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Monday, 23 October 2017

The Greatest of All Time; Triple A & the folly of chasing 4 %

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Anthony Peters, SwissInvest Strategist

Many congratulations today to Muhammad Ali – born Cassius Marcellus Clay – The Greatest, on his 70th birthday. If only the eurozone leadership could learn a lesson from him and not, as it does, sting like a butterfly and float like a bee.

It wakes this morning having to deal with the fall-out of the downgrade of the EFSF from AAA to AA+ by none other than Standard and Poor’s, its great bug bear. France has been particularly vociferous in its criticism of the agencies in general and of S&P in particular. It has accused them of being political in their ratings acts. The question truly is one of politics - however, would it be more politic to downgrade or not to downgrade?

Anyhow, I am concerned that German institutions, in their pursuit of target yields rather than target spreads are potentially laying the foundations to the next crisis.

If the ratings agencies have to endure widespread criticism for having failed to identify and to flag the flaws in the “tripe-A” nature of highly structured credit instruments, does that mean that identifying and flagging flaws in eurozone sovereign debt should be either morally or legally prohibited?

In my understanding of ratings, the only compelling spot on the ratings scale is the shift from the investment-grade universe to the speculative-grade one which is where discretionary funds, “widows and orphans” as they used to be known, had to be withdrawn.

Apart from that, it is entirely at the investors’ discretion as to what they chose to buy or not to buy or, perhaps more realistically, in the hands of those who define the investment guidelines, be that the trustees of the pension fund or the board of the insurance company.

If ratings and reality begin to diverge, then we can all fall back on the brains we were equipped with in working out where we want to place our money and how much risk we perceive there to be once we have made our choices.

The 4% question

I took advantage of the truncated Monday afternoon yesterday and went for “late coffee/early drinks” with some real money guys here in London (We passed on the coffee).

We had a fairly wide-ranging natter about this and that but at one point one of them asked me, knowing of my ties to the German investor base, whether the insurers there were still so obsessed with the 4% coupon hurdle. That I could not deny and I confessed to my concerns there. Yes, you can buy Triple-A rated French covered bonds at 4% but that is and remains more than 220bp over Bunds which are this morning yielding 1.79%. If there is one thing that the credit crisis should have taught us, it is that there is no such thing as a free Triple-A rating. Issuers do not liberally give away interest that they don’t have to, and, more to the point, that they don’t actually have.

If a securitised loan portfolio is able to pay away 4%, then it must be generating a devil a sight more than that. Given that EFSF with its sovereign guarantees is now no longer, in the eyes of S&P, a Triple-A credit, how can a portfolio of residential mortgage loans which permit a coupon payment of over 4% be Triple A either?

Yes, I know, it’s all in the over-collateralisation. That’s what we told ourselves in subprime lending too. The magic is in the correlation modeling…I could go on. In simple terms, if the eurozone debt crisis is going to be brought to a sensible and long-term conclusion, then it is up to the politicians to effect the changes needed to make it possible, not the ratings agencies.

I am reminded of Arsene Wenger, the manager of Arsenal football club here in London. On Sunday, they lost 2:3 against lowly Swansea City. In his post-match interview, as usual, he blamed the referee who had awarded a penalty against his side which Swansea had duly converted. Wenger said that the award of the penalty had deprived his side from the chance to win the game. I might not be a class act mathematician but in my book the penalty deprived them of no more than the chance to draw the match… I’m sure you’ll get my point.        

Anyhow, I am concerned that German institutions, in their pursuit of target yields rather than target spreads are potentially laying the foundations to the next crisis. If underlying Bund yields fall any further, they will have to take on more risk than they already are doing in order to meet their appetite for yield and there will once again be no shortage of investment banks who will be more than happy to create it for them. Then, when it all goes wrong, guess who’s fault it will be. I rest my case.

In the mean while, risk appetite seems to be growing and momentum is driving equities higher, credit spreads lower and guvvie yields – well that depends. Italy 10yrs at 6.45% is already down 60bp since the beginning of the year and that is, in cautious quarters, already beginning to hurt. How long until they start getting sucked in, irrespective of what the ratings agencies have to say?    

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