Europe’s negative yield explosion

Investing in Europe’s bond markets is costly these days. Like oil, you have to pay a storage fee to buy and own this debt, in the form of a negative yield. And the costs may be about to skyrocket.

The month of June saw euro-denominated negative-yielding government debt surge to a record level of almost $5 trillion, according to Markit iBoxx data compiled by Risky Finance. That’s up from $3 trillion at the end of December.

The biggest participants in the rally include France and Germany, whose yield curves are now negative out to ten years or more. Strikingly, the negative yield boom included Italy for the first time since the end of 2016, along with other ex-PIIGS, and countries thought of as European emerging markets such as Poland, Romania and Bulgaria.

The plunge in euro-denominated corporate debt yields is equally remarkable. In the space of one month, the amount of negative-yielding corporate debt increased from just under €300 billion to €500 billion. Even some junk bond yields are now trading below zero.

This all has caused havoc for those who for reasons of choice or necessity, have to hold cash and ultra-safe investments. Derivatives trading has boomed as corporate treasurers use currency swaps to boost returns on their euro-area cash piles. Savers in Germany who rely on bank deposits or life insurance-based savings products have suffered, so much that the International Monetary Fund recently blamed plunging yields for a decline in disposable income.

And traders who bought bonds in June didn’t do so because they were happy with paying a negative yield to maturity. They were gambling that the European Central Bank will soon restart bond buying as the economic climate worsens. In other words, bonds trading at a negative yield today will be bought at an even lower yield by the ECB in the future.

Supporting these thesis is the fact that the ECB already owns a lot: €2.2 trillion of Eurozone government and other public sector debt, and €178 billion of corporate bonds. For German and Dutch bonds, the ECB owns a third of eligible outstanding debt.

Unlike Germany, there is one Eurozone country whose government is keen to borrow more. So why not increase the proportion of Italian bonds the ECB buys? The problem is that altering its sacrosanct ‘capital key’ (which allocates bond buying by national GDP) in favour of weaker countries is politically toxic for the ECB.

In that case, the only way is down: lower deposit rates, and buying bonds at lower and lower negative yields.

We can get a flavour of this ‘new normal’ by filtering euro public sector debt for yields currently below the ECB deposit rate of minus 0.4 per cent. Almost $1 trillion of German bonds are trading below this level. No corporate bonds are currently trading below the deposit rate, which suggest that the ECB will likely focus its firepower here.

There’s a broader debate about what global trade, demographics and digital transformation are doing to the inflation that the ECB is desperately hoping to achieve. Printing money to drive up the price of traditional goods and services can’t overcome the demand-crushing wave of ageing populations and artificial intelligence.

The explosion of Europe’s negative yields may be a sign that policymakers haven’t figured this out yet.

The year that transformed Britain’s LOBO landscape

The last 12 months have been remarkable for changes at UK councils hobbled by lender option borrower option (LOBO) loans.

After years of denying the problem, attitudes at councils are changing, typified by the toppling of Newham’s long-standing mayor last year in favour of a transformative candidate, Rokhsana Fiaz. Multiple lawsuits have been filed by councils against the biggest LOBO lender, Barclays.

Meanwhile, there has been a wave of restructurings of LOBO loans by UK councils. According to results of Freedom of Information requests conducted by Risky Finance, among 55 of the largest LOBO borrowers surveyed, 21 of them reported refinancing some of their loan portfolio during this period.

In particular, two banks – RBS and Germany’s Commerzbank – decisively changed the LOBO landscape by offering terms that allowed councils such as Croydon and Cornwall to repay £1 billion of loans at a significant discount. The majority of these redemptions came before Newham council announced repayment of £150 million of RBS inverse floaters in May, a deal that I helped negotiate as a senior consultant for Vedanta Hedging Limited.

Prior to the Newham transaction, I analysed FOI responses and mark-to-market valuations in collaboration with Vedanta. Based on this data, we found that the councils paid a total of £300 million in breakage costs in addition to the £800 million face value, while the banks have written down £500 million in mark-to-market breakage costs to which they were contractually entitled. According to our analysis, RBS alone took a haircut of £430 million on the fair value of its LOBO portfolio.

