"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
Ironically, the precipitate fall in the bonds of the Co-op has increased its optionality with respect to using its subordinated bonds to bridge its capital gap. We estimate that the current gap between the face value of the Group’s tradeable subordinated bonds and their market value as of Friday close is £416m (there are other bonds which are much less liquid too in addition to this number). The monetization of this could be a key part of the solution, assuming that the bonds don’t jump in value next week as bottom fishers may come in.
That would be risky, we think, because all forms of liability management are potentially on the table, in our view, both coercive and voluntary. We can even see the possibility (though admittedly unlikely) of a debt-for-equity swap – the bank is a PLC after all, so it does have shares. The Group would resist this, we would expect, as it would hardly want to share ownership of the bank with sub bondholders, but it depends on how truly desperate the situation is and how the UK authorities decide to address it." - source Bank of America Merrill Lynch.
Of course the "unintended consequences" of Cyprus and "Abenomics" make us believe that in the "Wonderful Life" of the financial credit universe, no one is really prepared to "face the music" when the music, will stop, because at some point, with the implementation of "bail-in" it will!
It looks like Bank of America Merrill Lynch is facing our rather "sanguine" views as well on that matter:
"Is it priced in?
In our view the price action of Co-op bonds on Friday shows that the market is ill-prepared for bail-in of bank bonds, which rather undermines the idea that the concept is so well-known and talked about that it is ‘in the price’. It is not in the price in our view.
Our investment case for European bank bonds became much more cautious post-Cyprus. In summary, we think that the positive investment case for European bank bonds has faltered as a result of Cyprus. However we believe that has not been reflected in spreads or positioning. In fact, our recent investor survey shows that investors have been consistently increasing their allocations to subordinated debt and moving away from senior debt. Whilst we understand the concept that you don’t get paid for bail-in in senior debt, we have to underline that you don’t get paid for bail-in in subordinated debt either." - source Bank of America Merrill Lynch.
So, sorry to spoil the 'credit party mood', because current subordinated bond prices do not reflect the fundamentals and the underlying credit risk we think and we are not the only ones:
"We maintain our view that a more cautious stance is warranted, especially in the periphery where European bank asset quality problems are concentrated. We saw the recent USD 6.375% subordinated bond of Unicredit as the apogee of complacency in the market. This bond is currently trading well above 102 (a yield of nearly 5.9%). We can see the attraction of the yield but it is not normal for a bank to have NPLs of 20.1% in its domestic business. On a consolidated basis, a 14.1% NPL ratio (up from 13.6% at year end) with 44% coverage should not be considered normal either. It represents a significant risk to bondholders, in our view." - source Bank of America Merrill Lynch.
On a final note, given a few days back we pointed out that Air Traffic is pointing to additional economic activity weakness, we would like to add there is indeed a high correlation between passenger air traffic and GDP growth - graph source Bloomberg:
"Passenger air traffic correlates with GDP growth at a 1x multiple in developed countries and about a 1.5x to 2x multiple in developing markets. Consensus GDP forecasts provide insight to the trend for air traffic growth in the coming years." - source Bloomberg.
"It's not what you look at that matters, it's what you see." - Henry David Thoreau