Wednesday, 26 November 2014

Credit - The Hidden Fortress

"Even if it seems certain that you will lose, retaliate. Neither wisdom nor technique has a place in this. A real man does not think of victory or defeat. He plunges recklessly towards an irrational death. By doing this, you will awaken from your dreams." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai

Watching with interest, Japan hit again with recession, with Shinzo Abe's response by delaying the sales-tax increase while the GPIF increasing its share of risky assets, with neighboring China throwing as well the proverbial gauntlet with both a surprise rate cut as well as with its rising up-and-coming industrial technologies and industrial companies, we reminded ourselves of one of our favorite film directors of all time Akira Kurosawa's 1958 masterpiece "The Hidden Fortress" when choosing our title as an analogy. After all, Kurosawa's movie is all about epic self-discovery and heroic action as described by Armond White in The Criterion Collection in 2001: "Kurosawa always balances valor and greed, seriousness and humor, while depicting the misfortunes of war."

In our investment world it is all about balancing valor and greed while we, pundits continue to depict the misfortunes of currency wars we think.

What is as well of interest in our chosen analogy and movie reference is that in the movie, the two peasants heroes while driven by their ecstasy for gold end up with only one single Ryō gold coin: "A Ryō was a gold currency unit in pre-Meiji Japan Shakkanhō system. It was eventually replaced with a system based on the yen." - source Wikipedia. On a side note movie buffers like us know that Georges Lucas was heavily influenced by Kurosawa's movie which inspired him to create the lowliest characters C-3PO and R2-D2 in Star Wars. 

The Currency Museum of the Bank of Japan states that one Ryō had a nominal value equivalent 300,000-400,000 Yen, but was worth only 120,000-130,000 Yen in practice, or 40,000 Yen in terms of rice which but half of what an ounce of gold is in terms of weight (16.5 g vs 31.103 g). From an historical point of view it is interesting to note that in 1695 during the Togugawa shogunate, the government decided to debase the Ryō. By 1736, the government decided to stimulate the economy and raise prices, again by debasing the gold content of the Ryō until it was abolished in 1871 and replace by the yen but we ramble again...

When looks at the YTD returns of various cross-asset classes, as presented by Bank of America Merrill Lynch in their Thundering Word report of the 7th of November 2014 entitled "Humiliation, Hubris & Gold", one could fathom that the real "Hidden Fortress" has indeed been the US dollar:

In this week's conversation and in continuation to our musings relating to central bank intervention we will look at why the "japanification" process has been favorable to the on-going rally in credit as well as how the market has been playing the banking sector deleveraging through credit rather than through equities (a pure capital structure play we think).

While there has been a lot of noise recently around the SPX vs HY US widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning", this credit uneasiness is also visible in Europe with Investment Grade / High Yield renewed divide - graph source Bloomberg:

Itraxx Main 5 year CDS index versus Itraxx Crossover 5 year CDS index - roll adjusted as of the 20th of November 2014:

What has also been of interest in 2014 when it comes to the performance of credit, yet another "Hidden Fortress" we think, has been the total return performance in the US of High Grade versus High Yield in terms of Total Return as displayed in a chart from Bank of America Merrill Lynch from their 2015 2015 HG Outlook entitled "Un-reaching from yield":
"As our title suggests we expect US high grade corporate credit to come under pressure next year as the Fed begins its rate hiking cycle. The exemplary behavior of credit spreads in recent years stands as the key consequence of strong inflows to the asset class. As inflows disappear/turn to outflows we expect extended periods of spread widening – and high spread volatility - as interest rates go up, and thus continued positive correlation between interest rates and credit spreads" - source Bank of America Merrill Lynch

Of course we agree that one of the top main reasons in the behavior of credit spreads has indeed been strong inflows in the asset class as indicated by Bank of America Merrill Lynch in their recent Follow the Flow note entitled "Quality is king" from the 21st of November:
"Non-stop flows into ‘safety’
More of the same for another week it seems. More inflows into high-grade credit funds, and more outflows from equity funds in Europe. Note that euro IG cash is now trading at 2007 levels. So far this year more than $60bn has been added to high-grade funds, while equities have seen inflows of only $14bn. If the recent trend of outflows from equity funds continues at the same pace for the rest of the year, cumulative flows might be close to flat.
Government bond funds have continued to see outflows for a fourth consecutive week, with money-market funds down for a second week in a row. Note that over the last week, only high-grade credit and loan funds have seen inflows.

