Happy Holidays!

There'll be no posts over the last 2 weeks of the year.
I'll be back in 2009 with more interesting views, and here's wishing everyone a Merry Christmas and Happy New Year!
Eric Tan

The "Bezzle" shrinks

The "Bezzle" of Embezzlement
"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. there is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in - or more precisely not in - the country's business and banks. This inventory - it should be called the bezzle. It also varies in size with the business cycle."

- John Galbraith, "The Great Crash: 1929"

Rush to Convertibles. Week ending 11-Dec-08

Several weeks ago, I wrote about convertible bonds as an asset class that have been overlooked by investors and offer a potentially respectable stable yield in the current market environment.

Convertible bonds have been widely held by hedge funds keen to arbitrage the value of the implied option embedded in bonds, but as leverage available reduced from 5x to virtually zero, hedge funds became forced sellers and that resulted in convertible bond prices falling to all time lows.

There is now an opportunity to make relatively low-risk double digit returns without using leverage or complex hedging strategies. It is as simple as buying a distressed debt with a free option kicker on it, and in many cases, it's cheaper than the straight bond issued by the same company.

Recently, there have been pension funds, sovereign wealth funds (SWFs), and new credit opportunity and distressed bond funds being launched to invest billions of dollars into the convertible bond asset class that has become less opaque and complex with the financial market breakdown.

Eric Tan, London

US employment reaches 6.7%. Markets for the week ending 5-Dec-08.

Economy

This week European central banks (BOE, ECB, Sweden) slashed interest rates in a bid to deal with the worsening global crisis, but the mood remains grim. Investors continue to fret about the global economic and corporate outlook. Bond yields in both US and Europe reached historic lows and credit spreads made all new highs.

So what can we take away from the state of the economy now?

a) Low UK sterling: GBP has had 5 major declines in the last 20 years and each averaged 20% frrm peak to trough against the USD. But since the 26 year high of $2.11/GBP acheived in November 07, it has fallen 30%. The number of short position contracts on the pound is still at historic highs and although there is talk that it may fall further to $1.30, there are more interesting ways to play a weakening gbp such as buying UK companies with high overseas exposure.

b) CDX main, ITraxx X/O all made new highs this week. Looking back at Jan 07 when X/O rose from 340 bps to 550 bps in 2 weeks, the market was shell-shocked, but this week, X/O breached 1000bps, i.e. the cost of buying protection on high yield corporate bonds are > 10% now. Markets seems to be overpricing in a fear of major financial disruptions in the last 2 weeks of 2008, and currently imply a 63% rate fo default versus historic peak of 32% in 1932. IS it the time to sell protection ? Single names are being decimated, but the economy cannot recover until credit spreads fall. To play the credit theme, Insurance names and companies with high FCFs are preferred.

c) US unemployment rose to 6.7% and the non-farm payrolls figures exceeded the worst expectations of economists polled by Bloomberg. However, looking back at the last 2 crisises in the early 1980s and 1992, unemployment rates were 10.1% and 7.8% respectively, so it's highly likely that we can expect more job cuts into the new year.

Eric Tan, London

Inversion of the 30-year US swap rate

Power Reverse Dual Currency (PRDC) bonds are the latest instruments causing havoc in the financial world. This product which have been typically issued in Japan has a average maturity of 30 years with coupons linked to movements in a foreign currency such as Austrialian Dollar or US Dollar.

When the yen weakens against the relevant currency, coupon rises, but the issuer can 'call' or cancel the deal after the purchaser receives a certain return.
It allowed Japanese investors to enjoy a leverage form of the carry trade, where Yen is sold to purchase more risky currencies.

However, the deleveraging of assets in the financial markets has driven Yen to record levels instead of the steady depreciation of the Yen as widely assumed by markets. PRDCs are structured such that when a certain level of exchange rate is breached, the coupon stops but the note is still valid.

With strong volatility and strengthening of the Yen, instead of the bond being called early, banks are now struggling to hedge the longer term problems of the FX exposure and currency option embedded in the PRDC bonds. This left them short in the Yen and with Yen strengthening, the problem was amplified. Dealers had to buy Yen calls or Yen spot which accelerated the Dollar/Yen downward move.

Japanese investors have sought higher returns using US swap rates and recent rally in Yen resulted in dealer having to enter the 30-year swap market to stem rising losses. This has caused the 30-year swap spread in recent weeks to fall 60bps below the yield of the Treasury bond.

Eric Tan, London