Category / Bonds and CBs

Happy meals August 23, 2013 at 10:07 pm

For the name alone, I have to reblog a post from Matt Levine about CBs. You see, the majority of CBs are bought by arb funds, and to arb the CB, the fund needs to short the stock. For stock that is hard to borrow, that’s a problem. So the issuer facilitates the short, and this is called a happy meal. The issuers often fail to prosper, and Matt asks why.

First he points out that firms which want to monetise the volatility of their stock don’t have a ton of other appealing options, and if their stock is hard to borrow, it’s usually because lots of people have already sold it short. These deals in other words, “are for bad companies, not bad for companies”. A happy meal in short is often an efficient deal:

A company comes to its bank, low on options, unpopular with equity investors, and desperate for money. And the bank finds a way to raise money that would otherwise be impossible to get. This isn’t spivvy financing as a tax-or-whatever-advantaged alternative to wholesome normal financing, it’s spivvy financing as an alternative to not raising money. It’s financial innovation that actually helps actual businesses raise actual money. That’s what banking should be!

Just don’t expect it to taste good.

Once, twice, three times a columnist July 6, 2013 at 11:08 pm

Three good ones from Matt Levine when I was away:

  1. Why Blackrock wants corporates to reopen bonds rather than issue new ones, and why they probably shouldn’t, here.
  2. Shock, horror, exchanges want people to trade on exchange, here.
  3. That antitrust case, here. Footnote 3 in particular amused me. Yes, I read footnotes in out of date blog posts. So sue me.

There are no more bargains March 14, 2012 at 9:46 pm

Charlie Stross has an interesting insight. He has been trying to buy a used car, and has discovered…

…there are no bargains any more. Nor are there any horribly overpriced vehicles, either (unless you want to go to the authorized dealer, in which case you’ll pay over the odds but also get some hand holding). Nor are there any secrets about what can go wrong: there are model-specific online bug lists, online vehicle status reports that can tell you if it’s been chopped or stolen or is liable for outstanding finance, and getting an estimate of its book value isn’t a high hurdle to leap either. The process of evaluating a second hand car has become more transparent, but by the same token, so has the process of selling one: so nobody offers a car for much below the standard asking price.

Personally, I blame the internet. The web disintermediates supply chains, and the used car market is of course a supply chain, just like any other.

This feels entirely right to me. In something less liquid that I know about – large format camera lenses – something similar has happened. There is still price volatility, and a few quasi-bargains, but prices are a lot less volatile than they used to be, and many more people know the going rate for a 300m f5.6 symmar. This is a reasonably unusual lens, but still you can easily discover what they have sold for in the recent past, what shape the seller thought they were in, and so on. As a result the bid/offer spread has come in dramatically, and it is very hard to make money trading lenses unless you are willing to go to house clearance sales or otherwise expend effort sourcing inventory most folks cannot find.

What is interesting to me, though, is that this has not happened to the bond market to anything like the same degree. The problem is that people keep bond for sale and purchase information confidential. Sure, there is Trace, but not only isn’t it complete, more importantly you don’t get market colour, only prices. If you read the LF forum, you’ll find out that that 300mm Symmar is a well regarded lens optically, but it is heavy and big (especially as it comes in a Copal 3 shutter), so it’s usually pretty cheap. Knowing that the Denbury Resources 8.25% of 2020 last traded at 111.125 is useful, but it isn’t such high quality information. Now of course putting gossip, the internet and trade reporting together could be a recipe for disaster, but it is interesting to wonder why it is that second hand car (or lens) buyers find it easier to become well informed than corporate bond buyers do…

The problem with assessing bond return distributions February 1, 2012 at 1:24 pm

Yesterday we saw that one good way of visualizing bond returns is to look separate at the survival probability and the distributions of returns given default (also known as the LGD distribution).

(A minor technical point – in the prior post I used normal LGD distributions, whereas in fact something like a beta distribution might be more suitable.)

