Monthly Archives: September 2015

Fixed Income

Malta Government Stock – Should I Buy the New Issue?

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On Friday 25th September the government of Malta published on the Government Gazette the issuance of new Malta Government Stock (MGS). MGSs as they are frequently referred to in technical jargon, are bonds issued by the government in order to finance its budget deficit. In essence, the government will have income from taxes and other sources, expenses from the supply of public goods (such as street lighting, road works, general government services…) and when the expenses are bigger than the income the government will issue bonds to make up the difference. Thus through MGSs the government would be borrowing money from investors to finance its operations.

The Offer

The latest offer made by the government is for the following 2 options:

  • 2.00% MGS 2020
  • 2.30% MGS 2029

The Amount

The amount to be issued is €120mln, with the option of issuing a further €60mln (which most likely be the case).

The Interest

The fixed interest is payable every 6 months on fixed dates – for the 2% MGS 2020 this would be 26th March and 26th September each year, while for the 2.30% MGS 2029 it would be 24th January and 24th July each year. Thus the first interest payment would be a pro-rata payment starting from October 12th until the first respective interest payment date of each bond.

The Offer Period

Applications are already available from authorised financial intermediaries, even though the actual offering period starts on Monday 5th October. The offer is scheduled to close on Wednesday 7th October, however the Accountant General always reserves the right to close the offer before if there is a high demand (and this could well be the case).

The Price

As is customary with every MGS issue, the issue price of the new MGSs will be announced just a few days before the offer period starts, in this case the announcement will be made on Thursday 1st October in the afternoon. What is this issue price? The issue price is the price at which the bonds will made available for sale to the public. Thus, although the bonds will mature at a price of €100 per 100 bonds at the end of their respective term, they will not necessarily be issued at a price of €100 per 100 shares. The government most likely will add on a premium over and above the €100 maturity price, which will effectively lower the yield to maturity of the bonds (click here for more about yield).

What are the estimated prices then? Both these MGSs are already trading on the market since they had already been previously issued in the past. Thus if we simply check out the price at which they have been trading lately we can get a better idea of where the new prices might be establish. It is interesting to note that the Central Bank of Malta (CBM) issues on a daily basis what are known as secondary market bid-prices. In effect this means that the CBM is always ready to buy any MGS trading on the market, at the established daily price which it publishes every day (normally between 10-11am). You can access the link to these prices here.

If we focus on the two MGSs at hand, we can see that as at Friday 25th September the latest price for the two MGSs were as follows:

  • 2.00% MGS 2020 – €106.16
  • 2.30% MGS 2029 – €102.56

What does this all mean? This means that as at Friday 25th September (roughly a week before the actual price will be issued) the CBM is willing to buy back these two MGSs at the quoted prices of €106.16 and €102.56 per 100 bonds, respectively. One might ask, why is the bond with the lower interest commanding a higher price than the one with the high interest rate? This is directly related to the maturity risk of the second MGS. Since the second MGS matures in 2029 (c. in 14 years time) as opposed to the first one that matures in 2020 (c. in 5 years). The longer term presents a greater risk of a fall in the price if interest rates had to go up. In addition, it is easier to assess the viability and financial strength of the government over a 5 year period than it is over a 14 year period. This adds to the higher yield being offered on the longer dated MGS.

The above is explained much better in a recent post of mine which discusses Are Bond still Worth Investing Into? In this post I give a practical example of what would happen to the price of the 3.00% MGS 2040 if in 5 years time we had to experience a rise in the base rate to 2.50% (as it was just a few years ago). The result was that the price would go down to around €75 per 100 nominal!

This example serves to show that even the issuers that are regarded as the most safe present a risk to investors. Although the likelihood of a default from the government of Malta is very small, there is still an interest rate and maturity risk present that could have an effect on the investor’s return.

Are there any new Bond Issues?

Luckily Yes, We have Hili Properties which is the property division of the Hili Group which have just announced a €37mln bond with an interest rate of 4.50% maturing in 2025. Furthermore, Bank of Valletta have just announced that they will also be coming to the market with a maximum amount of €150mln in new bonds to be issued over the coming year (most likely the first in this series of issues will be this year).

Hili-_0002_hili-properties (1)BOV

How do the Corporate Bonds compare to the Government Bonds?

