Tag Archives: bonds

A Trillion Here, A Trillion There, Pretty Soon You’re Talking About Real Money

What a way to start out the week:

The European Central Bank, the Bank of England and the International Monetary Fund have all recently warned of a looming crunch, especially in Europe, where banks have enough trouble raising money as it is.

Their concern is that banks hungry for refinancing will compete with governments — which also must roll over huge sums — for the bond market’s favor. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.

via Crisis Awaits World’s Banks as Trillions Come Due – NYTimes.com.

Wow.  I didn’t know I could get a S**t Sandwich special first thing on a Monday…

And in case that wasn’t enough, they threw in a menacing chart for emphasis:

And just in case you still didn’t get the message, there’s this quote from the article:

“There is a cliff we are racing toward — it’s huge,” said Richard Barwell, an economist at Royal Bank of Scotland and formerly a senior economist at the Bank of England, Britain’s central bank. “No one seems to be talking about it that much.” But, he added, “it’s of first-order importance for lending and output.”

And so this is where I roll out one of those Minsky charts that illustrates this.  Oh, wait:

But why all the fuss over banks being able to roll the debt over?  Forget the amount for a second.  The key is to look at the average maturity:

A study in November by Moody’s Investors Service found that new bond issues by banks during the past five years matured in an average of 4.7 years — the shortest average in 30 years.

Now why does that matter?  It matters because there’s this issue called a maturity mismatch, where the assets and liabilities have different maturities.  Usually the assets are longer dated than the liabilities because when a yield curve is upward-sloping like this (from the FT)…

The incentive is to borrow short-dated funds and lend on long-dated assets.  I’ve covered this in similar ways before talking about duration hedging in the past where you measure sensitivities to interest rate moves, and this follows in a related vein.  When the yield curve inverts, or you have rate shocks at the front-end of the curve, you can find yourself in a precarious position if you have a lot of paper to roll.  Which is exactly where a lot of banks are finding themselves now.

But take a look at this section from the article (emphasis mine):

The financing crunch has its origins in a worldwide trend for banks to borrow money for shorter periods.

The practice of short-term borrowing and long-term lending contributed to the near-collapse of the world financial system in late 2008 when short-term financing dried up. Banks suddenly found themselves starved for cash, and some would have collapsed without central bank support.

Government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and banks issued bonds to match.

So the maturity mismatch issue played a huge role in getting us into this mess, and the government’s response may very well end up in exacerbating the problem.

Brilliant… I might as well go build a house and then torch it myself…

And Tim Backshall has a very interesting chart that shows the spreads between senior bank debt and sovereign are highly correlated and compressing.  That means the lines between sovereign and bank debt in Europe are getting blurrier:

One other facet about this problem: the link between external bank funding and Euro Libor:

Bond issuance by financial institutions in Europe plunged to $10.7 billion in May, compared with $106 billion in January and $95 billion in May 2009, according to Dealogic, a data provider. New issues have recovered somewhat since, to $42 billion in June and $19 billion so far in July.

My take: proof positive that the funding crisis for European banks is ongoing and getting worse.  How so?  Simple.  Longer dated bond issuance has fallen, which has led to a change in the maturity profiles of European bank liabilities.

Because the banks are rolling into shorter-dated Libor based funding…

Which has lead to the run-up in the Euro…

One way to mitigate this risk is matched maturity funds transfer pricing – where the asset side of the balance sheet has the same maturity profile your liabilities has.  I’m going to leave you with this paper which I also posted on Scribd:

And a link to this post by Don van Deventer at Kamakura, that has some really good ideas on how to implement funds transfer pricing effectively.


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What to Do With All That Cash…

This is an extension of some discussions I’ve been having and some blogs I had recently written on inflation and bonds.  Because as you think about inflation and investment returns, you inevitably come to a point where the discussion turns to the cash on corporate balance sheets.  I was going to put up some charts based on the Federal Reserve’s Flow of Funds data but thanks to Google, the Trader’s Narrative and the good folks at the Financial Times, I don’t have to (click here for the video).  But let’s take a look at some of these charts to tee this up:

Indeed, this view shows there’s a record amount of cash available. But when you look at it on a debt-adjusted basis…

Not so massive a pile now, is it?

