Groupthink on Carry, Subordination, and Secondary Market Yields (Tchir)


by Peter Tchir, TF Market Advisors

A boring start to the day as the market briefly attempted to rally but has since settled back to mixed. U.S. stock futures are up a touch, CDS indices across the board are basically unchanged, while Spanish and Italian bond yields drift lower once again. High Yield remained strong yesterday, particularly the ETF’s, one of the few signs of resilience yesterday.

The market will likely chop around based on headlines, which is painful enough to endure, but repeatedly reacting to the same headlines has hit new levels of annoyance. One of the EC members, whose career depends on keeping the Euro big and bureaucratic, comes out with some self serving piece of hopium and the market rallies. Merkel or some other high ranking German says Nein for the 1000th time, ahead of negotiations and we sell off. So and so says something and the market responds, regardless of whether that person is Hollande, or some backbencher from Austria.

Maybe we will see some strong data in the U.S. and we can attempt a “decoupling” rally here, but the reality is we are likely to be driven far more by rumors and stories out of Europe.

What Happened to the “Carry Trade”?

Remember when the carry trade was going to save Europe. That LTRO2 was great because all the banks were going to load up their sovereign’s bonds and ride carry to prosperity while at the same time ensuring that sovereigns could sell all the debt they wanted? Coming into LTRO2 the market had latched on to that idea. It was impossible to read a report or listen to the financial news without being told what a great idea the carry trade was.

We tried to point out the problems with carry trades. We repeated over and over that mark to market generally trumps carry. We pointed out that all the 3 year profit numbers from the carry trade were nice, but they come in very slowly. We pointed out that as the 5 year Spanish bonds touched 3.43% on March 1, that even if the carry trade had been interesting, most of the “juice” had been taken out. Heck, the Italian 2 year bonds, an ideal “carry” candidate since it matured before the LTRO, was down to 2.05% – not much carry.

When shortly after March 1 we pointed out that daily Spanish bonds were leaking a bit, and anomalies like Spanish 5 year bonds trading tight to Italy while CDS and other points on the curve had Spain wider, we were met with a chorus of resistance to any negative comments. The world believed in carry, until one day it didn’t.

The carry trade had nearly universal support until the day it didn’t. The market allowed itself to be swayed by a combination of vague arguments, price action, and a desire to believe.

The fallacy of the “carry trade” back in February is now obvious, though I could see it make a comeback. As banks accumulate more of the sovereign debt and leave it in non mark to market books, the carry trade might even be right. There may be very little free float to trade. Banks will get cheap ECB funding to buy the debt. Carry is starting to accumulate as the EU drags the negotiations on, and frankly, buying 5 year Spanish debt at 6.09% yield is a lot more carry.

The Misplaced Outrage of Subordination

Subordination is the new “carry trade”. It has become popular to bash any idea out of Europe because of subordination. Again, just like carry, there are some superficial arguments that can be made, and so far price action seems to confirm the analysis, but it is important to be careful.

There are two problems with the subordination argument so far. It ignores any detailed analysis of the amount of subordination, and most of it ignores the impact of what would happen if the subordination didn’t occur.

Take a simple example. A company has $50MM of debt expiring tomorrow and $150MM of debt maturing in 5 years. Due to a weak economy and some poor business decisions the assets of the company are only worth $100 billion. If the company defaults, all bondholders would receive about 50% of par and would likely be trading around that level. If the company raises $50 billion of 3 year secured money to pay off the maturing bond, what would happen to the other bonds? If the company filed for bankruptcy now, the “subordinated” bonds would only get a recovery of 33% (50/150) since the senior debt would get paid off first. But rather than trade down, the bonds are likely to trade up in price. The hope that the company with new management, or the economy, will turn around and drive up asset values will become important. Bond investors are likely to get up to 3 more years of coupon payments if nothing else, so the tendency will be for those bonds to rally on the back of being subordinated.

Spain is a more complex than this situation, but it is important to focus that yields should be a function of probability of default and recovery in the event of default. If the subordination dramatically reduces the risk of default, then the bonds go up in price even if expected recovery drops. It is much easier to chant “subordination bad” and sell, but be careful. If default risk is taken off the table, that subordination won’t matter much. The closest we have to sovereign sub debt is FNMA, where they have some 2 year sub paper that yields about 0.6% versus senior paper at 0.33%.

For banks, the spread of sub debt to senior debt is much more closely correlated to the spread of the senior debt than any attempted measure of recovery. So anything that makes an issuer safer tends to improve spreads on sub debt. The moment of becoming subordinated is a bit different, but may already have been more than priced in.

Take a different example. A company with assets worth $100MM has debt of about $125MM. No immediate maturities. Then the company sets up a guaranteed subsidiary to purchase new assets worth $50MM. The company borrows $50MM at that new entity to fund the purchases. The new borrowers are definitely “senior”. They have first claim on the $50MM of new assets and if in bankruptcy those assets are insufficient to pay them, they have a claim on the parent. In the worst case, the new company fails miserably. The old bonds are worse off than had no deal been done. They now only recover 57% (100/175) under that scenario. A default today would have yielded a recovery of 80%, so the old bondholders are much worse off? A default today where the new assets can be sold at cost would leave the old bondholders with an 80% recovery. So in spite of being “subordinated” by the new bond holders, the outcome is dependent on what happens to the new assets. So are existing bondholders going to panic on the news that they were “subordinated”? No. There are scenarios where the new entity actually generates proceeds that pay off the secured lenders and leave something for the parent. To the extent there was some form of connection between the new business and the existing business (vertical integration), the old business may see its value rise just from association.