There are many factors one needs to consider when deciding between investing in corporate bonds such as the Hili Properties and the BOV bond issues, versus the MGSs discussed above.

Relative Risk

From an issuer point of view the MGS are regarded as relatively safer than the corporate issuers, but this is just when it comes to default risk. If we had to compare the 2.3% MGS 2029 to the 4.5% Hili Properties 2025 the MGS is longer dated and hence presents more interest rate risk and more maturity risk. Nonetheless even the Hili Properties bond is regarded as a long dated investment since it has a maturity of 10 years. Thus should interest rates go up in the next ten years, both the Hili Properties bond and the MGSs would be negatively affected.

Resale Opportunity

The MGS have the advantage when it comes to selling them once bought since the CBM creates a market for MGSs by offering to buy them back at set prices on a daily basis. Having said, it is no secret there is currently high demand for almost any bond on the local market so it would not be envisaged to be difficult to sell the Hili Properties bond in the short term.

Capital Gain Opportunity

Both the MGSs and the corporate bonds would present an opportunity for capital gains, especially in the short term. Keep in mind that the government will be issuing €180mln of new bonds which is essentially new supply of MGSs. In basic economics we know that as supply grows the price of the object will go down. For this reason we would expect the price of the new MGS to be slightly lower than the current market prices. At the same time, virtually every time a new MGS has been issued the price has gone up on the market. Why? Simple – virtually every time the MGSs were issued they were over-subscribed meaning that there was a surge in demand. Back to basic economics, as demand goes up so does the price of the object.

With the corporate bonds the case is normally that the issuing price will be €100 per 100 bonds (i.e. no premium). Based on the same theory as the MGSs, there is normally an over subscription for the bonds and this in turn leads to an increase in the price, and thus a chance to sell at a  profit.

A simple introduction to bonds video can be displayed below:

The Bottom Line

One must be careful however here, what I have discussed in the above two paragraphs is an expectation over the first few days to weeks of the life of the bond/MGS. It may well be the case that new news comes to the market which could have a positive or a negative effect on the prices of the then issued bond/MGS. At the same time, there is no guarantee that the bond or the MGS would be oversubscribed. Even though past data suggests so, we all know the famous warning that past performance is not a guarantee of future performance and the value of your investment could go up as well as down.

As usual I must stress that this article is not intended to be used as investment advice and reference to the respective prospectuses should be made prior to investing in any of the instruments mentioned. Furthermore, Please refer to the Full Disclaimer.

Equities

How to trade the VW Scandal

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As many are aware by now, the German multinational automotive giant Volkswagen (VW) has been linked to a scandal relating to the manipulation of emissions relating to its diesel models. What’s more this is not just speculation, but the company has actually admitted to the accusations and insisted that it will “pay whatever it needs to pay”.

Background on the Scandal

According to a post on financialpost.com:

“Both the U.S. Environmental Protection Agency and the California Air Resources Board accused Volkswagen of fudging test results for “clean diesel” products, including the Golf, Passat, Jetta, Beetle and Audi A3 models, in some cases going back to 2009.”

In a nutshell the company was using devices to purposely reduce emission levels during testing and thus making its diesel engines appear much cleaner than they actually are. Why? Keep in mind that nowadays, even locally the license paid for registration and the annual road tax of a car are directly linked to the emission levels that the car produces. Furthermore, people have become more environmentally concious over the last decades as we have seen advances in many ‘clean energy’ products such as household appliances and the surge in renewable energy systems.

Therefore, the worst part of the scandal could be the reputational damage that it has created. This is besides the fines that the company could face which are expected to potentially reach USD 18 bln in the US alone (with possible law suits elsewhere). The matter is made even worse when one considers the vast range of brands that VW owns. Volkswagen Group sells passenger cars under the Audi, Bentley, Bugatti, Lamborghini, Porsche, SEAT, Škoda and Volkswagen marques; motorcycles under the Ducati brand; and commercial vehicles under the MAN, Scania, Neoplan and Volkswagen Commercial Vehicles marques.

Of course this is not the first time that VW and many other car manufacturers were involved in negative situations which are normally in the form of recalls. It will also not be the last time that a car manufacturer is faced with law suits or recall expenses.

