Deus Ex Macchiato

The Sunday Times (via FT alphaville) suggests:

Advisers to the government are working on a secret plan that could allow the state to start cutting its shareholdings in British banks just weeks after the general election.

The plot would see the Treasury create “convertible gilts” — government bonds that could be exchanged for shares in the banks once certain price targets are met.

It’s not a bad idea, and certainly it will allow the government to monetise the volatility of the stocks even if the CBs do not end up being converted. A long dated structure with a fairly far out of the money strike price would work well.

Another idea, reminiscent of how Caja Madrid got out of their position in Telefonica, is for HMT to sell physically settled calls and use some of the proceeds to buy OTM cash settled puts. The puts would floor losses for taxpayers, while the calls would provide an exit above current stock price levels. Ideally you do a strip, say 5% of the stake every quarter, so you get out of the stake slowly and thus without crushing the stock price. The first (three month) option could be set slightly out of the money, with later maturities having higher strikes.

Posted in: Bonds and CBs, Derivatives, Hedging and Convexity by David /
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Bloomberg has an interesting (if hard to parse) story on the consequences of the bout of CB issuance earlier in the year: CEOs Showing Remorse on Shares Stifle Convertibles. The basic gig is that vols were high in the first couple of quarters, so corporates monetised that by blowing out CBs. The equity markets went up, so these CBs are now in the money, and the companies are upset at the resulting dilution. CB investors have done well thanks to the share rally and tightening credit spreads. It can’t last of course, and those who have waited now face a much better issuance market. Sure, vols are lower, but 25% upside from there is unlikely, and spreads are unlikely to go much tighter in the near term. Blow out a 3 year deal non call 1, and thank the Gods you were patient.

Posted in: Bonds and CBs, Markets by David /
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This is an idea of Steve Randy Waldman’s, and I like it.

The basic idea is that you have a deferrable CB. That is, a fixed rate bond which pays coupons, but where the issuer can defer the coupon without it being a default event. Many preference shares are like this, for instance.

The bond is also convertible into shares. Unlike a normal CB, though, the bond is convertible after deferral at a fixed discount to the then current stock price. Thus it is a trigger CB – the trigger being the deferral. (One could have other triggers too, such as quarterly net earnings being sufficiently negative, or Tier 1 capital ratios falling too far. You could also have conventional conversion features too.)

The attractive part, akin to contingent capital, is that the holder is incentivised to fund fresh equity issuance just when the issuer needs it. The issuer pays something for the option to raise equity, but not nearly as much as it would have to pay for real equity capital. If the issuer wants to be sure of the capital, conversion after the trigger is hit would be mandatory: if they thought that the discount was incentive enough, it would be optional, with a correspondingly lower coupon on the bond.

Posted in: Bonds and CBs by David /
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FT alphaville has a post on the DMO at the tail end of last week, setting out the auction catalogue for the next quarter and setting out progress to date. It includes this summary of the year so far:

This squares with my understanding that the DMO has a policy to keep index linked issuance at less than 20% of the total. My question is why. There is massive demand for long-dated linkers from pension funds and life insurers. Given the need to sell a lot – really a lot – of gilts next year, why is the DMO not giving the market what it actually wants to buy?

Posted in: Bonds and CBs, Inflation by David /
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Further to yesterday’s post about CB arb, a short note on hedging options.

If you sell an option at an implied vol of v, and the Black-Scholes assumptions hold (in particular the underlying is a diffusion with constant delivered volatility w, and you can trade instantaneously at zero spread) then the expected P/L of a delta hedged position depends only on v and w. In fact, as Dupire amongst others pointed out, it depends on v versus the gamma weighted delivered volatility. Thus, on average, if you sell an option at v, and v > w, you will make a profit. If you buy an option at v and v < w, you similarly expect to profit.

