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

Update on US economic outlook

Update on the U.S.
- Preliminary Q3 real GDP growth in the U.S. (revised down to -0.5% from the initial -0.3%) displayed a downward revision to personal consumption from the original -3.1% down to -3.7%.
-The U.S. housing starts plunging, Inventories remain at record highs; Home prices (S&P Case-Shiller C-10) are down 23% from the peak and the pace of decline accelerating every month
-Sudden spike in job losses and filing for jobless claims in November.
-Monthly job losses (a lagging indicator) are expected to hit the 300,000-350,000 range in 4Q08 and early-2009, taking the unemployment rate to 8.5-9% by late-2009/early 2010
-Manufacturing sector is facing tight credit conditions and slowing domestic and export demand
- Auto sector is also in a perfect storm amid slumping vehicle sales and tight credit conditions
- Recent readings of both the PPI and the CPI are showing the beginning of deflation
In a sentence: Slow economic recovery, massive erosion of consumer wealth and demand and double-digit decline in industrial activity

Actions to combat:
- President-elect Barack Obama unveiled a first rate economic team (Larry Summers, Tim Geithner and Christina Romer) to address this most severe financial and economic crisis.
- Consumer confidence got a boost from falling oil prices and new leadership in the U.S. government
- Federal Reserve announced direct purchases of $600bn in conforming MBS and agency bonds ($500bn and $100bn, respectively.)
- Simultaneously, the Federal Reserve is setting up a new $200bn Term Asset-Backed Securities Loan Facility (TALF) for investors of consumer loan-backed securities
- Government provided a $306bn rescue package for Citigroup

Next Steps:
- Significant fiscal stimulus expected over next 4-5 quarters to prevent significant growth contraction and deflation.
- Spending on infrastructure and green technology as endorsed by Obama can provide some stimulus during prolonged growth slowdown
- Democrats are also pushing for unemployment benefits and food stamps which are well-targeted and have the largest bang-for-the-buck.
- Obama has prioritized a large fiscal package as soon as he comes into office in Jan 2009

Where are we in the crisis? Markets for the week ending 21-Nov-08

This week panic seized the markets and we saw citi's share price crippled by a vote of no-confidence. One begins to rethink if equities remains a viable asset class in this turbulent market.

Market indicators

a) The flight to safety pushed 10-year US bond yields to a 5-year low of 3.02% and the 30-year bond yields to it ever recorded low of 3.49% since 1977. As investors reduced holdings in riskier assets bond prices could strength further and yields fall further.

2-year Treasury bonds fell below 1% for the first time since it was issued in 1976

b) ITraxx Crossover, a measure of risk aversion, measures the credit spreads of junk-rated bonds at a record high of 942 this week.

c) Tips (inflation linked bonds) moves to levels that only make sense if US prices fell, on average, for the next 10 years.

d) Dividend yield on the S&P500 is higher than the yield paid on a 10-year Treasury note.

IS this the pricing for a deflationary Armageddon? or is it a sign for investors with longer term horizon to buy?

Good economic news is likely to take a long time to arrive as central banks prepare to wrestle with inflation and world growth is projected to decline to a miserly 1.1% (IMF criteria for worldwide recession is <>

But looking further into the wider investment universe, there are convertible bonds out there which have been overlooked by many investors. With some due diligence carried out, investors could yield a hefty 15-20% over the next 12 months, which might not be a bad bargain in these markets conditions.

Eric Tan, London

U.K. to adopt the Euro ? Risks to a further weakening GBP

Read a good article on risks of a further Sterling weakening, here are the main points:

Risks FOR U.K. Bank Runs:
a) The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: about 450% at the end of 2007 as compared to Iceland’s 900%.
b) The gross external assets and liabilities of the British economy are about the same size relative to UK GDP
c) England’s foreign currency reserves are puny and the government’s foreign currency reserves are small - around US$43 billion
d) Among the larger European countries, the UK government’s exposure, formal or implicit, to its banking sector is by far the highest. Switzerland, Denmark and Sweden are in a similar pickle, with the banking sector solvency gap threatening to become larger than the fiscal spare capacity of the state.

No doubt the Bank of England would be able to arrange swaps, credit lines or overdraft facilities with the Fed, the ECB or the Bank of Japan. And given sound banks and sound fiscal fundamentals, it should be possible for the UK to defend the banking sector against runs or market strikes.

Sterling Risk
By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but at the cost of increasing sovereign default risk.

In addition to the debt that has been and will be issued to finance asset purchases by the government, there are the future debt issuance associated with the large cyclical and structural government deficits that will be a feature of the coming recession. A seven percent GDP or higher government deficit for 2009 and 2010 look probable. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to higher.

Costs to U.K. PLC
With the true net public debt to GDP ratio probably already well above 100 percent of GDP and rising, and with massive public sector deficits, partly cyclical and partly structural about to materialise, the markets will question the fiscal-financial sustainability of the government’s programme. The CDS spreads on UK public debt will start rising.

The current deficits limits capacity to engage in a discretionary fiscal stimulus to boost domestic demand. For it to be meaningful, a debt or money-financed stimulus of at least one percent of GDP and more likely two percent of GDP is called for. Higher default risk premia to the longer-dated UK sovereign debt instruments will be priced in if the market believes that the government’s ability to raise future taxes or cut future public spending to safeguard solvency is weak.

The resulting interest rates rise can crowd out completely the stimulus to private demand provided by the tax cut or public spending increase.

Lack of confidence in the government’s fiscal sustainability would also undermine confidence in sterling. In the worst case, we could see a run on the banks, on the public debt and on sterling all at the same time. It provides another strong argument for the UK adopting the euro and for the Bank of England becoming part of the Eurosystem as soon as the other EU member states will let it

Proposals
The British government should go easy on the discretionary fiscal stimulus it applies, lest it risk a triple bank, sterling and public debt crisis. Better to first let the Bank of England use the 300 basis points worth of Bank Rate cuts that it still can play with. Even better to combine rate cuts with measures to directly target the disfunctionalities in the interbank market, such as government guarantees for (cross-border) interbank lending.
The UK shares with the United States of America the predicament that unfavorable fiscal circumstances make the wisdom of a significant fiscal stimulus questionable. In the US as in the UK the twin deficits (government and current account) severely constrain the government’s fiscal elbow room. Both countries need all the help they can get from fiscal stimuli abroad, in China, in Germany and in the Gulf
http://blogs.ft.com/maverecon/

A new president, a new hope? Markets for the week ending 7-Nov-08

Both the International Monetary Fund (IMF) and European Commission (EC) released reports downgrading growth forecasts stressing that output growth had slowed and financial conditions are likely to remain tight for a longer period.

Over the last week, the mood changes have been so quick from emerging market government bonds rallying to bad economic data from the US sending markets sharply lower.

The main themes that dominated a worsening of consumer sentiment are mainly around:

a) Financial crisis has continued to deepen in the rich world, with highly indebted countries like the UK particularly vulnerable

b) Commodity prices show signs of further weakness and is hurting exporters such as Russia and countries in Africa dependent on selling materials overseas

c) General souring of sentiment has hit all emerging markets especially those dependant on foreign investors to finance current account deficits

Further risks to the economy

The big danger is that a severe global economic downturn creates a massive wave of credit losses on both consumer and corporate loans, further destroying and eroding the already shrunken capital bases of financial institutions. This would once again require more rounds of large capital infusions by the governments of the world.

The big question to ask is: Will the election of the new American president signal to the market that powerful forces of natural and policy-induced help is on the way and should arrive before the scenario of a severe global economic downturn materialise...

Eric Tan, London