VWGroup

Ideas to Trade the Scandal

1. Trade the VW Shares

The most obvious manner in which one could ‘trade the scandal’ and try to benefit from it is to trade in the company’s shares. The main listing of the shares is EUR, however the share can also be traded in USD through the ADR. The big question if one decides to trade in the shares directly is should one buy the share or should one short the share? This all depends on one’s expectation of events.

Many a time in such situations of big news the stock market tends to over-do the situation and shares tend to move a lot more than they should. Is this the case with VW shares? Could be…however there are still a lot of unknowns surrounding the case. So we know that the company has admitted to the manipulation of the figures and we also know that the company has issued a profit warning directly related to this incident, meaning that the company is expected to have less profits this year directly as a result of the incident. These two facts have lead the company to lose roughly one third (-33%) of its value on the stock market in 2 days.

Thus investors who believe that the worst is over and think that the market has overdone the situation might consider buying shares or waiting a bit further to buy some shares in the coming days. The problem with this strategy is the unknown factors – will there be more law suits? Will the company come out with more negative news to get it all dealt with at once? How will sales figures actually be affected? How will the entire range be affected?

The other option if one wants to trade the shares of VW is to short the shares rather than buy them. When one shorts the shares one effectively ‘borrows’ them and sells them with the intention of buying them back at a later stage. Thus if one shorts the shares of VW today and buys them back in a few days/weeks time at a price lower than the current price, a profit will be made. Check out the video below for a visual description of what shorting is:

2. Trade Competitors’ Shares

Another option to try to profit from the VW scandal is to trade shares of competitors. Given that economies are improving and the price of running a car have gone down (as a direct result of lower oil prices), global car sales are expected to have a positive year. So an alternative trading strategy would be to buy the shares of competitors of VW – these stand to gain from the loss of market share of VW.

Some examples that come to mind that have publically listed shares include:

  • BMW AG
  • Toyota Motor Company
  • General Motors
  • Peugeot SA
  • Daimler AG
  • Ford Motor Company
  • Fiat Chrysler Automobiles
  • TATA Motors

3. Trade the VW Bonds

In the wake of the news the bonds issued by VW have gone down in value and could present an opportunity to  buy them at a discounted price. Please see the following link for a list of bonds issued by VW. If we take as an example the 2% Volkswagen International Finance 2021 bond the price has gone down from  around €109 per 100 nominal in March of this year to a current price of around €100.70 per 100 nominal. This gives one a yield of around 1.90% (please see my previous posts on yields and the worth of buying bonds).

This means that this bond has gone down around 8.25% since March, however it is still only trading a yield of less than 2%. This is saying two things to investors: a) Yields are so desperately low that even with such negative news the price of the bond did not go down enough to present a very high yield; b) bond investors are not expecting the scandal in question to be too severe for the company.

4. Trade an ETF containing VW

Another option is to buy an ETF that has VW as one of its holdings. Please refer to a previous post of mine which discusses what an ETF is. One such ETF that comes to mind is the iShares STOXX Europe 600 Automobiles & Parts UCITS ETF (DE) which has an exposure of around 11.55% in VW. The idea here is to gain exposure to VW, but to do it in a limited manner. Furthermore, if the other automobile companies benefit from the loss of market share of VW one would also stand to gain in such a fund since the other 88.45% of the fund is invested into competitors of VW.

The Bottom Line

VW is still a very large company with a diversified range of brands and very large reserves (as at June 2015 the half yearly report of Volkswagen AG Group showed a figure of €17.6 bln in cash reserves). The incident will continue to affect them negatively in the months to come when sales figures are expected to be lower as a direct cause of this scandal. There are many unknown factors surrounding the company so investing directly into the shares of VW could be quite a risky preposition. However, as I discussed above, there are other ways of potentially profiting from the situation without having too much exposure to the company.

Group premium brands such as Porsche, Bently, Bugatti, Lamborghini and Ducati will not be expected to be affected by this incident. However there could be a spill over effect in the lower to mid range brands such as Seat, Audi and Skoda. All in all it is very difficult to gauge the severity of the situation and as always only time will tell how this one will play out.

As usual please keep in mind that nothing on this site should constitute investment advice and further discussions with a financial professional would be required before considering any option mentioned in this post. Please refer the full disclaimer.

KD

Fixed Income

Are Bonds Still Worth Investing Into?

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Money

It is no secret that in Malta investors tend to prefer fixed income products and tend to shun away from investing into shares, even more so if they are foreign shares. However, given the current scenario where interest rates are virtually as low as they can be and with the possibilities of rate increases in the coming months/years – does it make sense to be 100% in fixed income?