A history of bank P&L for LOBO loans. Over £600m of trading profit was booked between 2001-2011, while £500m of writedowns occurred in 2018. Screenshot of interactive visualisation available to subscribers.

Why would a bank voluntarily write off £430 million rather than stick with the full value of assets that aren’t in default? Is RBS a template for Deutsche Bank, which claims that it can reduce its derivatives-heavy balance sheet by €180 billion with just €2 billion of restructuring costs?

Why would 20 councils voluntarily pay an extra £300 million now rather than letting the loans run for another 40-60 years? Is it possible for councils to get to a better position compared with the counterfactual of having borrowed from the government a decade or more ago instead of using LOBOs?

To answer these questions, Risky Finance has written an in-depth report that can be downloaded by subscribers..

In the report, 1) we explore how councils go about refinancing LOBO debt from an accounting perspective, and 2) we look at the redemption terms achieved by some individual councils. 3) We examine the regulatory capital motivations for banks to offer discounts, and how RBS may be a playbook for Deutsche Bank. And finally 4) we explore the implications of the recent redemptions for the three big lenders (Barclays, FMS and Dexia) that have resisted offering discounts.

Councils across the UK still have about £14 billion of LOBOs left outstanding, mostly with these three lenders. Four years after I helped produce a documentary for Channel 4 Despatches called “How Councils Blow Your Millions”, the redemption wave could yet turn into a tsunami.

The Sharpe Ratio Ratio

Portfolio optimisers often give results that are extreme and unstable. With so many variables involved, it can be hard to decipher why. This article presents a simplifi ed formula for a two-asset optimisation which will bolster your intuitive understanding of how a portfolio optimiser behaves and why it may behave badly.

Download the paper here

About Thomas Smith

Thomas Smith specialises in quantitative investing. He currently works in the Quantitative Analytics division of Barclays plc. Previously, he was Lead Quant Researcher and partner at Brooksbridge Capital LLP, and a member of the fixed income research team at AHL, a division of Man Group plc. Thomas holds degrees in economics from the University of Toronto and the University of Oxford.

Smart Beta and Dumb Optimisation

Over the past 60 years, a rich history of quantitative research has emerged aimed at the investing community. None has had as much influence as the concept of portfolio optimisation.

According to research, portfolios do better when optimised for low risk and high returns. This has prompted the growth of passive index funds, because the idiosyncratic risks of individual stocks aren’t compensated enough, limiting the alpha that stock pickers can generate.

More recently, the idea of smart beta has become fashionable. If you divide the universe of stocks by factors such as size, momentum or value and optimise your exposure, you can outperform the index and demonstrate this using a backtest. Analytics provided by MSCI Barra or Bloomberg make this as easy as pushing a button. Today, hundreds of billions of investment dollars are being allocated to smart beta products.

In reality, the theory behind this fashion is shakier than many investors realise. When applied naively to input data, optimisation models can lead to extreme or unstable trading strategies.

To demonstrate this, the quant Thomas Smith has devised a simple framework, in a new paper published by Risky Finance . Smith’s model uses a small portfolio of just two assets, but that is enough to illustrate the problem, with the bonus of being easy to understand.

First portfolio: correlations and SRR for treasury bond and Dow Jones Industrial Average ETFs, with portfolio weights at bottom.

In his paper, Smith shows that the optimal portfolio (expressed as a pair of weightings for the assets), depends on just two numbers: the correlation between the assets and the ratio of their Sharpe ratios (called the Sharpe ratio ratio or SRR). He then shows that just a small change in these two parameters can flip a trading strategy from a long-short spread trade to long only and back again.

As an example consider an investor that owns just two assets, ETFs that track stocks and bonds. Chart 1 shows the relative weightings over time. The correlation is negative and SRR are fairly stable over time so this portfolio behaves predictably, providing diversification in line with orthodox theory.

Dynamic optimisation doesn’t add that much here (it probably underperforms a portfolio with a fixed allocation to stocks and bonds) but it doesn’t do that much harm either.

Second portfolio: correlations and SRR for small caps and DJIA ETFs, with portfolio weights at bottom. The change in sign denotes the change from a long-short spread trade to long-long.