We noted too that once we look at the distribution, subtler differences between bonds than just probability of default are obvious. Another example of this is how much uncertainty in recovery there is. Consider this example:

Visualizing bonds 5

These two bonds have the same PD, the same average recovery and hence the same expected loss. But one has more uncertainty in recovery than the other, and hence can reasonably be called riskier.

Now, a plain vanilla tranched security supported by a diverse pool of collateral assets might well have quite a benign return distribution. Losses come from the bottom up, and if the loss distribution of the collateral is fat tailed, and our tranche is not the bottom of the stack, then we might well find something roughly like this (although of course the precise form is subject to considerable debate):

Visualizing bonds 6

In other words, even if you do get a loss, it will likely not be large. The problem though is that this assumption is rather sensitive both to the collateral loss distribution, and to the structure of the securitization. Something like this is entirely possible too:

Visualizing bonds 7

Now, remember first that it is really hard to know what the real loss distribution is – there is a lot of model risk – and second, its shape really effects the expected loss. For instance, for the first tranched ABS above, the expected loss (EL) is only 0.25%, whereas the EL for the second bond is 0.65%. Assessing the real world return distribution of these securities is difficult.

This brings us nicely to informationally insensitive assets. What people want is something with PD = 0 (and so EL = 0). There isn’t any such thing. What is available are assets with small PDs, and unknown loss distributions. Sovereign recoveries are typically low and uncertain: 30 to 40 isn’t a bad guess for an average. AAA ABS, on the other hand, can be structured to have whatever loss distribution the issuer wants. What we learn from this is that it is a serious error looking just at PD or EL in assessing credit quality; you need to get several different views of what the whole return distribution might be like. Moreover, a crisis in the securitized funding markets is caused not just by a reassessment of PDs, but also by a realization that the loss distribution is likely to be more like the third graph above than the second.

Visualizing high quality bond returns January 31, 2012 at 5:46 pm

I have been musing for a while on how best to give insight into the returns of fairly safe instruments, like an asset swapped government or investment grade corporate bond. Here’s what I have come up with.

The first thing you need is to understand what the probability of default is. Now, in a precise sense this number is meaningless in that ‘probability’ implies that we have some (ideally large) population of things that we are sampling, and they are IID. This isn’t true with a typical bond – either it defaults or it doesn’t, and no two bond issuers have exactly the same return distribution. Still, let’s pretend that probability of default makes sense. For high quality bonds, survival probabilities (i.e. 1 – PD) are close to one, so showing full return distribution won’t tell us much; instead then let’s zoom in to the 90% to 100% area. Our first visual aid then is survival probability, graphed between 90% and 100%.

The second thing we want to know is how much we get back if default happens: the recovery. Again, we can’t know this, nor does it really make sense to talk about a distribution of recoveries. We have Knightian uncertainty rather than risk. However, if we make the (false) assumption that recoveries for similar types of issuer are similar, then one could (mis-) represent unknown recovery as a distribution of possible returns, which we can also separately picture.

A typical high grade corporate bond with PD = 1% and average recovery 45% would then look like this:

Visualizing bonds 1

(By keeping the ‘doesn’t default’ part separate from the ‘does default’ we can at least see what is going on in the latter.)

Now consider a higher quality corporate bond, with PD = 0.5% but still with average recovery 45% and the same uncertainty in recovery. Comparing the two bonds, we would have

Visualizing bonds 2

Here we can clearly see that the second bond is safer: it is less likely to default, and the average recovery is the same. Thus for the first bond, the expected loss (EL) is 0.55% (1% PD with 45% average recovery), while for the second it is 0.275% (0.5% PD, same recovery).

Now let’s turn to a typical high grade ABS. Here credit enhancement typically means that the PD is low, but if the credit enhancement doesn’t work, then the losses can be quite large. Recoveries, in other words, are often lower when ABS don’t pay in full*. Thus we might have the following comparison:

Visualizing bonds 3

This shows that the ABS has the same PD as the corporate bond but if it defaults, you are likely to get less back. Intuitively, it is riskier, and indeed its EL is 0.72%, higher than the 0.55% for the corporate bond.