What do low interest rates mean for fixed income investments?

The fact that interest rates are low presents two major problems for fixed income investors. Both problems are intrinsically tied to the inverse relationship between bond prices and interest rates. As was discussed in a recent post when interest rates fall, the price of existing bonds rises. This has been in effect over the last years, since central banks around the world have been cutting interest rates and the prices of bonds have been rising. 

What this means for an investor who wishes to buy a bond is that prices are high and yields (i.e. returns) are low. In some instances, such as certain German Government bonds, we even have a situation of negative yields. This means that if you buy the bond, since the price is so high and it will eventually mature at a price of €100 per 100 bonds, even if you consider the annual return from the interest you will receive, you will still end up with less money. 

This is just one of the problems when faced with low interest rates. The other major problem is that if an investor holds bonds currently, once interest rates start to go up, the prices of his bonds will go down. An important factor to consider here is the fact that the more longer dated the bond is, the higher the risk of the price of that bond going down. So even if an investor buys a really safe bond that has very little risk of defaulting, that investor would still have to suffer a capital loss if he/she wanted to sell his/her investment before maturity.

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So to sum up, if an investor buys a bond today, such an investor would be earning a low interest return and would also be taking on the risk of being stuck with that low return even if interest rates go up.

An Example of a Long Dated Bond and an Interest Rate Increase

Let us take as an example the latest issue of the Malta Government Stock (MGS). Earlier this year the government issued a 3% bond that matures in 2040, making it a 25 year bond. The bond is currently trading at a price of €106.50 per 100 bonds. So basically anyone who bought it at a price of €100 when it was issued, is currently making a profit of 6.50%.

As a new investor however, if one wanted to buy into these bonds, such an investor would be paying a premium of €6.50 per 100 bonds bought since at maturity the bond swill pay out €100 per 100 nominal. So there would be a known one time capital loss of 6.50%. However, one would also earn 3% per annum on the nominal amount of bonds bought. By using a YTM Calculator we can easily work out that the yield to maturity would be around 2.65% on this bond. This means that if the investor buys the bond today and holds it until it matures he/she would earn an equivalent of 2.65%.

Now imagine that 5 years pass and the base rate, (that is, the rate set by the central bank on which other interest rates are based), goes up from the present 0.05% to say 2.50%. So as a quick rough estimate, if with a base rate of 0.05% the government of Malta can borrow until 2040 at a rate of 2.65% (the YTM). Then if the base rate goes up to 2,50%, the same government of Malta would have to offer around 5% interest on a bond maturing in 2040.

So how would this affect our current bond holder who bought the 3% MGS 2040? Badly – very badly.

If an investor could earn 5% on a new government bond that matures in 2040, the yield of the existing government bond he holds has to go up to 5% as well. For the yield to go up to 5% on our original 3% MGS 2040 bond the price has to go down so that new investors can make a capital gain on top of the 3% per annum interest. One might reason that this difference would not be that much since the difference between 3% interest and 5% yield is just 2%. The problem is that 2% difference has to be achieved over a period of 20 years!

So if we simply use a Bond Price Calculator to see what price the 3% MGS 2040 has to be in order to yield 5% if bought in 2020 we get a result of around €75! This means that the bond holder who opted for the long dated yet very safe investment can only sell his investment for a loss of around 30% (considering it was bought at €106.50 and sold at €75). One may argue that if the investor does not sell the bond and simply keeps it, that investor would just lose the 6.50% capital loss and still earn his full 3% per annum. This is true, however it must be pointed out that the same money that is earning that investor 3% per annum could have been earning him/her 5% per annum in our scenario. Multiply this 2% difference by 20 years, that is a total difference of 40% in interest lost.

quick-tasks-increase-income

This example begs the following questions:

  • Are local bond investors prepared for interest rate increases?
  • Is the local bond investor mature enough to recognise the different types of risks involved in investing into bonds besides the obvious risk of default of the issuer?
  • Are investors buying any locally issued bond recklessly?

The Bottom Line

At the end of the day, investors seeking a fixed income have come to accept the fact that interest rates are low and will probably remain so for the coming years. Although interest rate increases are expected from next year in Europe, they are not expected to be drastic and nobody really knows when and if they will actually happen.

