This article from The Independent
is worth a read – it claims that using corn for ethanol production is misguided. It quotes an estimate that corn needs 30% more energy to produce (transport, fertiliser etc) that the fuel it produces, and that the grain needed to fill the tank of a car with ethanol would feed a human for a year. With food having roughly a 10% weighting in the inflation data continued price rises will have a significant impact. Also worth watching is the news of the Australian drought
. The government there is considering turning off the nation’s Murray-Darling basin irrigation system if it doesn’t rain soon. This is home to 55,000 farmers, and it would devastate the nation’s agriculture and send food prices higher. As an aside Prime Minister John Howard doesn’t believe in climate change and didn’t sign the Kyoto Agreement. The last year has been the driest there in 115 years.
For the first time since it was granted independence in 1997, the Bank of England’s Monetary Policy Committee has had to write an open letter to the Chancellor explaining why inflation has breached the government’s target. CPI inflation rose by 3.1%
year-on-year in March, more than 1% away from the 2% level. This was up from 2.8% in February. The drivers of this unexpected increase were food, non-alcoholic drinks, furniture and household goods. The RPI print was even higher, at 4.8%, thanks to rising house prices and mortgage interest payments which are not included in the CPI target. Fortunately the bulk of this year’s pay round – which tends to focus on RPI as a benchmark – has already gone though, at modest levels of increases. Nevertheless today’s numbers make further UK rate rises a certainty, and short dated gilts have sold off heavily this morning.
You can read Governor Mervyn King’s letter to the Chancellor here
, and Gordon Brown’s response here
. In brief, King states that inflation is higher than expected due to domestic energy price hikes, and a weather related global food price hike. However he states that this only explains around half of the problem and that money and credit growth are growing too strongly, and capacity issues are growing – these, to some extent, were within his remit to control, whereas the oil and food prices issues were external shocks. So is he admitting that he should have set tighter policy? No – he talks a lot about lags in policy setting, and about unforeseen volatility in the inflation numbers, as well as other temporary factors. In particular he expects household gas and electricity prices to fall back later this year, bringing inflation back within target. He says that the MPC will assess these inflation numbers at its May meeting (flagging a hike then). His final quote is probably quite reasonable – “when the MPC was set up in 1997, the chances of going almost ten years without an open letter beig triggered seemed negligible”. And the Bank has done a good job – but whereas inflation was consistently below the government’s target in the first half of the decade since independence (under Lord George), it has been stubbonly above it in more recent years.
SLM Corporation, commonly known as Sallie Mae, announced yesterday that it is to be sold to a group of investors led by two private equity houses for $25 billion. The two private equity players will own 50.2% of the business with Bank of America & JP Morgan Chase splitting the balance. The two banks have also agreed to put a whopping $200 billion in backup financing in place over the next five years. So is this just another in a long line of leveraged buyouts seen recently in the US? Well not exactly.
You see Sallie Mae provides government guaranteed and private student loans in the US, which means that it resides in the financials sector. So what you ask? Well, financial companies were considered less likely candidates for an LBO than most other sectors. Infact many considered them almost LBO proof. The thinking goes that the financial business is either too cyclical to support aggressive leverage and/or requires access to cheap funding that is the preserve of a more conservative balance sheet. In other words, people have always believed that financial companies need an investment grade credit rating to do business – ie a minimum of a BBB rating, and usually at least A. However, there are a number of examples within the sector where LBOs have been achieved and we believe that we could potentially see more in the future. Clearly the largest of the banks may yet prove too big to LBO but those finance companies with depressed share prices (pre LBO SLM Corp share price had fallen 12% YTD) will undoubtedly come under ever greater scrutiny from a private equity community with very deep pockets. So far bondholders in financial companies could have been fairly relaxed about the chances of their bonds getting junked (in other words their ratings cut to BB or below) – not any more.
My last housing market note at the end of March discussed how strong mortgage approvals are an excellent predictor of future house price movements. If mortgage approvals are strong, then many people are taking out mortgages. If people are taking out mortgages, then they are looking to buy a house, and if demand for housing increases, house prices do too.
Mortgage approvals data is a good proxy for the demand for housing, but what about the supply of houses on the market? The RICS sales to stocks ratio shows the number of house sales relative to the number of houses advertised by estate agents, and is therefore a good indicator of housing market supply. Data released last week show that the sales to stock ratio has increased to 0.48, a level which has historically led to strong double digit house price growth (click on graph to view). London homeowners saw their properties rise by an average of £76,000 over the past year, 3 times the median London salary – and similar boosts to income have been seen across the UK. Therefore I am less worried than Jim about the erosion of consumers’ incomes from higher taxes and fuel costs. These rising home prices will continue to keep consumption strong.
