Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 17 January 2012

European downgrades and investment strategy

As usual the rating downgrades were priced in and after the initial knee-jerk reaction, the inevitable post downgrade rally happened. More proof of rating agency uselessness if any more proof was indeed required.

Even though downgrades and their short-term effects are a sideshow, in a world of benchmarked investors who "outsource" their credit research to the rating agencies (and hence buy AAA sub-prime CDOs) ratings do matter.

The first is because bond inclusion in portfolios and indices is governed by ratings. Rating downgrades lead to forced selling of bonds irrespective of value offered at that point in time. The second is because ratings define collateral eligibility in the repo market. A downgrade can cause collateral to stop being accepted causing a cash crunch for the owner of the downgraded bonds. This again may lead to forced selling or at the very least make the bonds a less attractive investment.

This theory is validated by the price action in Portuguese bonds. After S&P's downgrade, Portugal was relegated to the third division, i.e sub-investment grade by all three rating agencies. This means that Portuguese bonds would be kicked out of investment grade indices which led to forced selling by the benchmarked crowd. Although why anyone would still be long Portuguese bonds irrespective of whether they are in an index or not is a puzzle worthy of a PhD thesis.

France and Austria's prospects depend on Moody's mood. Therefore for the time being the market is holding in. In any case, a downgrade will have a more muted effect by only impacting collateral eligibility. 

One needs to look past this sideshow to the main issue impacting the market. Policy action has caused a trifurcation of the bond market. The top tier is German, Dutch and Finnish bonds. These have ceased to be investments and are being hoarded as cash equivalents. Hence the negative yields on German 6-month bills where investors are effectively paying for the privilege of "investing" their money safely. The second tier is French, Austrian and Belgian bonds. The possibility of default is remote (unless Belgium splits up) and the yields higher than the rate at which limitless funds can be borrowed from the ECB. Carry traders cannot help but be drawn towards this Scylla of low default probability and the Charybdis of yield. The third tier consists of iPIGS. This is where default is almost inevitable in some shape and form (calling it "voluntary" doesn't change the fact that bondholders lose money). Of course Spain can still avoid it by following the Swedish model to restructure its banking system. But the sheer quality of political leadership in Europe makes this unlikely. The only significant source of demand for third tier bonds is from investors who are already holding so much of this toxic debt that they cannot get out. Italian and Greek banks are in this boat and their fate is now determined by their sovereign. Therefore they have no choice but to buy more and attempt to keep the sovereign afloat. It helps that ECB generosity earns them a sizable interest spread. Like the passengers remaining on the Titanic after the lifeboats had left, they are trying to enjoy the band. 

This trifurcation has sharpened over time and is likely to remain. As before, there may be migration from one tier to another. Carry traders considered Italy and Spain to be in the second tier until Scylla and Charbydis ground them to pieces. Belgium may slip down, Spain and Ireland may move up and Greece is likely to soon form a tier all by itself. Trading and investment strategy primarily depends on the tier of the sovereign as given below:

Bond position
CDS position
Avoid unless required for use as collateral
Sell CDS. Default risk is low and headline driven mark-to-market risk is low. Sweden, Denmark, Norway, US and UK also come in this category and have the advantage of currency independence
Buy and shift credit risk to ECB for the duration of the bond in return for income stream. This income stream should be swapped out of Euros
Short-term trades based on trading level with a bias towards long protection positions
Avoid. Too expensive to short. Too dangerous to be long
Buy Italy, Spain CDS. They are still not pricing in the scale of the problem (despite Monti’s panicked pleas)

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