Furthermore, investing into bonds still is normally considered one of the safest options, however one has to appreciate that there other risks when investing into bonds besides the risk that the issuer defaults. In practice the default risk as it is known is one of the least factors that affects investors since through diversification and through the selection of good quality issuers this risk is normally seen to. In reality most investors are currently mainly subject to interest rate risk and maturity risk. I had already discussed the risks of investing into bonds in a recent bonds which you can access here.

KD

Alternative Investment

What are ETFs and how should they be used?

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ETF

In this post I would like to highlight the characteristics and features of Exchange Trade Funds (ETFs) and more importantly, how they can be used as an investment vehicle as part of one’s portfolio. Although ETFs are considered as a recent financial innovation they have been around since the 1980s. Having said that, their popularity has increased mainly in the last decade or so.

What is an ETF?

The textbook definition  of an ETF  is that it is a fund that tracks indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. but trades like a share. When one buys shares of an ETF, he/she would be buying shares of a portfolio that tracks the yield and return of its underlying index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index (known as active management), but simply replicate its performance (known as passive management). They don’t try to beat the market, they try to be the market. In short, buying an ETF is like buying a fund that trades like a share on a stock exchange.

ETF

Although most ETFs are broad in nature you can also find narrow ETFs that focus on a particular sector or group of related companies. For example, one can use an ETF to invest in the oil industry by buying an ETF that tracks the price movements of companies that operate in the oil industry. By doing so, an investor would be investing his/her money in a wide range of companies and not just into one or two companies, which is especially advantageous if his/her desired allocation of funds to such an investment is small.

ETFs vs Traditional Funds

Since ETFs trade intra-day, meaning that you can buy or sell an ETF anytime during market hours, one can use ETFs for intra-day trading. This is a major advantage that ETFs have over a normal mutual fund such as a regular bond fund (see more about bond funds here). A regular fund would use what is known as forward pricing, meaning that if an investor wishes to buy or sell a mutual fund, the price at which the investment would be bought or sold would be the end of day’s price, which is always unknown.

Another advantage of ETFs over regular funds is their lower costs. Since ETFs are passively managed as they simply replicate a portfolio as opposed to trying to outperform it, they benefit from lower costs. A traditional fund’s expense ratio is usually around the 1.40% per annum level, while that of an ETF is typically more around the 0.40% level. The higher costs of normal funds are due to the following items: a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.

ETFs can also be more tax-efficient than mutual funds because most of the tax on capital gains is paid on sale and completely up to the investor. Even if an ETF sells or buys shares while attempting to mimic the basket of shares it is tracking. This is because the capital gains from in-kind transfers, seen in ETFs, do not result in a tax charge, and therefore can be expected to be lower compared to mutual funds.

Other Features of ETFs

Two other features of ETFs that are important to note originate from the fact that they trade like shares. So like shares, one can buy an ETF on margin and one can also short an ETF. In simple terms, buying on margin means that the investor borrows the money (normally at a fee) with which he/she then buys the investment. Shorting means that the ETF is ‘borrowed’ and sold, with the intention of buying at a later stage. So if for example, an investor is expecting the price of gold to fall, such an investor could short (or sell) a gold ETF and then buy it back at a later date (hopefully at a lower price).

Both buying on margin and shorting are not possible with traditional funds, but whether this is an advantage or not depends on the outcome of the result. For example, if an investor borrows €5,000 to buy an ETF on margin and the value of that ETF subsequently falls and is sold at €4,700 the investor would still have to pay back the broker the original €5,000 plus borrowing and brokerage fees. Shorting could be a bad thing if the price of the ETF actually goes up. If an investor shorted (i.e. sold) an ETF at a value of €5,000, and subsequently the value of the investment goes up to €5,500 when the investor comes to buy it, that investor would have lost €500 from the trade.

An ETF could also use leverage in order to magnify the returns on a portfolio. So for example, an investor could buy an ETF that trades 3 times the DAX (the DAX is a stock index that represents 30 of the largest and most liquid German companies that trade on the Frankfurt Exchange). This means that for every 1% movement in the level of the index, the ETF moves by 3 times that amount, i.e. 3% in this example. This feature actually adds risk since it magnifies the returns, both the positive ones and the negative ones.