Now consider the second portfolio that tries to optimise two families of US stocks, in the form of a large-cap and small-cap ETF. The correlation is now positive and close to one. As the chart shows, a small variation in the SRR between these assets is enough to flip the portfolio from being a spread trade to long-long. But the fundamentals are not enough to justify such a radical change.

The lesson Smith invites us to learn from this exercise is to treat optimisers with caution, especially when dealing with highly correlated assets. A successful backtest may hide the fundamental instability lurking inside, leading to extreme behaviour when correlations change.

To paraphrase Smith’s fellow quant Emanuel Derman, it’s a case of ‘models behaving badly’ which deserves attention when hundreds of billions are allocated to it.

Inside China’s real estate bond boom

Rising trade tensions with the US haven’t dampened the pace of dollar-denominated bond issuance by Chinese companies, particularly in the highly-leveraged property sector. In the last 12 months, real estate issuers in China have increased their outstanding debt by $38 billion, half of that in this year alone.

Screenshot of interactive data visualisation.

The biggest names here include Evergrande Group, Sunac and Country Garden, with most issuance done via Caribbean tax havens. Let’s look at them in more detail.

According to Evergrande’s annual report, it owns property inventory with floor area covering about 50 square kilometres in mainland China, an area the size of Chicago, as well as land held in reserve. Country Garden has about 24 square km, while Sunac boasts 150 square km of floor area, the size of Liechtenstein.

These three are just the tip of the iceberg – there are dozens more of Chinese developers whose bonds feature in iBoxx’s emerging markets corporate bond index. According to Chinese government statistics, there are about 1,200 square km of uncompleted properties in China – a floor area that if laid out flat would be almost the size of Greater London.

To pay coupons on their bonds, the property developers have to complete these buildings and then sell these properties at high prices to China’s growing middle class. While rating agencies categorise most of this as junk debt, investors such as Pimco’s emerging markets bond fund have snapped it up.

Total outstanding Chinese corporate borrowing tracked by iBoxx is now approaching the half trillion dollar mark, with $120bn in real estate alone. Shanghai property prices, measured in dollars per square foot, are now similar to London and New York. Even so, average credit spreads for the sector have tightened by 145 basis points this year. Things worked out well for Evergrande chairman Hui Ka Yan, who spent $1 billion of his own money buying his company’s bonds last October.

In June 2007, then-Citigroup CEO Chuck Prince famously talked about having to “keep dancing until the music stops”. That remark came just before the global financial crisis. In June 2019, the music may be still playing, but the notes are growing more discordant by the day.


Leveraging the Powell put in US M&A markets

Warning signals multiplied in the first half of June – the US treasury curve inverted, the US-China trade war intensified, and the prospect of a very real war in the Persian Gulf pushed up oil prices. Central banks have reversed the tightening rhetoric of a few months ago, and markets are now anticipating a rate cut later this year.

That sparked a remarkable rally in stocks as investors bet that Fed chairman Jerome Powell will bail them out.

Screenshot of interactive data visualisation tool

The picture of S&P 500 cumulative performance this year is almost identical to a year ago, with the difference that Microsoft has replaced Amazon as the ‘tentpole’ holding up the index. Once again, holding the four biggest market cap stocks at the start of the year outperform the index itself, with a 23% return vs 16% 1)note that our capitalisation weighting is different to the free-float weighting used by S&P.

The $420bn increase in Microsoft and Facebook’s market caps this year is equal to the entire market cap of the smallest 60 S&P 500 members (the world of Mattel, Harley-Davidson and Foot Locker). The gigantism arguments we have written about before seem truer than ever: the incumbent power of tech giants makes them unstoppable, their huge R&D budgets goose their shares with option value, and regulatory threats are perceived as impotent.

For companies that lack the same dominance or R&D optionality, the alternative is to buy it in, using cheap borrowed money. In the long term, the strategy is rife with execution risks, but in the short term, investors love it.

It pays to be acquisitive in 2019

To see how, let’s filter our cumulative return chart for stocks that at the beginning of the year were in the midst of the process of acquiring others. These 76 M&A acquirers in the S&P 500, when ordered by cumulative cap-weighted return, converge on 21%, five percentage points more than the entire index.