Credit flows (week ending 19th November)
HG: +$2.0bn (+0.3 %) over the last week, ETF: +$669mn w-o-w
HY: -$700mn (-0.3%) over the last week, ETF: +$20mn w-o-w
Loans: +$41mn (+0.5%) over the last week
Flows into high-yield funds dipped into the negative territory. After a short stint of inflows European HY funds saw a $700mn outflow. YTD outflows now point to $2.5bn. Should HY flows remain in negative territory for the rest of the year that would mark the first year since 2011 of negative flows for the asset class. On the other side, high-grade credit with another $2bn+ inflow last week is set to have its best year according to EPFR data.
Mid and long-term high-grade funds continued to see strong inflows, while short-term funds suffered moderate outflows, as investors are reaching for quality yield.
- source Bank of America Merrill Lynch

In total YTD inflows in Investment grade represents $60 billion versus only $14 billion in equities. So much for the "Great Rotation" story of 2014...

When it comes to the gradual move towards higher quality in the credit rating spectrum, this adds validity to what we argued back in October in our conversation "Sprezzatura":
"When it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space. This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit."

In fact, as per Bank of America Merrill Lynch AAA-rated US corporate bonds (9% annualized) outperformed CCC-rated bonds (2%) validating the “flight to quality” theme and quality credit being a somewhat a "Hidden Fortress".

In terms of the impact the rate hiking cycle we have a preference with scenario number two from Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield":
"Why the rate hiking cycle is different for credit this time
There are three reasons why we are particularly concerned about the rate hiking cycle this time. First, we are at the tail end of an unprecedented five years of zero interest rates, which led to an unprecedented reach for yield. Thus we are about to see an unprecedented un-reach from yield. Second, dealer balance sheets have collapsed due to new regulation, and are thus unable to mitigate a situation with heavy outflows. Finally, the less stable mutual fund/ETF ownership share of our market has jumped compared with the 1990s (Figure 5).
#1 risk to our outlook – Upside to the economy
The #1 risk to our outlook is that the US economy really takes off and leads to a more rapid rate hiking cycle and much higher long term interest rates. To us the economy looks really strong, and the November reading on Philly Fed being the highest since December 1993 (Figure 6) reminds us about the biggest risk scenario for 2015 – a repeat of 1994, where a strong economy forced the Fed’s hand and financial market conditions became disorderly. 
In that scenario we think HG credit spreads could widen to 200bps, taking global credit spreads wider too. That could lead to excess and total return losses of about 200bps and 8%, respectively.

#2 risk – Downside to the economy
We also find it entirely possible that that the US economy slows down meaningfully from here to around 2%-2.5% GDP growth in 2015 (compared with our house forecast of 3.1%). This #2 risk to our outlook would mean that the rate hiking cycle is pushed beyond 2015, and that global investors may become sufficiently comfortable with US interest rate risk that we get a big global reallocation into US fixed income, given ultra-low global yields. Such scenario could lead to lower interest rates and much tighter credit spreads – say, as tight as100bps, with US HG spreads compressing significantly to EUR HG spreads. This provided that the economy does not slow too much. In this scenario HG excess and total returns could be as much as +330bps and +9%, respectively

#3 risk – Upside to the global economy
As #3 risk to our outlook we have that strong US economic growth pulls up the global economy. As we have argued, the US is a relatively closed economy and thus unlikely to be pulled down meaningfully by the weak global economy. However, the US economy is big enough that its imports can serve as an important driver of global economic growth. The problem with this scenario is that it lessens the downward pressure on long term US interest rates asserted by the weak global economy. That means more outflows from credit and further credit spread widening." - source Bank of America Merrill Lynch

When it comes to credit and liquidity, it has been a recurring theme in our musings. On the subject of liquidity we agree with our good friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR from his last post entitled "A confidence in crisis":
"Bloody, ugly

ICMA, the International Capital Markets Association – I am honoured to be sitting on one of its committees – has just published a paper titled “The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market”. It is based on a series of interviews with senior market participants from both sides of the street. We might nod knowingly at most of its conclusions but it finely articulates knowledge and concerns of the bond markets for those who don’t fully understand them but who are, nevertheless, responsible for their governance.

It is a fine piece of work by Andy Hill but it carries one big and stark warning which is that most players are patently aware that debt markets are living in a liquidity fed vortex and that nobody has a clue what might happen when if, as and when the cheap money is withdrawn. What they are certain of, it would seem, is that whatever the outcome might be, it will be pretty bloody and ugly." - source IFR - Anthony Peters

A good illustration from this report pointed out by our good friend is the RBS Liqui-o-Meter graph measuring market liquidity we think:
"The RBS Liquid-o-Meter, which attempts to quantify US bond market liquidity, suggests that liquidity in the US credit markets has declined by 70% since the crisis, and continues to worsen. Anecdotal evidence suggests that this is equally applicable to the European corporate bond markets.
The RBS ‘Liquid-o-Meter’ attempts to quantify bond market liquidity by combining measures of market depth, trading volumes, and transaction costs. Currently it is only modeled for US markets." - source ICMA report "The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market.