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Top ETF Providers

Investors can find ETFs on any investment imaginable, from the more traditional types such as bond fund-like ETFs and stock exchange trackers to more avant-garde options like Fishing ETFs. Something to keep in mind when investing through ETFs is that the more narrow and small ETFs will have the bigger difference from the actual value of the portfolio they track and their actual trading price. It is normally best to stick to the larger based ETFs for more reliable pricing. Below is a list of the top-5 ETF issuers as at July 2015:

Rank Provider No of ETFs Assets (US$ Bln) Market Share (%)
1 iShares 756 1,101 36.7%
2 Vanguard 116 503 16.8%
3 SPDR ETFs 238 449 14.9%
4 Power Shares 179 103 3.4%
5 BD/x-trackers 351 82 2.7%
Source: ETFGI

The Bottom Line

ETFs are a great option to get access to a diversified portfolio of assets at a lower cost than if one had to build their own similar portfolio. One can use more focused ETFs to get a wide exposure to a particular market, such as a Natural Gas ETF if one wanted exposure to natural gas. They have some advantages over more traditional funds, however they are simply passive investments and will not try to outperform the market like traditional funds will.

Like any other investment they still have to be used with caution since certain features can actually increase rather than decrease risk in an attempt to achieve better returns. Like with any other investment it is always advisable to get professional advice from a licensed investment service provider when considering ETFs. If you used correctly and with full understanding of the way they work ETFs can be a good addition to any investors’ portfolio. 

KD

Alternative Investment, Historical Financial Events

Securitisation and The 2007/09 Financial Crisis

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Loan

In the words of George Santayana, ‘Those who cannot remember the past are condemned to repeat it.’ For this reason I have decided to dedicate today’s post to the process of securitisation and how it was at the heart of the 2007-09 Great Financial Crisis. What have we learnt and is securitisation still important as a method of risk management?

I will try to keep the post as simple as possible but at times I will have to use some technical words. For the investment enthusiast the content may be a bit heavy at first but the important thing is to understand the overall picture and not the detailed specifics. For the readers with knowledge and experience in finance it is interesting to refresh your memory on the subject. The post will first attempt to introduce the key elements in a simplified manner and then a short clip will be presented at the end.

What is Securitisation?

Securitisation is the process in which certain types of assets are pooled so that they can be repackaged into interest-paying securities. For example, a bank would package together an amount of home loans (known as mortgages), or car loans or credit card loans or any other asset and then sell them off to a Special Purpose Vehicle (SPV). The interest and principal payments from the assets are passed through to the purchasers of the securities. Thus, the SPV then sells securities to investors which are backed by the assets it would have bought, hence the name Asset Backed Securities (ABS).

Securitisation is not a recent invention and has been in existence since the 1970 when home mortgages were pooled by U.S. government-backed agencies. In the 1980s other income-producing assets began to be securitised, and in the years leading to the financial crisis the market had grown quite dramatically.

Why Securitise?

One might wonder, what is the purpose of securitisation and why would banks in particular use it so much? To answer this question we must first recognise that banks are subject to increasingly strict capital requirements. This means that for any asset on a bank’s balance sheet it must keep or reserve a certain amount of capital. In a way, this reserved capital is an expense for the bank since it cannot use the funds for other profitable uses. Furthermore, traditional bank assets such as home loans are not very liquid, meaning they are not easily converted into cash at short notice. Therefore the bigger the loan book of the bank the more tied up capital it needs to keep on reserve and more the restricted it becomes.

However, if the bank had to somehow find a way of getting these slow moving assets off its balance sheet it would not have to keep any capital against them, plus it would have the cash to buy/create more profitable assets like new loans. Keep in mind that banks make commissions form new bank loans from the fees they charge, so the more bank loans they create, the more fees they earn. Therefore, one of the major advantages of selling off existing loans by securitising them is that the bank has more capacity to make new loans and earn new commissions.

Another advantage of using securitisation for a bank is that it can limit its risk exposure to a particular sector. Imagine Bank XYZ Ltd was specialised in construction loans in a particular geographical region. If the construction sector of this region had to slow down for some reason or another, bank XYZ Ltd would lose income and risk having more bad debts or defaults on its existing loans. Therefore, in order to be less dependent on these types of loans bank XYZ Ltd could securitise an amount of these construction loans and sell them off its balance sheet. By doing so  it is transferring the risk attached to these loans to someone else, plus it is getting new money to make new investments with.