Screenshot of interactive data visualisation tool

Acquiring R&D expertise or market dominance seems to increase stock returns whether you are a media giant like Walt Disney, or a tech company like IBM or Fiserv. The only sector where investors are sceptical of M&A is healthcare, where companies such as Eli Lilly or Bristol Myers Squibb have lost ground this year.

If the market is so kind to the idea of M&A, then it makes sense to use leverage to do it. Indeed, two thirds of the $460bn of M&A deals in progress at the start of this year used cash, or a mixture of stock and cash.

Paying for M&A deals is what drove US corporates to increase their total bonds outstanding by $170 billion in the first five months of 2019 according to iBoxx data. This increase was led by the technology sector which contributed $34 bn, followed by health care and industrial goods at $24 bn and $21 bn respectively.

Screenshot of interactive data visualisation. Corporate bond data provided by Markit iBoxx.

Although things were less frenzied than in the equity market, by their own sober standard, credit investors were fine about the new borrowing. Credit spreads for US corporates declined across the board. It’s telling that spreads of companies that borrowed the most, such as IBM or Bristol Myers Squibb, declined more than companies that didn’t increase debt.

As with equities, perhaps the M&A deals that drove the borrowing seduced investors, offering them a more compelling growth narrative than the alternative of sitting on the sidelines doing nothing. And they can ignore all the worrying recessionary and geopolitical signals because they know that the Fed has their back.


References   [ + ]

1. note that our capitalisation weighting is different to the free-float weighting used by S&P

What happened in bank risk last year?

Risky Finance has crunched the year-end regulatory filings for the biggest 11 global banks. For those who aren’t subscribers to the full database, here are some of the key trends we noticed.

1) Is reducing risk increasing it?

Troubled Deutsche Bank is on a mission to cut its complex balance sheet and reduce risk, and at first sight, the numbers bear that out. The bank shrank its derivative assets by more than 15 per cent in 2018, and its total assets by more than 12 per cent.

Screenshot of interactive visualisation available to subscribers

However, Deutsche’s regulatory capital requirement or risk-weighted assets barely went down despite credit and operational RWA reductions of five per cent apiece. The culprit? An unexpected 15 per cent increase in market RWAs that was caused by the balance sheet reduction.

It sounds like a contradiction but a paragraph buried in the bank’s annual report explains why.

“The increase was primarily driven by stressed value-at-risk”, Deutsche said, “coming from a reduction in diversification benefit due to changes in the composition of interest rate and equity related exposures”.

So according to Deutsche’s calculations, that bloated, complex derivatives portfolio would actually be helpful in a 2008-style crisis when correlations all went to one, because the exposures offset one another. The idea is not totally far-fetched: remember how Gregg Lippmann’s famous ‘big short’ helped save Deutsche in 2008?

It’s a bit like saying that nuclear power stations don’t melt down when all the components are aligned properly. But what happens when things go wrong? As Deutsche Bank is telling us, when the portfolio is being dismantled, it becomes even more dangerous.

2) Steinhoff really spooked JP Morgan

It was the big story at the beginning of last year, how a South African retailer came unstuck with accounting irregularities, ensnaring the global banks like Bank of America and HSBC that extended margin loans to its largest shareholder. It was that rare thing these days: sudden hefty impairments on investment grade corporate loans.

Screenshot of interactive visualisation available to subscribers

When we published a story about it in March, we noticed how JP Morgan and Citigroup did things a bit differently, booking the loans through their securities financing business, incurring mark to market losses when the value of the equity collateral plunged in value.

A few months later, JP Morgan did something quite dramatic: it reduced its securities financing exposure by $130 billion. This wasn’t reported by any news organisation, perhaps because the disclosure to the Federal Financial Institutions Examination Council never appeared in an SEC filing.

In this disclosure, there are two types of securities financing exposure reported, and the second one in which margin loan collateral is reflected in JP Morgan’s loss-given default (LGD) model saw the $130 billion decrease. The other type of exposure stayed constant, but saw an equally dramatic rise in its capital requirement.

One might detect the hand of the New York Fed here. Until Steinhoff, JP Morgan appears to have run its collateralised margin lending on the tiniest sliver of capital. Without that advantage, the bank saw no point in operating in this market, and made a quiet exit.