As we posited in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

We remind ourselves from the wise word from our friend and credit mentor Anthony Peters when it comes to liquidity:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk

From the same Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield" here is another illustration of the lack of liquidity premium in the credit space:
"When the tide goes out
Currently we think that investors are not getting paid sufficiently for taking liquidity risk. Furthermore the most obvious consequence of the lack of retail inflows and institutional outflows, when short term interest rates go up, is that liquidity deteriorates. Hence we prefer positioning in liquid bonds.
For credit the most prominent unintended consequence of increased financial regulation is reduced liquidity via the collapse in dealer balance sheets (among other things, Figure 12).
As we have argued, that means high grade credit spreads should be permanently wider as the fair liquidity premium is much higher – in the appendix we update our analysis to estimate potential cycle tight HG spread levels of 100bps, compared with 79bps during the previous cycle.
However, this effect has been masked as strong technicals from significant inflows to HG, and credit spreads moving toward new tights meant investors were forced to reach for yield in off-the-run names and maturities. As a consequence, again, the liquidity premium has collapsed (although very recently there has been a small increase, Figure 13).
However, with the Fed expected to hike interest rates next year obviously inflows are destined to weaken and even turn to outflows. That means the liquidity premium is going to widen back out to – we estimate – about 10% of on-the-run spreads as a rule of thumb. Hence we continue to think investors are better off in liquid on-the-runs, as they are not being compensated for taking liquidity risk.
This also means that our HG index spreads of presently around 130bps are artificially tight. In fact, if our index is priced under next year’s deteriorating liquidity conditions we think spreads would be about 10bps wider (given that the vast majority of bonds are illiquid). That represents formidable headwinds for HG credit next year. Add a rate hiking cycle to much worse liquidity conditions and we look for HG credit volatility to increase significantly next year from currently around 44% (1m ATM options on the CDX IG) to 80% - thus exceeding levels seen last year during the taper tantrum" - source Bank of America Merrill Lynch

The Hidden Fortress in the credit space lies therefore in high quality and liquid bond we think.

Moving back to the subject of the potential downside to the US economy, what we find of interest is that the "Cantillon Effects" have indeed generated positive correlations. The world is much more intertwined macro wise.

The "japanification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We commented at the time that the credit markets and equities markets were no exception to "rising forced correlations". In recent years, credit and equities have correlated closely, but, as credit has moved towards a lower bound, Investment Grade for instance have become even more sensitive to interest rates movement, making it incredibly likely that any rate rises will have a large impact given the disappearance of the interest rate risk buffer in the asset class given the on-going spread compression supported by large inflows into the asset class.

As we reminded ourselves from the conversation "The Monkey's paw" when discussing too much liquidity in the world:
"It seems to us the central bank "deities" are in fact realising the dangers of using too much the "Monkey's paw" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space, but that even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in credit funds given that the Fed's role is supposedly one of "financial stability"." 

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
 Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

We concluded at the time:
"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment and the fact that recently one of the largest player in the single names CDS trading space, Deutsche Bank has decided to exit entirely the business, which is no doubt another headache for the credit players looking for duration risk mitigating tools.

When it comes to interest rates risk and positive correlations we find of interest that all global sovereign rates declined together in 2014. Most investors were positioned for higher interest rates, we were not. 

Several factors come to play when asserting the reason behind the global decline. On this subject we read with interest Bank of America Merrill Lynch recent Liquid Insight note entitled "The world is flat":
"Is this a coincidence or a trend?
Is the global decline in rates a mere coincidence in 2014, or is it a recurring theme? Chart 1 illustrates the time series of 10y rates in the US, Euro area, UK, Japan, Canada and Switzerland, suggesting strong co-movement over time. 
To see the strength of the correlation, we conduct a Principal Component Analysis (PCA), and compute the fraction of total variance that can be explained by the first principal component (PC). On average, the first PC can explain 85% of total variance in global rates over the last 10 years. 

As one would expect, during crisis periods such as the Lehman collapse (2008) and the European peripheral crisis (2010-12), the fraction is particularly high. There is either a growth shock or a flight quality move, which spills over across markets. However, the first PC has remained very high in 2013 and 2014 even though we are not at a crisis period per se. This suggests recently global rates seem to be as correlated as they were during crisis periods. This could reflect deeper inter-linkages in the macro economy as well as financial markets globally post crisis. Some research also suggests uncertainty shocks such as the Lehman crisis can put downward pressure on terminal rates globally." 

