Anthony Peters
SwissInvest strategist
I HAVE IN my universe of clients one chap who built a sizeable credit portfolio almost entirely populated by senior bank debt. He was not permitted to buy either sub-Single A rated or subordinated bonds but in the past couple of years he has made out like a bandit within the confines of his mandate.
Now, it appears, his management has decided that the time has come to lock in some of that profit and to diversify into the broader corporate space. It is not because they think that corps are good value but because they don’t see any further upside from the financial sector. They certainly have a point.
Over the past couple of years, most of the focus of the credit markets when it comes to the banking sector has been on the fancy “double Rittberger with a triple flip”-type hybrid issues. But the enthusiasm for such products is only possible if the multiple risks are ignored.
Bill Blain of Mint Securities, who has seemingly been in that business since Hannibal crossed the Alps by elephant and who is a fully paid up sceptic, wrote last week about such instruments: “The randomness of the capital triggers, the upending of the subordination ladder, the fact they are Frankenstein creations of regulators rather than considered investments agreed by negotiation and consent between bankers and investors … I just can’t pin down any particular reason why I hate them so.”
He went on: “JP Morgan may be able to weather a massive trading failure and umpteen massive regulatory fines – but not every bank could. Even a modest JPM event could send most banks’ CoCos into touch … and if ever threats emerge to the banking sector, the CoCo market will be entirely one-way.”
I agree with him up to the last words – there won’t be a one way market; there will in all likelihood be no market at all.
Those who remember the fateful day in 1986 when the BIS rules on the capital adequacy treatment of subordinated bank debt changed and 100% capital weighting was introduced (as opposed to the 20% required for senior debt) will know what I mean.
A “JPM moment” might be awaiting a string of banks that can barely afford one
REAL AFICIONADOS WILL recall BNP innocently issuing a US$500m junior subordinated perpetual floater at par with a coupon of Libor plus 7.5bp just a few days before the BIS changed the rules. Or how about the HSBC Is, IIs and IIIs or the StanChart Is and IIs? It’s amazing what happens when the rules suddenly change.
Those old perps dropped from par to 95/96 overnight and are now all to be found somewhere in the mid-60s. Somewhere out there is the trap into which players in CoCos will surely be treading; when the first one blows and panic sets in … I’d like to be on holiday.
But back to my highly conservative senior guy.
The thinking seems to be that most of the rest of the post-crisis good news has now finally been discounted in the banks’ results. Earnings have supposedly improved but we all know that much of this has been driven by both asset write-backs and some very cheap interest rates, which have kept defaults capped.
Both of these are expected to be treated to the cold light of day as QE is wound down, albeit gently, and some of the buffers will therefore be removed. On the other hand, as Bill Blain points out, a “JPM moment” might be awaiting a string of banks that can barely afford one.
It looks as though the authorities, both American and European, really have got the fining bug and I find it hard to believe that any of them give a fig for the fate of CoCo holders.
On the contrary: how cool would it be for a regulator to see the newspaper headline that investors in bank capital notes, so far uninjured by the state of the institutions in question, had been hit by capital losses?
Would that not prove that the naughty “naughties” are now well and truly gone, that taxpayers are visibly shielded from the vagaries of the credit process and that regulation has now achieved what it had previously failed to do?
BUT THE REALLY smart move by my guy was that he didn’t worry about the liquidity of his positions, only credit quality, so long as the yield pick-up was sufficient.
There is a simple calculation that measures the yield pick-up of the illiquid over the liquid-adjusted by holding period in order to mark the break-even point where the lack of liquidity – that is the higher bid/ask spread – begins to pay off. Smart and thoughtful portfolio management technique beats chest-beating liquidity any day of the week.
But, as my investor chum and his bosses have concluded, an arbitrage is about being where the market is going before it has got there and knowing the time to move on has come. Selling financials and buying corporates is for them not a new investment strategy but the reversal of a highly successful tactical risk concentration and reverting to a more balanced credit risk profile. What clever thing they think of doing next will be of huge interest to me. I sit and wait with bated breath.