This is definitely more complex, and has risk, but right now, the market seems to assume that any money given to the FROB to invest in banks will turn out to be worthless. That, as a base case, makes no sense. The base case is at least some value for the investments. The base case should also probably include some assumption that pumping equity into banks helps the Spanish economy which in turn helps the sovereign. The best case is that the new money gets fully repaid with something left over by the investments and the investments breathe enough life into the economy that the sovereign is earning more money from taxes. I wouldn’t bet on the optimistic case, but the base case being priced in, is essentially the worst case so plenty of room to be surprised at how little subordination matters when new assets are being added.

The elevator pitch that “subordination” is bad is compelling, but if anything is done that stops the rise in yields, it will quickly be forgotten and will add to the bounce in prices. The subordination occurring in Spain looks like it will be very different than what occurred in Greece.

Secondary Market Yields Don’t Matter Much

Spain above 7%. Spain below 7%. Italy above 6%. Italy below 6%. Italy back above 6%. All are useful indicators of the state of the markets and the assessment investors place on the debt. The prices cannot be ignored. On the other hand, they are not as important as many would have us believe. In part, secondary market prices for bonds, while important, doesn’t have much day to day impact on the issuer. That is true for most issuers. The other reason it is less important at the sovereign level than ever before, is because the lending market no longer functions like it once does.

As an investor I could buy the SPGB 3.8% of January 2017 for 90.75, to get a yield of 6.17%. Alternatively I could buy the 5.5% July 2017 bonds at a price of 96.75 for a yield of 6.26%. My decision to buy those bonds at that price has no impact on the government of Spain. They continue to pay coupons of 5.5% and 3.8%. It takes a long time for the current prevailing yields to affect the actual flows of the issuer. Just like Spain’s average cost of debt didn’t drop to the lows hit on March 1st, it won’t immediately rise either.

It is only as debt matures and new debt is issued that the cost to Spain changes. The more debt they issuing and the more debt that is maturing, the sooner the cost will be reflected. Issuers tend to shorten maturity when they think that conditions are going to get better. That can be the kiss of death if it backfires and yields continue to rise. Spain and Italy both missed a chance to term out more debt back in February and early March. They should have been aggressively issuing longer dated bonds, but they were enamored still by the lure of even cheaper short term funding. Of all the things the Fed is doing that I disagree with, helping the treasury lock in low coupons for as long as possible is one I agree with.

Any plan that is designed to help Italy and Spain has to focus on getting them as much low coupon, long dated issuance as possible. As we wrote yesterday, plans should NOT focus on secondary market purchases. Getting new money to the issuer is key. Buy back t-bills and issue long dated low coupon bonds. Better yet, buy back existing high coupon bonds at a discount, retire them, and borrow from the EFSF/ESM at much lower rates for even longer maturities.

The secondary market prices are important and can impact the economy as the change in yields signals optimism or pessimism with the economy and turnaround story, but the cost to the issuer takes much longer to hit than it has.

In a normally functioning economy, the cost of the sovereign debt quickly impacts all other borrowing within the economy. Banks have to pay more than the sovereign. Banks then charge even more to the companies that they make loans to. The ripple effect is felt much faster as all debt is affected. New projects, which are completely dependent on current financing levels dries up. We are seeing some of that. It is important, but even here, the ECB and now possibly the EIB are doing what they can to minimize the damage. While banks won’t lend to each other, even collateralized, the ECB has stepped in with a myriad of programs all designed to fund banks cheaply. Normal market discipline is being thrown out the window as the ECB has demonstrated a willingness to lend to banks at levels cheaper than even the sovereign can access. Banks are using collateral to get this money, but it is a weird world where you can post almost anything and without too much initial margin, get a 1% loan. If you need $’s instead of €’s, no problem as there is a facility for that as well.

So, yes, the sovereign rates do transmit to the economy as a whole, but with so much central bank subsidized lending, the impact isn’t as bad as it would normally be.

I am watching yields, and over time current levels may be unsustainable, but it is not an immediate danger. It is sad that yields not too different than long term averages, are considered unsustainable, because countries have taken on too much debt, and that isn’t just in Europe.

Put Buffett in Charge of Bank Recaps

How does National Bank of Greece still have any market value? What sort of a deal are they getting from the Greek government? There is no evidence whatsoever that wiping out shareholders would stop a bank from making loans in the future once it is recapitalized. I keep thinking about the deal Buffett got with BAC a couple of years ago. Or the one he got with GS in 2008. Those were onerous deals for the companies. Many investors eyed the terms aggressively. Our own TARP failed by forcing banks that didn’t need capital to take it, but also by offering terms far too generous to the existing shareholders.

Europe needs to toughen up. Make shareholders take the pain. Let the Greek people, and in Spain, the FROB get good value for their money. The banks will function well if they get enough capital, no matter what happens to current shareholders. By wiping out existing shareholders, the recapitalization can be done on best terms possible for the new investors. That needs to be done.

If Buffett wouldn’t do it, why should the governments. That should be the motto, and I’m not even a fan of Buffett, but he did extract good value for himself, with lots of protections, when he stepped in. The same thought process needs to go on now in Europe. That would give me the best hope, but here I am likely to be very disappointed as some cushy programs will be made available, making the risk/reward of the new investment inferior to what should have been achieved.


Copyright © TF Market Advisors

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