Two things can screw you up. Firstly this result only holds if the underlying is a diffusion. Therefore in the real world, with jumps, you can buy a ‘cheap’ option (i.e. one whose implied is less than realised) and still lose money on hedging. Secondly all the other imperfections (bid/offer spreads, variable interest rates, stock borrow costs etc.) hurt, so in practice you need at least a 2 vol point difference between realised and implied to have a good chance of a profit.

Thus, to return to yesterday, you will judge a CB to be cheap if the implied vol needed to recover the price of the CB is significantly less than your expectation of future delivered vol of the underlying during its life. If you are right, you can make money delta hedging the embedded option. Before 2004 or so CBs were often cheap – the issuers discounted them a bit to be sure of getting the issue off – and so CB arb could be profitable. The problem is that buying a CB to get the option is inherently deleveraged, since the option is only a fraction of the total (the rest being the bond floor). Hence callable convertible asset swaps. But that is a story for another day.

Posted in: Bonds and CBs, Derivatives, Hedging and Convexity by David /
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FT alphaville comments on convertible bond arbitrage (in connection with VW, but that need not detain us here). A few points. First the article says CB arb had sizzled out post-2005 due to lack of issuance. Is that really true? I always thought it had sizzled out because CBs were more fairly priced, so it was no longer obvious that buying vol via the CB and delta hedging was a good idea.

Secondly, there was a surge in CB issuance earlier this year: financial companies sold more than $35bn of convertible bonds in the first nine months of 2008. A lot of this paper was presumably gobbled up by hedge funds keen to get back into the play. And for a while it went well. As the FT reported back in 2007:

Convertible arb has returned from the dead. Two years after investors abandoned one of the pillars of the traditional hedge fund portfolio, convertible bond arbitrage is once again attracting interest – and billions of dollars of new money.

Hedge funds specialising in convertible bonds produced their best performance since 2000 last year, returning as much as the previous three years combined.

That has all changed. The Barclays CB arb index was down 9.3% in September. But why? I am puzzled…

• Classic CB arb players are long the CB, short stock. This is a long vol position: rising vols should make money. Perhaps some of them were hurt by short selling bans or increased stock borrow costs, but that explanation not seem to explain the scale of the losses.
• Clearly leverage is more expensive and harder to come by. Advanced CB arb players bought CB options (the right to call the CB on an asset swap basis), though, and that is term leverage. You can’t easily repo CBs (can you?) so repo squeeze isn’t an issue. Again I don’t see quite how this factor would impact CB arb specifically.
• Credit spreads have gone out, and that will have hurt those funds with naked credit longs, but many funds bought CDS protection on the credit, so again the size of the move is surprising.

So, does anyone know why September was so bad for CB arb?

Posted in: Bonds and CBs, Hedge Funds by David /
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I am reminded of the terrible joke about the Lone Ranger and Tonto. They are surrounded by hostile Indians, their horses are dying, they have no cover, and their enemies have arrows pointed at them. The Lone Ranger turns to Tonto and says “What shall we do?” Tonto replies: “Who’s this ‘we’ white boy?”

The bond market is similarly one way at the moment. The FT comments on the spread widening in high grade debt here, while FT alphaville discusses the related turmoil in the CDS market here, the latter partly related to concerns over the stability of Bear, Stearns. Yet actual experienced defaults are low and even taking into account a severe recession, many high grade bonds represent excellent compensation for default risk. The problem is that they may be even better value tomorrow, given that some of that compensation is also for liquidity risk, and liquidity is terrible in many parts of the market right now. Until we can kick the ‘they will be even cheaper tomorrow’ mindset, spreads will remain wide.

Posted in: Bonds and CBs, CDS and Negative Basis, Markets by David /
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Following yesterday’s announcement that a Carlyle fund is in default over its repo arrangements on Agency RMBS, Bloomberg comments on the agency/treasury spread:

Yields on agency mortgage-backed securities rose to their highest relative to U.S. Treasuries in 22 years as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15.

