Saturday, 22 September 2018

On shock calls and CoCos

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Anthony Peters emerges from the IFR gala with a warning about indices and reading the fine print.

All slightly foggy this morning after a darned good night out at the IFR annual awards dinner and largely still the same haze through which I saw and through which I spoke to a string of old chums whom I tend to see only at that very event.

I found myself seated at a table with a bunch of worthies who will probably have been disappointed to find nobody better than me as their dinner partner but awards dinners are all about winners and losers. This time I believe that I was the winner.

There seemed to be two recurring themes last night – other than who had donated how much or how little to the Save the Children charity appeal which once again raised over £1,000,000 on the night – and they seemed to be the shock resignation of Mohamed El Erian from PIMCO and the unexpected move by ArcelorMittal on Tuesday when it called its US$ 650,000,000 hybrid bond, the latter which had caught the world and his wife off-side.

I have a feeling that unconsidered, misunderstood and underrated risk will be a recurring theme as structures become ever more complex and documentation becomes ever longer and more opaque 

ArcelorMittal was, and this was never in dispute, quite within its rights to call the bond at the point at which the ratings agencies decided that it could not, for accounting purposes, be treated as equity and that it was simply nothing more than debt disguised as equity. This enabled the company to call the bond with impunity and that is what it decided to do. The wailing and moaning which followed could be heard from here to Luxembourg for certain and in all probability all the way to India. There was outraged yelling of “How could they?” along with a lot of pointing at the Danish energy group, Dong, which had also brought home a hybrid perpetual but by way of buyback in the market at a level above the call price.

Prior to the company exercising its call option, the bonds had been trading at or around 109.00 and of a sudden they were worth 101.00. Strictly speaking they had been worth 101.00 all along – why a bond should trade above its call price when there is more than a passing risk of it being called is beyond me and if it does trade at a higher price, then that is the investors’ problem and not that of the issuer. Ignorantia legis neminem excusat – ignorance of the law is no defence.

Remembering a Mexican bulldog

I recall a highly tricky valuation situation which I encountered in the late 1980s when I was asked to put a price on an old bulldog issue, the United Mexican States 16½% 2008. The bond paid a massive coupon, even by the standards of the time, but contained an annual par put option. Mexico was in all kind of financial trouble and nobody could agree whether to price to the maturity or to the next par put, least of all the seller and the buyer. Needless to say the bonds never traded and I guess the seller will have ultimately been the happier of the two parties as they were fully redeemed at par at maturity. However, the putative buyer was entirely within his rights to price to the put even though he would have retained the option to exercise or not. Puts and calls used to be common features and I suspect they were then treated with more respect than they appear to be now.

ArcelorMittal has reminded investors that the documentation is not there entirely for the benefit of the law firms and that they should read the small print too. Times are tough in the European steel business and if Lakshmi Mittal can find a method, both moral and legal, to save his shareholders some money, he is obliged to do so. He and his treasury team are not there to shell out an 8¾% semi-annual coupon for fun and not exercising the call could quite possibly, in some European jurisdictions, lead to a charge of failure to exercise one’s fiduciary responsibilities in respect of one’s shareholders.

Keeping an eye on documentation when dealing with anything other than plain vanilla bonds is not at all a bad idea but one now being discouraged by Merrill Lynch which is in the process of creating an index for CoCo bonds. The moment an index is introduced and adopted, being index neutral becomes the risk-free position for asset managers. In other words, nobody cares whether the buyer understands or doesn’t understand the deal, if it is bought precisely to index weighting nothing can happen, irrespective of the outcome. In my view, the last thing assets with the embedded risk of contingent capital bonds need is to have a “get out of jail free” card pinned to them and that is precisely what index neutrality is.

Using an index – or suggesting to pension fund trustees or to insurance companies’ management boards that they should be – is pushing the risk decision to people without the detailed knowledge or skill to appreciate what risk they are entering into. We saw the outcome of that approach during the pre-crash asset price bubble when the self-same committees instructed their investment people to buy nothing less than AAA rated paper. They were not the ones to know that triple-A didn’t necessarily mean triple-A and the asset managers at the coal-face were not the ones to tell them.

As Yogi Berra would have had it, “Deja vu, all over again.”

I have a feeling that unconsidered, misunderstood and underrated risk will be a recurring theme as structures become ever more complex and documentation becomes ever longer and more opaque. Unfortunately, for some investors the end appears to justify the means and if the coupon is juicy enough, they are prepared not to ask the questions to which they’d rather not know the answers.  

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