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Tuesday 19 March 2024
One of the latest fixed income innovations are CPDOs, which stands for “Constant Proportion Debt Obligation” – a bit of a mouthful I know. These new products are causing a stir because credit rating agencies such as Moody’s and Fitch have assigned CPDOs with AAA ratings, which is remarkable considering that they offer a yield of 1.5% to 2% above interest rates. So is there really such thing as a free lunch after all?

 

A CPDO is a structured product based upon an investment grade corporate bond index, and has a maturity of about ten years. The attractive yield is generated by doing clever things with Credit Default Swaps and using a very large amount of leverage (8-12 times).

What are the risks? The big danger is that there are a large number of defaults in the investment grade bond market. It is, however, very rare for an investment grade bond to default immediately – in almost all cases, companies that default are high yield companies that have been in distress for a considerable period of time. Indeed, it would require an unprecedented incidence of investment grade defaults for investors in CPDOs to lose their original investment, which is why the ratings agencies have given CPDOs an AAA rating.

The current low yield, low default environment makes these products attractive, and institutional investors are expressing a keen interest. The complexity of these products means it will be quite a while until the regulatory authorities allow retail investors access, but encouragingly, things are definitely moving in the right direction. The new “wider powers” regulations allow retail investors to buy funds that use derivatives such as Credit Default Swaps, so it’s not an impossible leap for retail investors to have the option of investing in CPDOs in the not too distant future.

Today, the pound strengthened for the 10th day in a row, climbing to 1.96 against the dollar, the highest level since September 1992 (when the UK currency was ejected from the ERM). When I started in the City in 1985, the exchange rate stood at 1.05$/£, and if it breaks 2 $/£ it’ll be at the strongest level since 1981. What’s going on?

 

In one word, “globalisation”. American consumers make UK consumers look tight with their money, with huge sums of money flowing from the pockets of American citizens into the pockets of businessmen in Asia. The trade deficit is enormous, standing at just under 6% of total US GDP. This outflow is the main reason why the dollar has weakened by so much.

What do Asian countries do with their money? They save a lot of it, and because many Asian financial markets aren’t particularly developed, a large proportion finds its way into the US equity and bond markets, pushing up stock prices, pushing down bond yields and supporting the dollar.

I believe the dollar will continue its decline over the long term. Global currency markets are constantly adjusting, reflecting changes in the flow of money to and from countries. Asian financial markets are developing rapidly, particularly in Shanghai, where the Chinese government is aiming to build a financial centre to rival New York and London. As Asian investors put more money into their own markets, and less into the US, the dollar will have to depreciate as demand for US dollar assets falls.

US dollar depreciation will prompt investors to diversify their currency risk away from the greenback. Indeed, this is already happening – oil is no longer denominated purely in dollars, but in euros too. US foreign policy is a major grievance for the Middle East, and Iran is threatening to trade oil solely in euros. Meanwhile, Russia and China, two countries accumulating large foreign currency reserves, are not exactly famous for their support of Uncle Sam, so it would be no surprise if they went down the same path.

The early stages of globalisation led to rising demand for US dollars. But the next stage of this process could well mean that it is only a matter of time until the US dollar is not the only de facto reserve currency for the world’s central banks.

I was in Chicago on business on Friday. Up at 5am with jetlag I was able to take my time reading the Chicago Sun-Times. Two articles in there caught my eye.
First was news of the death of Chicago’s own Milton Friedman. Friedman was the ultimate free market economist, arguing for an individual’s freedom to buy heroin, and against the necessity of having licensed doctors (the market would determine which were good doctors or not, and at a lower cost than a regulated medical system!). His economic thinking became prevalent during the Reagan and Thatcher years of the 1980s – and his monetarist views informed the importance of targeting of the money supply during this period as a way of fighting inflation. The second article that interested me was a half page feature on the Chicago property market, where there is a definite weakening in demand. Unsold houses are increasingly going to auction. Two houses in the West Pratt area had been up for sale for over a year, and eventually sold at auction in the low $600,000s, having been on the market for $899,000. More weak official housing numbers from the US on Friday reinforced the fact that there appears to be a significant slump taking place over there. Have US rates peaked at 5.25%?

Private equity continues to be in the news with ever bigger deals. Freescale, a semiconductor business, yesterday priced almost $6bn of High Yield bonds (the largest deal ever) to help finance the $19bn acquisition. The group of private equity firms wrote an equity cheque for $7bn which demonstrates just how much money they have been raising if they can invest that amount on one deal. Will it continue?

In a word, yes. Private equity has continued to raise cash and only earns a fee when it is invested. They can take advantage of the liquidity in the loan and bond markets to arbitrage the fact that bond yields are lower than earnings yields.

A new report by rating agency Fitch (“UK Banks – Managing the Consumer Debt Burden”) suggests that although results for the banking sector in the second half of 2006 and into 2007 will be good, things will become increasingly difficult thereafter.

Further increases in personal bankruptcies and IVAs, together with a higher unemployment rate and interest rates will lead to those banks who have been aggressive lenders suffering higher losses on their loan books. They do point out however that banks’ profitability is so good at present that even a fairly sharp increase in consumer debt defaults would not cause them significant problems. Fitch estimates that UK interest rates would have to rise by a massive 3%, to 8%, before we saw the levels of consumer distress that we experienced in the early 1990s. However they also point out that UK banking sector credit ratings are already at a high level, and ratings upgrades are therefore unlikely. Our corporate bond funds are generally overweight in the financial sector – but we have continued to avoid those banks and building societies with aggressive consumer debt books.