Share buybacks seem to be the most obvious use of the excess cash at the moment.  And with good reason.  The prospects for future growth don’t look particularly good at the moment.  So if you were going to do fundamental analysis of equities right now via a dividend discounting model (let’s use the Gordon Growth Model as an example):

Your denominator gets larger as the spread between required rates of return and growth rates expand.  And as a result, the valuation for the stock is lower. If this sounds like a bearish case based on fundamental analysis, it is.  How do you boost the price in this event?  Simple: demand a lower rate of return.  Good luck in getting your investors to go along with that.

But let’s try to take this train of thought and think strategically.  If you’re a corporate Treasurer or CFO and view the economy and your business the same way, that means you would be expecting P/E multiple compression: prices fall while earnings level off and growth rates turn anemic.  All of which leads to an interesting question: why do a buyback now if you can get more bang for the buck later?  The case could be made for saving some dry powder.

As always, feel free to leave a well-reasoned, on point comment.


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On Inflation and Bonds… in < 140 Characters

Today I saw an interesting tweet from Jennifer Ablan:

And based on a daily move like this…

you get the impression there’s a divergence.  Stocks have a gangbuster move to the upside while bond yields have been moving lower.  Is Goldilocks appearing again?  Hardly.

But I had a response for her:

Yes, I cited Japan as the example.  But I don’t think they’re going to be alone.  Indeed, there are a couple of ways to look at inflation.  One is just prices paid and you can use the Consumer Price Index or the Personal Consumption Expenditure index.  Well, by either measure, they’re headed lower:

PCE hasn’t fallen the way CPI has but they are both still going lower.  Why?  Because as Steve Keen demonstrated with his Minsky-based approach, aggregate demand is falling because private debt is collapsing and unemployment is rising:

And the 2/10 spread has responded in kind:

One point I’d make is that when you step back and see what’s going on in bonds, unemployment, inflation and debt is there could be a new feedback loop between these things that has taken root.  I don’t know the mechanics of it, but I’d say there’s a link between these phenomena going on.

And it isn’t pretty.  Just ask the Japanese how well things turned out for them the last 20 years…


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The 6.30 Libor Earthquake, Aftershocks and Tsunamis

First, let’s update our Dollar/Euro Libor spread chart.  That’s the one that really matters now because looking at the Libor curves in isolation won’t help us understand what’s going on:

Across all maturities, we saw rates increase about 1bp from Wednesday into Thursday.  Not a healthy sign.  Indeed, I along with others were wondering about the €310bn that didn’t settle and it’s looking more and more like the liquidity it provided is gone and now there’s a mad scramble – a tsunami of buying, if you will – for Euros:

But if you’re watching the Euro-Yen cross like I am, you still need to use the Dollar-Yen as a crossing pair to get a Euro-Yen quote. The last time I checked, the Euro-Yen cross was at 110.039. In a word, ugly.  That cross has been the great carry trade cross for years, so any movements in this cross should be noted and heeded.

But I also wanted to take a look at some other trading activities in futures:

Surely with the correlations we’ve grown accustomed to, a rise in the EURUSD should mean stocks, commodities and well, everything that is not cash is headed higher.  But right now, it doesn’t because of the banking issues in Europe.  Gold collapsing the way it did was rather stunning, frankly.  And the fact that crude oil, in the midst of the summer vacation/driving season coupled with a natural disaster of epic proportions, couldn’t maintain the trend line on the daily chart that would imply $80/bbl, is telling.  And the message seems rather ominous and foreboding:

Meanwhile, two Treasury ETFs, SHY (iShares 1-3 yr Treasuries) and TLT (iShares 20+ yr Treasuries) have benefited from the safe haven bid.  If you executed a bear flattener by shorting the SHY and going long  the TLT, you would’ve had a very nice 6 months, in spite of the gains in the SHY:

My point in showing all of these charts?  It’s to try and present/describe a macro level picture that shows one simple message: the problems in Europe can’t – and shouldn’t – be underestimated and the spillover/contagion/whatever buzzword you want to use that means “spreading” are the worst kinds of scenarios you can think of: higher probability and high severity.  I characterize them as “higher probability” for two reasons:

  1. Never underestimate people’s ability to underestimate tail events.
  2. The probability of a spooky tail event occurring  is increasing.

I don’t know how long the EURUSD “rally” lasts.  It will last as long as banks in Europe are afraid their balance sheets are too illiquid.  It could be over in days, weeks or months.  I don’t know.  But I do know that trade is not acting the same way it would have in the past for a reason.