What drives co-movement across global rates?
A recent IMF study3 attributes co-movements in global rates to the usual three 
factors: level, slope and curvature. Interestingly, the authors associate these 
factors with a clear economic interpretation of global inflation, global growth and 
future financial and economic instability, respectively.

Since global growth and global inflation are closely related to US growth and US 
inflation, it is important to differentiate whether the correlation in global rates is 
merely a reflection of correlation of macro fundamentals, or whether global factors 
provide additional information. In other words, do global factors impact US rates 
beyond US growth and inflation factors? This question is of particular interest 
currently as growth dynamics seem to be diverging, with the US outperforming 
much of the developed world.
To this end, we compare two regressions: In one, we only include US growth 
measures as proxied by the PMI indices. In another, we include global PMI in 
addition to US PMI measures. Regression results are tabulated in Table 1 and 
Table 2. 

When we take account of global PMI, the fit improves, and R-square 
increases from 12% to 30%. This signals that global PMI provides explanatory 
power for US rates that go beyond US PMI measures. Another way to see the 
relevance of global PMI is that the coefficient in front of global PMI is significant 
(with t-stat 3.72). These results suggest that global growth measures provide 
additional information for US rates beyond US growth measures.
This finding does not contradict our previous finding that 10y German rates do not granger cause 10y US rates. While granger causality examines whether lagged 10y German rates provides explanatory power for 10y US rates in addition to lagged 10y US rates, the discussion above focuses on macroeconomic fundamentals that drive movements in 10y US rates. It is quite possible that lagged 10y German rates do not contain new marginal information of global growth over lagged values of 10y US rates.

Market implications: Mind the globe
Even though US domestic factors of a narrower output gap and slowing demand from price inelastic sources argue for higher US rates currently, we think investors should be mindful of global factors. The recent weakness in global growth (as evidenced from global PMI) and inflation can prevent a significant move higher in US 10y rates. By the same logic, any pick-up in global growth or inflation will likely have a disproportionate effect on US rates, all else being equal.- source Bank of America Merrill Lynch.

Given the disappearance of the interest rate risk buffer in the investment grade asset class, mind the volatility gap in 2015 and hedge accordingly.

Another factor explaining the global trend in lower yields has of course been the role played by Japan and its pension funds allocation, in particular the GPIF which is reducing its domestic bonds exposure aggressively while pursuing a higher share in risky assets: domestic equities, foreign equities as well as foreign bonds as disclosed its July-September quarter financial results published on the 25th of November and as reported by Nomura in their note entitled "GPIF still has room for a portfolio shift":
"The GPIF, the biggest pension fund, announced its Jul-Sep quarter financial result today. The share of domestic bonds in its portfolio declined to 49.6%, the lowest share ever, from 53.4% the previous quarter (Figure 1). 
The share undercut 50% for the first time and it was lower than the minimum share under the old target portfolio. We estimate that the share fell to 52.3% by end-September owing to valuation effects. Thus, the fund reduced its domestic bond exposure aggressively, more than valuation effects suggest. Trust accounts, which manage pension fund money, were net sellers of JGBs in August and thus, the decline is not necessarily surprising" - source Nomura

We note that the allocation to international bonds from end of June at 11.1% increased to 12.1% and given the maximum target portfolio new target has increased from 16% to 19% and the target portfolio is set at 15% therefore there is room for further yield compression we think in the global sovereign space.

Moving to another case of "Hidden Fortress", we continue to think US treasuries are compelling, particularly in the long end as we believe the US is far from normalizing and investors might yet again be disappointed in 2015.

The potential catalyst for US Treasuries has been summed up nicely by Societe Generale in their November publication entitled "The Japanization of the US economy? What if the US follows Japan (and the Eurozone) down the rabbit hole of deflation?":
"Potential catalysts for US Treasuries:
• Differential between US, Eurozone and Japan rates are at historically high levels, in part based on the belief that US can avoid global deflation
• What could push US into same vicious spiral as Europe and Japan?
• Consensus has not priced in risk of deflationary conditions in the US
• Deflation in the US would be very bullish for US Treasuries but there are additional factors driving capital flows into US Treasuries
1) Chinese official sector buying Treasuries - underinvested in Treasuries since Fed started QE-III
2) ECB negative discount rate policy drives EM reserves out of € into US reserve deposits
3) Return of the geopolitical crises; Greece and Venezuela/Argentina induced by China
4) US dollar should continue to appreciate, which is disinflationary and compresses rates
5) US elections – GOP control over Congress leads to lower deficits, lower growth
6) Lack of alternative, dollar denominated, risk free assets
7) Mortgage pre-payment hedging – Mortgage investors have to buy Treasuries to hedge pre-payment risks
8) Fed will likely remain more dovish than many currently forecast
9) Demographics - Surging retirement of 75ml baby boomers will drive investments into Treasuries
10) Regulation – Fed and US regulators forcing financials to hold more Treasuries"- source Societe Generale

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).
When it comes to Europe, the deleveraging continues and amounts to goldilocks period for credit particularly in the banking space whereas banking equities will continue to underperform we think.