The Bank of England’s Inflation Report was less hawkish on the future path of inflation than we’d expected. The Bank’s targeted measure of inflation is forecast to return to its 2% target level by the middle of 2007, rather than 2008 as predicted in August’s Inflation Report. Given these projections are based on the market’s interest rate forecast (currently around 5.1% for 2021/12), this could imply that no more rate hikes are necessary during this cycle. Why the change since August?

Rising unemployment might be one reason, but perhaps most important was yesterday’s low inflation print. The market had expected CPI to rise by +2.6% year on year. In fact it came in at +2.4%, with weakness in the prices of furniture, fuel prices, clothing and electrical goods. The biggest shock was that the expected huge hike in university tuition fees failed to materialise. This should have added 0.3% to CPI, but only added 0.12%. Apparently the statisticians had not realised that postgraduate fees were only going up by 4%, rather than the 50% hike seen for the poor undergraduates, and this explains the surprise!

So nearly a week since the US midterm elections, and neither bond nor equity markets have seen significant moves. Is that right? After all, while we had all expected the Democrats to make gains, winning both houses of Congress was a bit of a surprise. The departure of Rumsfeld, and Bush’s acknowledgment that he could use suggestions as to what to do about Iraq were also not expected. So we have a weakened President for the remainder of his term, and a resurgent Democratic party. But what is there to worry about?

Perhaps nothing, but some of the Democratic rhetoric has suggested that the long period of increasing trade liberalisation and globalisation we have enjoyed might be under threat. “Putting Americans First” was a campaign slogan – this means punishing companies that outsource American jobs, and standing in the way of new trade agreements that open up global markets. The Financial Times this weekend suggested that Bush will now find it “virtually impossible” to reopen the Doha world trade talks next year. Globalisation has been a major force in driving global growth rates to record levels, and in keeping inflation low. We should be very alert as bond fund managers that protectionism does not reassert itself as a popular concept – it could cause collapses in growth, blips in both inflation and deflation, and, history shows us, wars.

Goodhart’s law states that once you start targeting a certain statistic in the course of economic policy, the relationship between that statistic and the economy breaks down. Charles Goodhart was a Bank of England advisor, and the law gained publicity during the 1980s attempts by the Conservative government to target the monetary aggregates (broad money (M4 – money in bank accounts and circulation), and narrow money (M0 – notes and coins and money in circulation)) as a method of controlling the UK’s inflation problem. Whilst targeting the amount of money flowing around the economy has become unfashionable over the past decade – partly because inflation was falling steadily even though the money supply stayed strong – there are signs that monetarism might again have its time in the sun.

The statement accompanying last week’s Bank of England rate hike highlighted the fact that “credit and broad money growth remains rapid”. And the European Central Bank is stressing that even with core inflation there below its 2% target, rates will still rise because of the strength of the M3 measure of monetary growth. It looks like the only dissenter is the US Federal Reserve. Ben Bernanke, the Fed Chairman, suggested that it would be “unwise in a US context” to place too much emphasis on these statistics, going on to say that “the rapid pace of financial innovation in the US has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables”. In other words, the ever changing nature of “moneyness” means that setting interest rates purely on the basis of monetary statistics would be a mistake. But the fact that we’re having the debate again, at a time when money supply growth is so strong, makes me suspect that global rates go up again, before they can come down.

One of the biggest drivers of corporate bond returns over recent years has been demand for long dated assets by company pension schemes in order to match retirement liabilities. We think this trend will continue, not least because the length of time we are expected to live after we retire is increasing rapidly.

John Ralfe, the pensions consultant who famously switched the Boots pension fund entirely into bonds, said last week that BT is underestimating its pension fund liabilities by £3bn, simply because it expects its pensioners to die at 83.3 years of age, whereas the more conservative Royal Mail pension fund is using a life expectancy of 86 years. The US Census Bureau forecasts that there will be 5.3 million Americans over the age of 100 by the start of the next century – all consuming pensions and increasingly expensive healthcare. Bad news for pension funds, but also bad news for our children’s generation who will bear a massively increased tax burden in order to support the ageing population. I wonder if certain company finance directors read the scare stories about a future bird flu epidemic with interest, rather than fear. For the record, the Bible says that Methuselah lived to be 969.

Roger Bootle famously “called” the decade long fall in global inflation in his 1996 book “The Death of Inflation”. He predicted that globalisation would mean that an individual country could have low levels of unemployment without that generating inflation, as companies would outsource manufacturing (and increasingly services too) to cheaper labour countries.

Previously the academic model (The Philips Curve) had predicted that a fall in unemployment would lead to a rise in prices as a scarcity of labour meant that wages would increase. It’s interesting therefore that in a speech last week Bootle raised the prospect of stagflation in the global economy, suggesting that just as falling unemployment no longer generates inflation, rising unemployment, such as we have in the UK now, might not lead to falling inflation. We could end up with slower growth and higher inflation. We do expect growth to slow in the UK in 2007, as the over-indebted consumer stays home from the shops, and as government spending cuts come through. However, as long as the Bank of England continues to talk tough about fighting inflation they can control inflationary expectations and prevent Bootle’s theoretical nightmare scenario.

Month: November 2006

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