This will be an interesting month…

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How Quickly Are We Turning Japanese?

I came across this piece from the Business Insider.  Their post talked about one of the more surprising aspects of this recession: the low default rate in high yield credit.  I’ll openly admit, in the words of Frank Vitchard, “I did not see that coming!”

They referenced a Fitch report, “The Extreme Credit Cycle – Making Sense of a 1% U.S. High Yield Default Rate”, which talks about this development.  According to Fitch, the high yield default rate went from 13.7% with 151 defaulters last year, to a forecasted 1% default rate for this year.  A stunning drop, to say the least.  But let’s a take a look at the following chart, which comes out of the report:

The thing I note is the divergence in growth rates between TTM revenues and TTM EBITDA we’ve seen since ’07.  In ’05 and ’06 you can see  the growth rates tracked pretty closely together, but in ’07 as the economy started wobbling, TTM EBITDA started turning negative.  Plus, EBITDA went lower, farther and sooner than revenues.  But EBITDA growth is slowing down, possibly peaking.  Not much of a surprise since we knew companies were cutting costs via layoffs and forgoing cap ex.  But what are we talking about when we refer to EBITDA?  From WikiInvest:

EBITDA = Income before taxes + Interest Expense + Depreciation + Amortization

via Metric:EBITDA.

Ah, yes…. Earnings Before I Trick the Damn Auditor… actually it’s Earnings Before Interest, Taxes, Depreciation and Amortization.  I don’t particularly like the metric because the things it leaves out are, well, kind of important.  But the metric is supposed to reflect a relatively clean cash flow measure.  I guess to me, aside from the drop in income (which is obvious), the thing I’m most curious about in the high yield space is which component had the biggest impact in the second half of ’08 as well as the second half of ’09: was it interest expense? Or depreciation and amortization?  The answers we get there can help explain why we’ve seen such a dramatic drop-off in default rates.

My theory is interest expenses have taken such a dramatic cliff-dive it has only served to help high yield companies in managing interest costs and as a result their weighted average cost of capital.  This differs from Fitch’s conclusion that it’s the cap ex piece.  How did I arrive at that?  Let’s take a look at the chart:

The coverage metric EBITDA less CapExInterest feel further going from a peak of just over 3 times coverage to roughly 1.5 times coverage – about a 50 percent drop in a coverage metric.  Yet the EBITDA/Interest only fell from a peak of near 5 times coverage to a low just under 4 times coverage.  So I don’t buy the reduced CapEx story all that much.  I think the story is really in the reduced interest expense.

And on the heels of that, we read this from Bloomberg:

Investors are returning to junk bonds after the worst month since 2008 on speculation the economy is growing fast enough to avert corporate defaults without sparking inflation.

“High yield is the place to be,” said Manny Labrinos, a money manager at Nuveen Investment Management who oversees $1.8 billion of fixed-income assets. “Sub-par growth is somewhat of a Goldilocks scenario because it means rates stay low and people are still going to reach for yield.”

High-risk debt has returned 1.76 percent in June, almost double the gain of investment-grade corporate bonds, Bank of America Merrill Lynch index data show. Underscoring demand, CNH Global NV, the Fiat SpA unit that makes tractors and harvesters, boosted the size of its speculative-grade offering by 50 percent to $1.5 billion in the largest junk-bond sale since April 20.

via Junk Bonds Revive on Bernanke `Sub-par’ Economy: Credit Markets – Bloomberg.

So the paper is exceptionally well-bid, but what would you expect in a rate environment like ours?  Indeed, as one of the more astute people I follow on twitter said:

And this:

The reason I worry about it is the same reason I worry about sovereign deficits.  The amount of debt worries me not because I think there’s some magic debt/GDP number from which there’s no point of return, but because low rate environments are highly convex and rate shocks can kill.  Especially when growth rates for GDP, earnings, etc. grind lower.  At some point, you’re bound to have a problem.  I’m going to cover more on the sovereign-related stuff later.

In the meantime, chew over the idea that with rates so low and liquidity being so excessive, defaults in high yield will continue to surprise to the downside, grinding returns lower still.