Why? There are a number of reasonable explanations. Firstly and most obviously there are more buyers than sellers of treasuries and more sellers than buyers of agency MBS. Why does no one step in to arbitrage the spread? Because there is little risk capital in this market that is not deployed, and/or anyone with money is waiting for things to get worse.

Next, even if we do accept that an arbitrage relationship holds between treasuries and agencies, (1) the liquidity premium on agencies is high; (2) the credit spread on agencies is increasing [since as the agencies lose money and become more highly leveraged, the likelihood of government support must decline somewhat]; and (3) regulatory risk in the mortgage market makes it unclear what the cashflows of the underlying assets will be anyway. (Remember even if the agency guarantee holds good, a reduction of principal on the asset pool causes prepayment, thus regulatory risk effects the optionality of the pass through.)

Posted in: ABS, Bonds and CBs, Federal Agency, Mortgages by David /
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The mot de jour for the last few days was ‘tsunami’. Now it seems we need something more potent. Bloomberg quotes Ed Steffelin: “People are calling it financial Ebola,”. Certainly the moves in ABS spreads are impressive:

Yields on three-year, AAA rated credit-card bonds with floating rates rose to 75 basis points over the London interbank offered rate, up from 40 basis points at the start of the year [...] Spreads over three-year swap rates for three-year, AAA rated fixed-rate auto-loan securities rose to 140 basis points, up from 75 basis points. The average spread over U.S. Treasuries on AAA rated commercial-mortgage securities climbed to 364 basis points, from 167 basis points on Dec. 31

Meanwhile, a sticking plaster is in sight. Henry (when did he become Henry? I thought it was always Hank – perhaps that’s the best sign of how serious things are) Paulson is to release new proposals within weeks:

“We’re looking at the mortgage-origination process, we’re looking at the securitization process, we’re looking at rating agencies, we’re looking at disclosure issues, we’re looking at capital issues and regulatory issues,” he said in an interview today with Bloomberg Television. More specifics will come “in the weeks ahead,” he said.

Now clearly action is needed. But speedy action has its dangers too, and Paulson has a big list of maladies there. Treat at haste, autopsy at leisure perhaps?

Posted in: ABS, Bonds and CBs, Markets, Regulation by David /
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…according to Deutsche Bank:

Euro investment-grade company bonds are pricing in defaults 15 to 20 times worse than the average since 1970, and six times the worst on record in that period, Deutsche Bank said, due to the turmoil in the structured credit market.

The sharp widening in spreads has come even though actual defaults on investment-grade bonds are extremely rare events, and even the global high-yield default rate remains close to historic lows.

The average five-year default rate for euro investment-grade bonds is just 0.8 percent, with the worst on record 2.4 percent, while current spreads are pricing in a rate of 15 percent, Deutsche Bank said in a note.

Buy bonds then. If you can fund them.

Posted in: Bonds and CBs, Markets by David /
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Friday market update: from Bloomberg, we learn that

Merrill’s 6.4 percent notes due in 2017 pay a spread of 2.24 percentage points, almost double the premium of 1.21 percentage points a month earlier

Meanwhile

Citigroup paid 1.90 percentage points more than Treasuries of similar maturity to sell $4 billion of 10-year notes on Nov. 14

That’s nothing compared with the monolines in the CDS market. According to FT alphaville there is a one in three chance of monoline default, while Bloomberg gives more detail:

Credit-default swaps on MBIA more than tripled to 410 basis points since Oct. 15, according to CMA Datavision in New York. The price suggests that investors see a 28 percent chance MBIA will default, according to JPMorgan Chase & Co. valuation models. Contracts on Ambac have climbed to 620 basis points, CMA data show. They imply a 40 percent chance of default.

Things are interesting out there. Have a good weekend folks.

Update.Naked Capitalism estimates the likely cost of a monoline downgrade as $200B. (Is that all of them or just a big one?) Anyway, with the kind of impact, we had better hope someone at the FED plays golf with someone at the New York State Insurance department this weekend.

Posted in: Bonds and CBs, Broker/dealers, Monoline by David /
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