TRADITIONALLY AT THIS time of the year I look back at the period, pat myself on the back for my best calls and ’fess up to my worst ones.
2013 has not been bad to me in terms of forecasts. I went in long equities and short bonds but you didn’t really need a qualification in anything more that hairdressing to get that one right. I also was long credit – but not low enough down the ratings scale – and liked real estate. I made no call on Japan and so I can happily report that I got that one neither wrong nor right.
Where I was quite clearly out of kilter was the economic recovery in the UK. But I will qualify my admission by pointing to my concerns about the way in which asset prices are outstripping organic growth and the renewed reliance on household credit.
Maybe one of the best investments of the year would have been in the manufacturing sector in general and in the makers of smoke and mirrors in particular.
THE MOST IMPORTANT development I failed to foresee, however – and the one that will define 2013 in my mind – has been the extraordinary revival of the hybrid bank capital market.
Just a few years back, during the depth of the crisis, all the risks of being invested in the lower part of the bank capital structure were being laid bare and – although they nearly never came to pass – the potential for future capital losses was being highlighted left, right and centre.
It was then that the term “bailing in” was invented, a concept that really should be giving investors sleepless nights. And yet, bit by bit, the formerly highly toxic is now again being treated as if it tastes of mead.
Hybrid capital instruments in general and AT1 instruments in particular are highly complex and although “certain risks” are always discussed in the prospectuses, I wonder what will happen if, as and when the first one of these bonds triggers a capital writedown (so elegantly called “gradual loss absorption”).
Do we really know, or can we even model, the sort of environment that would prevail in order for losses to begin to bite? More to the point, are we not doing exactly what we did when we all got involved in synthetic CDOs and subprime mortgage bonds? Are we believing what we are told simply because the yield is so high that we feel that we have to?
Are we believing what we are told simply because the yield is so high that we feel that we have to?
PORTFOLIO PERFORMANCE IS not an end in itself. It is, in the real world, no more than a means to an end, that end being the attraction of new, fee-generating funds to manage.
Aunt Augusta can’t see what is in a fund management company’s bond portfolio and even if she did she’d barely understand what she saw. All she can observe and understand is the return and if that is what will sway her in her investment choices, no self-respecting fund manager will be able to decline an instrument that fits their investment guidelines and yields juicy income.
I already hear the call for a CoCo index. Show me an index and I’ll show you a host of forced buyers for whom “risk free” is represented by index-neutral holdings and for whom not owning a risky asset represents risk they are not allowed to take.
AT1 is turning into T1-lite and no doubt we will be able to watch the trigger points creep incrementally to the investors’ disadvantage until something unpleasant hits that proverbial fan and flies straight at the emperor’s new suit of clothes.
At that point it will be: “Those wicked banks sold us this junk without telling us … while they knew exactly what would happen in the event that …” You can fill in the missing bits yourself.
HAVING SPOKEN TO a number of people far smarter than myself, I am led to conclude that not many manufacturers or consumers of these new forms of hybrid capital can accurately quantify the risk embedded in them.
If you can’t quantify the risk, how can you price it? Trust those who build the models for the issuers that are presented at roadshows to construct best case/worst case scenarios that fit their requirements? No criticism here – it’s natural. But some of these newer structures are highly sensitive to just a modest downturn in the banking environment – can’t we already hear the hue and the cry if it all goes wrong?
Meanwhile, close your eyes and clip those coupons while resting safely in the knowledge that this time, of course, it’s all going to be different.