Seems we have started another feedback loop, just like the Japanese did, 20+ years ago…


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Another Look At The 2Yr Treasury – 3Mth LIBOR Spread

Wanted to take another look at this, briefly.  Here’s the chart I had from an earlier post that looked at this tantalizing subject (well, for me it is, anyway):

That was a 20 year chart.  Let’s take a look at smaller timeframes.  First, here’s a chart that shows the two yields moving together through time:

Other than the summer of ’08 where we saw a divergence (timing difference is actually a better term) in rates, these two time series performed quite similarly.  So let’s take a look at another chart of the spread:

That black vertical line is the low in the series, and it occurred in October of ’08.  Turns out it was 5 months almost to the day before we saw the March lows in stocks from which the market rallied off of.  I’m not suggesting this spread is a leading indicator.  I haven’t run any statistical tests or anything like that. 

But this should serve as a reminder for an equity investor to consider taking some cues from the credit markets.  Even looking at things from a capital structure perspective it makes sense.  Why?  Just look at the capital strucutre.  Equity investors are the last to get their money.  So if credit markets are showing stress, it should serve as a warning to equity markets to be wary.

The last chart to look at is here:

The blue line represents support that has been in place for over a year.  It has been decisively broken and the trend is to head lower.  How fast will it head lower and how far remain to be seen. 

But I can only imagine what it will take to make this spread widen out again, though.

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Buckle Up For Safety: Liquidity (Or Lack Thereof) In CDS

The issue of liquidity in CDS has been many people’s minds of late, myself included.  This piece from FT Alphaville, written by Gavan Nolan at Markit, is exceptional.  First, we have the ways market liquidity in CDS can be measured:

These are all important indicators in determining liquidity.  I, along with other folks, have talked about liquidity issues in the CDS arena before:

But isn’t the 83.7% of trading by dealers “real”? If there are only 6 firms in the United States controlling the credit derivatives market and slightly more than that internationally, how can that be “real”? Since CDS positions are a zero sum game, all dealers combined can only be net long what non-dealers are net short, and vice versa. Just as in the used car analogy, we care only about the trading by retail car buyers, not the movement of volume between dealers, who still need to sell whatever cars they buy en masse. Moreover, we want as many price points from retail car buyers as we can get, so we want the www.kbb.com Kelly Blue Book prices, not the prices from one dealer’s lot.

via Kamakura Blog – Kamakura Blog: Sovereign Credit Default Swaps and Lessons from Used Car Dealers.

My hope is that the data from Markit will begin to get at the heart of some of these issues.  It looks like it will because a bunch of that data will show market breadth and depth.  Which many folks believe to be shallower than a kiddie pool.

But there’s also some disturbing – but expected – trends we see taking shape:

However, if we look at the bid/ask spreads this week, we can see that they have widened dramatically. This is to be expected – the CDS spreads of all five countries have widened sharply. But the expansion of the bid/ask spreads outpaces the widening in CDS spreads.

via FT Alphaville » CDS liquidity update: Focus on European sovereigns.

Why?  Call this a consequence of the BaFin ban.  And I don’t think it was unintended.  Indeed, as the Alphaville piece continues:

It is also evident that there was a big jump in the bid/ask spreads on May 19. This was after the German regulator Bafin announced a ban on naked CDS referencing eurozone sovereigns. The move created some uncertainty in the market and appears to have led to a disruption in liquidity. Overall, the disproportionate widening in bid/ask spreads in recent weeks suggests that liquidity has fallen.

This is just more of the same government heavy handedness directed at symptoms instead of diseases.  Don’t like reading about CDS quotes screaming higher on a day-to-day basis?  Ban their use; that will sort it all out.


Because as I pointed out before, viewing CDS strictly as “insurance” is wrong:

Liquid credit indices are just like liquid stocks.  You can buy/sell them in size, and pay very little for the privilege.  Illiquid credit protection, however, is a whole other ballgame.  You can’t get in/out of positions easily even in good times and you’re going to pay through the nose to do it.  And if you try to do a trade in size?  Puhleeeze…

This also illustrates why it’s laughable to think CDS have anything to do with making the sovereign credit situation worse. These are synthetic shorts when you buy them. If they didn’t exist, there would only be one option: sell the cash bonds and watch the yields & spreads blow out even higher than where they are.

via On Goldman, Synthetic Longs & Shorts, and S_ _ _ Sandwiches « Deep Thoughts by Professor Pinch.

So what are we going to be in for?  Most likely, reduced liquidity in the market.

And with reduced market liquidity, we get things like this


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