Sunday, 22 July 2018

Practising neutral buoyancy

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Anthony Peters wonders where credit markets will be when the drugs are taken away.

AT THE 1988 Seoul Olympics, Ben Johnson won the 100 metres gold medal for Canada in a world record time of 9.79 seconds. He was subsequently found to have been on drugs, was disqualified and lost his world record.

While giving evidence to subsequent enquiries, Johnson and his coach Charlie Francis claimed that they only turned to drugs in order to match up to the rest of the field, which was, they suggested, also doped. Six of the eight finalists were later banned for illegal drug use. Carl Lewis, beaten into silver at Seoul, was elevated and declared the winner. No video will ever show him winning.

Credit markets, so it can safely be assumed, are also on drugs. But those drugs are not illegal. On the contrary, they are officially sanctioned. The persistent ZIRP – everyone has another name for it but the principle and the outcome are pretty much the same – makes sure that anabolic steroids for financial markets are in ample and cheap supply.

Persistent ZIRP makes sure that anabolic steroids for financial markets are in ample and cheap supply

I HAVE READ and scanned over more research papers on fair value in the credit markets than you can shake a stick at. All they seem to be able to agree on is that all the runners and riders are on drugs – known as “unconventional policy measures” – and that there is, at this moment in time, nothing to be gained by trying to stand in the way.

Most of the research focuses on the simple fact that drugs are being injected into the markets and that when the addict is deprived of them, credit pricing will have to adjust. The Macronomics blog, which is written by the very smart but chronically understated Martin Tixier (who left France for the UK because he is, in his own words “Mr Tix and not Mr Tax”) goes to extraordinary lengths to find when and what will mark the inflection point. His most recent piece “Credit – The Vortex Ring” goes into the most interesting of theories, which includes the “helicopter stall” – oh, what lengths people have to go to now to find new analogies when it comes to warning that one day markets will go down.

Nobody was ever fussed to find out how fast Johnson could have run without drugs. But it is of critical importance to assess what bonds might be worth without the ZIRP.

With all due respect to Mr Tix, we can all call the reversal in the fortune of credit markets until, one day, we will be right. As important as it is to know when it will happen is being able to estimate by just how much the market will fall. In other words, what is the neutral price of credit – that is the credit spread when it is not supported by excessive central bank stimulus.

I worked on a similar subject during the pre-euro convergence period where I found that, given unchanged credit fundamentals, individual but related credits performed as though they were knots in a bungee. Stretch and relax – the absolute yield and the yield differential expressed in basis points might change but the relative value between the names remained more or less constant.

There has been a technical short in the credit markets since the grand rally began in March 2009 and the more rates have fallen, the more credit spreads have compressed. However, if we look at the relative credit quality, the “bungee adjusted” credit spread remains unchanged unless the borrowers’ balance sheet gearing and hence credit rating  has significantly shifted one way or the other.

WHEN LOOKING AT establishing the neutral price relative to the current price, one also needs also to account for the variance in liquidity – still an element of credit issuance that is usually either incorrectly priced or not priced at all – for there are a significant number of bonds issued by new and single issue borrowers for which there will most likely be no price at all. The oft-mentioned AT1s, for instance, have no bear market track-record and nobody can “back-test” spread performance in different interest rate environments.

I contend that with sufficient manpower and computing capacity a usable model could be built that would be able to reasonably forecast a fair-value range for credit spreads in an unsupported market. How clever would that be!

Whether it would be worth the effort or not is a different matter entirely – for when the panic button has been hit and the cry of “Sauve qui peut!” has gone out, the correct value of credit will be of no interest to anybody and heaven help those who try to stand in the way. There will, nevertheless, be a point when fair value has been overshot and it would be nice to know when it makes sense to begin buying back into the asset class.

Whether management that sees credit spreads widening as an invitation to buy or to sell is probably more difficult to predict. But it would be nice to be able to present a paper that could explain that, should central banks return to a neutral policy (by offering, say, a 25bp real return), respective credit spreads should be, well, whatever the model says they should be – the credit market equivalent, in other words, to neutral buoyancy. Could be an interesting exercise.

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