Now let’s look at an ABS with the same EL as the corporate bond, but with ABS-style low recoveries. It’s PD is 0.764% or in pictures:

Visualizing bonds 4

Which of these bonds is riskier? The corporate bond is more likely to default, but if it defaults, the expected recovery is higher. The two bonds have the same EL. Riskiness isn’t easy to call; it really depends on your tolerance for large losses vs. your desire for 100% capital return. Depending on your rating system, you could justify rating either bond a notch over the other – and all that that demonstrates is how hard it is to compare things with multidimensional properties on a single linear scale.

In the next post we will use this tool to discuss ABS structuring and the recurrent topic of informationally insensitive assets.

*This is not necessarily true, but it is common especially in structures where reserve accounts are used. We will say more about this tomorrow.

AAA demand July 15, 2011 at 1:23 pm

Here at DEM we have been rather keen to point out that you can’t have a bubble if there are no buyers of the bubbly assets. Viewed in that light, FT alphaville’s declaration of a bubble in AAA bonds gives rise to the question why is there such a demand for AAA assets?. The answers – pension saving, central bank reserves, the need for safe collateral uncorrelated with exposures – are pretty obvious. But it is worth noticing that if this demand doesn’t go away, then there will be a great incentive to meet it one way or another. Like it or not, the world needs a supply of safe assets, and the lack of such is a major challenge to financial stability.

Give me priority May 18, 2011 at 7:10 pm

Priority in securities is a really, really important idea. There is a list. When trouble happens, people get paid out in order. Thus if you are senior, you get paid out first*, then the subordinated claims – perhaps a number of levels of them – then finally the equity. If there is nothing left at some point then you stop. Everyone at the same level is treated equally, so if the total senior claim is 100 and there are 40 of assets available, the senior recovery is 40%, and no one else gets anything. If there is 120, the senior debt holders get everything and 20 is available to meet claims below them.

In my earlier post on bank resolution, I tried to discuss bail in in a way that respected priority. There’s no problem if a single level – the sub debt say – is sufficient to fully resolve a firm. But there is a problem if you start to talk about using more than one level. For instance you certainly should not start to haircut senior debt holders until you have fully converted the sub. So yes, there should be some risk in the senior, and senior debt holders should be at risk, but only at the level they have paid for (i.e. after the sub but before the tax payer). That’s why the step down theory of bail in is important.

* Let’s not mess with supersenior claims and such at the stage, OK?

Equador is still poor, but slightly less poor than it would otherwise have been April 28, 2011 at 8:14 am

There is a story that Equador rather cleverly bought their bonds back in the secondary market after default rather than waiting for the restructuring. Essentially instead of having to pay 35 cents on the dollar, they paid in the 20s, and so saved the country a few hundred million dollars. Apparently the State Department thinks that this is market manipulation. Well, frankly, screw them and anyone who thinks like them.

Equador has GDP per capita of of $8,000 comfortably putting it outside the top 100 countries in the world by income per head. 33% of the population is below the poverty line. (Figures from the CIA.) It is only keeping its head above water thanks to the high oil price. If a country like this can extract a few hundred million out of emerging market bond holders through some smart trading then my view is good luck to them.

Convertible gilts and other exit strategies March 29, 2010 at 12:53 pm

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.

Convertible remorse October 19, 2009 at 5:32 pm

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.

Trigger convertibles May 12, 2009 at 4:23 pm

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.

What I don’t understand about the DMO December 8, 2008 at 7:19 am

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:

Gilt sales vs. remit

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?

On Black Scholes Hedging October 31, 2008 at 10:34 pm

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.

CB arb October 30, 2008 at 9:57 am

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?

Buy bonds now, Tonto March 12, 2008 at 7:50 am

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?”

Monument Valley

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.

Why are Agencies so wide? March 7, 2008 at 7:44 am

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.)

A cure for Ebola? March 4, 2008 at 8:06 am

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?

Corporate bonds are good value… February 26, 2008 at 9:07 am

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.

Spread wide November 16, 2007 at 4:23 pm

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


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.