With both demand and supply measures indicating a strong housing market over the next six months, the pressure is firmly on the MPC to hike rates. The UK bond market has sold off over the past month on strong economic data, and the benchmark 10 year gilt yield has risen to 5.10%, the highest since July 2004. The bond market is now pricing in a 0.25% rate hike next month with about a 70% chance of another 0.25% rate hike by September. If the next rate rise fails to stem the housing market (and hence the economy), then I expect significantly more rate hikes than the market is currently pricing in.
The European Central Bank
(ECB) confirmed on Thursday (as largely expected) that it was leaving its key interest rate unchanged at 3.75%. The statement made by ECB President Jean-Claude Trichet was by and large the same as the one he made in March and as ever the bond market listened intently for certain ‘key’ words that either were or were not present. The rhetoric continues to suggest that the Council has a hiking bias remaining in ‘very close monitoring’ mode, describing the key interest rate as ‘moderate’ and monetary policy as continuing to be on the ‘accommodative side’. The bond market is now pricing in a further hike to 4% in June. As you would expect Trichet was unwilling to be drawn on predicting if or when the ECB would choose to raise rates but he did little to suggest the markets expectations of a June hike were flawed.
Growth in the Eurozone led by Germany remains strong. Real GDP grew at 3.3% in 2006 and the indications are that this strong growth has continued into 2007 despite concerns around the US economy faltering. Corporate profitability as a share of GDP remains high and money expansion remains at levels that appear above the ECB’s level of comfort. German exports remain strong and I believe the consumer could potentially surprise to the upside in 2007. Whilst inflation remains anchored below 2%, we remain worried that wage developments threaten to the upside. The ECB unsurprisingly continue to talk tough; ‘the medium-term outlook for price stability remains subject to upside risk’ and that it remains ‘essential to ensure that risks to price stability over the medium term do not materialise.’ Just as Richard believes the Bank of England will continue to hike in the face of inflationary pressures I believe that the ECB could be forced to go beyond the 4% that the bond market is currently expecting as its peak.
So what does this mean for my fund (the M&G European Corporate Bond Fund)? I have taken the fund shorter duration expecting yields to rise further. Ten year Bund yields have moved from 3.95% at the start of March to 4.23% as I write. This week is likely to be an important one with the US Q1 reporting season getting into full swing. For now I intend to continue to run a short duration position though just like the ECB I’ll be watching the data closely!
We’ve been a bit lazy about posting lately. Sorry. It’s been an interesting time in the bond markets however, with gilt yields rising to 2 1/2 year highs (5.07% for 10 year gilts as I type) and risky assets performing well again after the wobbles of February and March. Rising oil prices aside, the other inflation indicators appear reasonably well behaved, and the Q1 wage round looks like it’s delivered sub-inflation rises (meaning a squeeze on incomes). Recent UK data showed that not only was 2006 the weakest year for over two decades for income growth, but also that the UK saving ratio has slipped below zero. In other words times are becoming increasingly hard for consumers, with 3 mortgage rate hikes since the middle of last year, and higher utility and council tax bills all meaning that people are having to borrow to make ends meet. Given the importance of consumption to our economy (it’s about 2/3rds of our GDP) this is all very bad news. There’s still a good chance that the Bank of England hikes rates again, but I think there’s also a possibility that rates might have to fall back again by the end of 2007 – and that’s not expected by the market. Gilt yields over 5% might look like a very good buy. You’ll also be aware at how closely we’ve been watching the US housing market, and that there are signs that it’s starting to roll over. This short video shows the housing market in the States depicted as a rollercoaster ride. You’ll be bored for the first 2 1/2 minutes, but it’s worth hanging in there for the finale. White knuckle times ahead?
The Financial Times’ main headline today (see here
) was that there were $1130bn of M&A deals over the first three months of this year, the largest ever for a first quarter, and 14% higher than Q1 last year. Private equity accounted for a large chunk (the $45bn proposed LBO of TXU was included in the figures). As we have regularly stated on this blog (such as here
), leveraged buyouts are getting larger – private equity groups raised around €100bn in Europe last year, which translates into €500bn to spend on takeovers once this is leveraged up five times. This money will be spent, since private equity companies do not earn any fees until the companies are taken over.
Within the M&G Optimal Income Fund
, I have expressed my view on rising LBO activity by buying protection on the iTraxx HIVOL index, which contains the 30 most volatile CDS names (see here
for more information on iTraxx indices). All CDS within the HIVOL index are investment grade companies and the list is updated every six months. As you’d expect, the vast majority of the companies with the most volatile CDS are those that are subject to takeover speculation, and particularly those that are seen as LBO targets. This can be seen by looking down the names on the HIVOL index – BT, Cadbury Schweppes, Compass Group, Continental, GKN, ICI, Kingfisher, M&S, Pearson, Telecom Italia and Vivendi are all rumoured to be takeover targets. If any of the index constituents are bought via LBO then the index spread would be expected to widen out.
