Tuesday, February 11th, 2014

A Little Detective Work

Like many other commentators, we have noticed and welcomed the decline in volatility across all areas of global financial markets. In our view, it was the principal mechanism through which the Federal Reserve and other central banks prevented market intermediaries (banks and brokers) from being forced to liquidate their inventory of distressed securities. One area which benefitted significantly from the decline in volatility was US high yield bonds, and for much of H2 2013 we were happy to recommend them as our preferred category in fixed income markets. We reasoned (we think correctly) that the accelerating US recovery would reduce the risk of default, and allow spreads to narrow even if Treasury yields rose. The fact that the taper was delayed until December was consistent with this explanation.

But now we are in 2014. We have had two rounds of the taper, and will likely get a third in March. And still the volatility of high yield bonds continues to decline – in fact this decline has accelerated in recent weeks. We still believe the underlying causes mentioned earlier, but we begin to wonder whether they are sufficient to explain everything that has happened. Could it be that the asset class is receiving a little extra help?

We can’t help noticing that 2013 was a record year for high yield issuance in the US. According to SIFMA, the numbers are $336bn, compared with $329bn for 2012, and $224bn for 2011. Issuers like stable market conditions; so do their sponsors, and they are specifically authorised to stabilise the aftermarket for new issues. High levels of issuance equal high levels of stabilisation. We think that this has carried on into 2014, even though the level of issuance for January is down ($25bn vs $33bn in 2013). In our view, the turbulence of recent weeks explains why some planned issues have been postponed. It also explains why the need for stabilisation is as great as ever.

We used this logic to look for other areas of the global financial system where it is hard to explain the behaviour of volatility. This is obviously a guilt-by-association argument and we are not suggesting there is anything underhand or sinister at work. However, we can’t help noticing that, over the last six months, the volatility of Eurozone banks has fallen significantly more than that of the UK or US banking sectors. This is true in absolute terms and relative to the local index. Financials are ranked #1 in our Eurozone sector model, compared with #6 in the UK and the US. And yet, there is widespread agreement that their capital situation is significantly worse and that several banks will have to issue fresh equity in order to pass the stress tests set by the ECB.

It’s that word again: “issuance”. Low share price volatility is in the interests of several Eurozone banks and their advisers. Investors need to be aware of this and do their own detective work as to which banks need to issue equity, and which don’t.

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