3) Securitisation is back

Of course it never completely went away – the 11 banks in the Risky Finance database have $800 billion of securitisation exposure between them. But after years of slow decline after the financial crisis, 2018 was the year that securitisation bounced back.

Screenshot of interactive visualisation available to subscribers

$48 billion of new exposures appeared on the balance sheets of BNP Paribas, Barclays, Citigroup and Deutsche Bank, offset by about $20 billion of reductions at the likes of Goldman, HSBC and Wells Fargo, where legacy portfolios continue to run off.

When you look at the contribution of new securitisation to credit RWAs at the banks, you can see why they are doing it – the impact on capital requirements is tiny. And that’s the whole reason for securitisation in the first place: the tranching of exposures in a waterfall of losses which gives huge risk transfer benefits to originating or sponsoring banks.

The financial crisis cast a long shadow over this market. The most toxic parts of it, like correlation trading or asset-backed CDOs, have all but disappeared. But collateralised loan obligations are in rude health, with BNP Paribas having done $20 billion of them last year, while Barclays structured $6.7 billion of synthetic CLOs. Mortgage-backed securities origination also saw a comeback, with Barclays doing $11.5 billion of European MBS, while Citi ramped up its private label MBS and asset-backed financing to the tune of $16 billion.

These are modest numbers compared with pre-2008 but are significant nonetheless.

Where would the market be without share buybacks?

The decline in equity markets seen in the last few months would have been worse without the countervailing effect of buybacks. But by how much?

Share buybacks are an enduring part of market practice. Warren Buffett loves them. And the numbers are huge. For example, the aggregate annual figure spent on buybacks by S&P 500 companies is approaching a rate of $1 trillion, according to S&P Dow Jones Indices.

Yet despite numerous headlines suggesting that the buybacks have been propping up the market, it isn’t clear is how much of an impact these buybacks have had on share prices. Or to express this as a counterfactual, where would the market be without buybacks? Risky Finance has conducted some analysis to shed light on this.

Is size becoming a risk for S&P 500 stocks?

During the two months before Thanksgiving, more than two trillion dollars were wiped off the S&P 500, dragged down by the technology giants whose stocks saw declines of 20 per cent or more. Until this week’s rebound, the index itself came close to being in ‘correction’ territory.

Screenshot of interactive chart available to subscribers

Although by many indicators a full-scale market rout may be overdue, October and November’s decline was something different. Correlations didn’t converge to one, and winners and losers could be categorised in several ways.

First of all, consider the sector story. Amid the $2 trillion of wealth destruction some sectors of the index performed well. Consumer goods stocks like McDonalds or Starbucks enjoyed double digit returns since September. Healthcare and utilities are other sectors with decent returns over this period.

The Risky Finance equity visualisation tool shows the cumulative cap-weighted returns for stocks in each sector over the last two months, and the effect is easy to see.

We can also see the same result as a histogram of returns, where the columns are the number of S&P 500 stocks with a return in a specific range. Here each sector is assigned a different colour. Technology stocks (in orange) are clustered over on the left (negative return) side of the chart, while consumer staples are mostly on the right.

There’s not only a sector story – there’s also a size story. We have been writing about gigantism in the S&P 500 for some time now, exploring theories and evidence on how size defeats everything in its path as an investing strategy. The last couple of months suggest an interesting reversal.

We’ve created a scatter chart plotting returns versus the log of market cap at the start of the period for S&P index members. Taking the returns from the start of the year, there is a small positive relationship between size and return. Taking the returns from the start of September to Thanksgiving, and this relationship becomes modestly negative.

Of course one must be cautious about small statistical effects buried in noisy data. But it chimes with the feeling that the climate is changing for once-charmed mega-cap tech stocks: either because of a regulatory backlash as with Facebook and Google, or the fear that consumer appetite has peaked, as with Apple.

When we plot the cumulative year-to-date returns of the index members, the striking dominance of giants like Apple is tempered compared with a couple of months ago, although you still would do better by holding just the largest four members of the index, stopping at Amazon. Adding the fifth-largest stock at the start of the year, Facebook, would have dragged your return down to 6 per cent. For active funds that track the S&P, the choice between these two stocks as the largest member of their portfolio makes all the difference. For those whose pensions are invested in such funds, these distinctions are worth bearing in mind.