Net mortgage lending last month was £10.3bn, only a fraction below the record of £10.304bn set last December. Net mortgage lending has only ever exceeded £10bn three times, and all three have taken place in the past fivemonths. The number of new mortgage approvals was also relatively strong, with the figure of 119,000 slightly higher than expected. As I have previously argued (see here
), mortgage approvals are a fantastic indicator of future house price movements, and the strong mortgage data over the past few months reinforces my view that UK rates need to rise at least once more.
The housing market is the key transmission mechanism between Bank of England interest rates and the wider economy. When the UK economy is weak, UK interest rates are cut in order to reduce the cost of borrowing. Cheap borrowing costs encourage consumers to spend more, and the biggest beneficiary is the housing market. A strong housing market generates awealth effect, resulting in strong economic growth. Eddie George was recently accused by the press of deliberately fuelling
the consumer boom, but this is precisely how the Bank of England uses monetary policy to manage the economy through the economic cycle.
When the housing market (and hence the economy) is growing fast, rates are hiked. In the late 1980s the Bank of England was a little too aggressive -it doubled interest rates from 7.5% in 1988 to 15% in 1989 in an effort to slow the housing market and subdue inflation, but the result was recession and a housing market crash.
The economy today is in a much better shape than in 1989, but the issues facing it are similar. The Bank of England has kept interest rates too low for too long, as shown by a UK housing market that’s growing by around 10%per annum. Inflation is pushing the 3% upper limit, and the Bank of England has no choice but to hike rates in order to put the brakes on the housing market and dampen economic growth. It may even have to riskrecession to do this.
In my catch up reading from holiday (Argentina – stunning and very very cheap!), I noticed that World Directories, a European telephone directory company, has re-financed its euro-denominated leverage loan to be ‘covenant-lite’. Covenants are very important for us as bond investors. This is because they impose restrictions on a company’s management by preventing management from undertaking activity that would not be considered bond-friendly. If a company violates covenants, bondholders have the power to restructure the company, impose additional covenants or even initiate bankruptcy proceedings. The trend towards covenant-lite issues in the leveraged loan market (where loans are being issued with weaker covenants akin to those seen in the high yield corporate bond market) is therefore grounds for concern for leveraged loan investors.
Leveraged loans have traditionally had strict covenants called ‘maintenance covenants’. These are covenants that issuers must comply with on a regular basis. These covenants vary from issue to issue, but may include limiting capital expenditure to a certain level, or preventing the issuer from breaching certain financial ratios.
‘Covenant-lite’ issues drop the maintenance covenants in favour of ‘incurrence covenants’. These covenants only refer to pre-determined events, such as the firm taking on additional debt or engaging in takeover activity. Incurrence covenants are more typical in the high yield corporate bond market – so when Apax (a private equity company) bought Travelex via leveraged buyout in 2005, Apax had to buy Travelex high yield bonds back above par value.
As the chart to the left illustrates (click to view full chart), covenant-lite issuance is a growing trend in the US leveraged loan market – there was more covenant-lite issuance in the first two months of this year than in the previous ten years put together.
I expect the rise in covenant-lite issuance to result in marginally lower default rates, since there will be fewer covenants to break and bond holders will not be able to force bankruptcy so easily. However, I would also anticipate lower recovery rates, because once companies do go bankrupt, there will be less left for bondholders. Covenant-lite issuance is a good example of how leveraged loan issuers are taking advantage of the huge demand for the asset class. This is because they are now able to issue loans with weaker covenants, but with very little additional spread.
Both Jim & I have previously commented upon the US housing market woes and the sub prime lending concerns that have arisen in recent months. This week’s Economist magazine highlights the ‘growing enthusiasm for subprime lending in Britain’ better known as "non-conforming" or "adverse credit" (those interested can subscribe and read the article here
) and asks the question whether we are setting ourselves up for the same problems that US lenders are currently facing?
In a somewhat timely manner the article in The Economist points to a recent sale of bonds secured upon a pool of mortgages issued by the Kensington Group
(the British mortgage group specialising in lending to those individuals with impaired credit profiles). The article points to demand outstripping supply in the bond markets, the relatively low premium demanded by such investors whilst at the same time witnessing a very precarious situation in the US. A mere matter of hours after reading the article on Friday my attention was brought to the 23% fall in Kensington’s share price on the back of a profits warning and the resignation of its CEO John Maltby. The bonds have also suffered but as you’d imagine to a lesser degree than the equity.
Clearly we aren’t in any immediate danger of finding ourselves in a US type scenario. Structural differences between the two property markets mean that UK borrowers remain in a position to re-finance and avoid defaulting on their obligations – house prices in the UK continue to rise strongly, in contrast to the recent US experience. However, the article, along with press reports over the weekend of a 102 year old pensioner being granted a £200k (interest only) buy to let mortgage do highlight the need to keep a close eye on loose lending standards on this side of the Pond too.