We pointed out in our conversation "Actus Tragicus" the attractiveness of European investment grade credit:
"While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:
"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura
We also argued at the time:
"We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...)."

The continued underperformance of European banks equities versus credit can be explained by the simple underlying mechanism of capital arbitrage as explained by Exane BNP Paribas Research in their note from the 13th of November entitled "How the market plays the banking sector deleveraging":
"The relative fall in banks’ shares vs credit reflects a capital structure analysis
The banking sector has underperformed the whole market by 9% since the beginning of November. At the same time, the credit spreads of banks have accompanied those of the whole market. This is a normal capital structure pattern. The market anticipates a value transfer from equity holders to debt holders. This is the case when a company or a sector reduces its leverage, for example through disposals, capital increases, or improved market conditions. Such moves reduce the risk borne by debt holders but reduce the speculative time value of equity holders."
The underlying mechanism
The banking system arbitrage is so simple that it can be explained using the Merton model, notwithstanding the model can be refined. To allow for complex capital structure analysis and arbitrage, we generally use our proprietary ALRG™ model.
The simplified Merton view states that the sole driver of a firm’s value is its asset value. As long as the asset value covers the nominal of the debt, the firm continues to operate. If not, the firm is liquidated and the proceeds go to the debt-holders.

Debt and equity are seen as options on the assets.
– The debt holder gets back the nominal debt value if the company is solvent and receives the residual value of the assets in the event of default; the payoff of the position is MIN (debt, asset). The equity value is seen as a call option on the assets, the amount of debt is the strike.
– The equity holder owns the net asset value if the company is solvent but loses everything in the event of default; the payoff is MAX (0, asset - debt). The credit spread is the premium of a put option on the assets, the amount of debt is the strike.
The equity (call option) value includes intrinsic value (asset value less the amount of debt) and time value (speculative value).
The put option has no intrinsic value, as long as the value of the assets is greater that the debt amount. Yet, it essentially has time value.

A deleveraging is a very simple move: the strike is lowered. Doing so, the risk borne by debt holders is reduced. This is reflected by the value of the put option sold by the bond holder. With a lower strike, its value is lower. And of course, due to the call/put parity, this value is taken from the equity holder. The speculative value of equities is reduced.

In the real world, things are more complex and worse:
1) Banks hold an implicit guarantee “offered” by central banks and/or governments. Its value is reduced by the deleveraging. This is the target of the too-big-to-fail regulation. Consequently, the deleveraging also has a negative impact on assets value, increasing the transfer from equity to debt holders.
2) Like any other company, a bank has to bear significant operating costs – which do not come down with reduced leverage. The expected equity return is reduced, but the costs to obtain this return will remain the same.

To offer a caricature, a “perfect” bank would only hold treasury bonds and would be fully financed with equities. In this case, the shareholder’s return is defined by the treasury yields minus operating expenses and taxes. This is not a very good investment." - source Exane BNP Paribas Research

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" which displays Europe earnings as % of global earnings:
"The Berlin Fall
25 years on from the Fall of the Berlin Wall and Europe is arguably one recession away from severe political and social stress. 24,512,000 men and women are currently unemployed across the continent and anti-establishment political parties are surging in popularity across the continent. Monetary convergence between 1989 and 1999 (as disinflation from Eastern Europe and the promise of good fiscal behavior initiated a decline in interest rates toward German levels) and the monetary union of 1999 and 2008, has been replaced by a monetary divorce as bond markets price-in various sovereign risks. Meanwhile, Europe’sshare of global profits has collapsed (see Chart 4)." - source Bank of America Merrill Lynch

When it comes to QE in Europe in general, and the ECB in particular, we think our last quote resume appropriately the "Japanication" situation:
"If you keep your sword drawn and wield it about then no one will dare approach you and you will have no allies. But if you never draw it, it will dull and rust and people will assume that you are feeble." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai

Stay tuned!


  1. Is it possible to get a copy of the Nomura note referred to?

    1. Sure Nikki, send me your e-mail address at




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