How Securitisation Works

The table below helps us to understand better how the securitisation process works in more detail:

Securitisation

 

In essence the securitisation process involves just two steps:

Step 1 is for the bank to identify the assets (e.g. home loans) it would like to remove from its balance sheet and pools them into what is called a reference portfolio. This portfolio of pooled assets is then sold off to an issuer, such as an SPV which is normally set up by a financial intermediary specifically to purchase these portfolios and transfer the assets off-balance sheet.

Step 2 the issuer finances the purchase of the portfolios of pooled assets by issuing tradable, interest-paying financial products that are sold on to  investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the bank that originally made the loans keeps servicing them in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee.

The reference portfolio is not divided into assets with the exact same characteristics, however such assets form part of several slices, called tranches, each of which has different risk and return parameters associated with it and is sold separately. The more senior tranches would be the less risky ones, however they would also pay the less returns (mainly interest). The senior, least risky tranches would have first call on the underlying assets if something had to go wrong. Therefore, if there had to be a number of defaults in the reference portfolio first the senior tranches have to be paid off and then the least senior ones.

The conventional securitisation structure assumes a three-tier security design—junior, mezzanine, and senior tranches. In such a structure the junior tranche will be the one to suffer the first losses, then the mezzanine and finally the senior tranche. The senior tranches were regarded as very safe and unlikely to suffer any loss of value, and hence where often classified as AAA rated by the credit rating agencies. See more about credit rating agencies in one of my previous post on Bonds vs Bond Funds.

What went wrong?

In theory securitisation is a good thing both for banks and for people seeking loans. Banks, as we have seen, are able to make more money through fees by securitising loans and making new ones. On the other hand the people seeking out loans would find it easier to obtain credit since the banks are more able to lend them the money. So as long as banks are making more loans to individuals or entities that are of good quality and can actually afford the loans the whole economy will be better off.

The problem however is that when banks realise that they do not really have to keep any capital against the loans they make, since they are selling them off to some other entity, they may become more lenient and less interested in the quality of the borrower. This is exactly what happened in the 2007-09 Financial Crisis. As banks created more and more loans the amount of good quality borrowers who needed to take out a loan started to shrink. As a consequence, banks started to relax their screening and monitoring of borrowers. This eventually resulted into a system-wide deterioration of lending and collateral standards.

This means that more and more sub-prime (i.e. more risky) borrowers were finding it easy to obtain cheap money. As long as house prices keep rising and the banks can keep selling off these loans to investors the banks will keep earning more and more commissions. The problems will occur (as the they did in 2007-09) when the housing market no longer keeps rising and when (inevitably) the borrowers who could never afford the loans that they made in the first place will eventually default.

As any home-owner knows, a property can take a few weeks or years to sell off. If many borrowers are defaulting then the banks would have taken over the properties which were set as collateral for the loans. The situation would be that banks would end up with a lot of properties on their balance sheet which they cannot hold and would like to sell off quickly. Since the supply of properties is so high the prices have to fall. In turn, as prices keep falling the housing market gets worse and even more people would end up defaulting. Thus a downward spiral is created which then affected the entire economy.

An easy way to understand better all the above is by seeing the cool visual presentation below:

I hope you enjoyed the trip down memory lane, which is a lot easier to accept now that we have recovered from the lows of 2009!

KD

Fixed Income

YTM and Bond Price Movements

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Bond YTM

In connection to last week’s post about Bonds vs Bond Funds a good follow-on mid-week post would be a short discussion on what we understand by a bond’s yield or yield to maturity . Once we understand this concept better we can then go on to see how bond price movements can be explained better.



The Basics of a Bond

Lets start with the basics, a bonds as we discussed is essentially a loan. So it is a debt obligation with a maturity of more than  one year. When for example a company wants to make a long-term investment, of say opening up a new plant, it can borrow the money from investors by issuing a bond. In return it promises to pay a series of pre-determined interest payments and the original value of the loan at the end. In technical words the interest payments are known as the coupon, the end date is known as the maturity date and the final value or original capital is know as the principal, face value or par value of the bond.

Once a bond has been issued to investors, it is then traded in the bond market. Therefore, although a bond may have a maturity of 10 years for example, an investor can cash in his investment earlier by selling the bond on the market. A bond’s par, or nominal, value is typically €100, however its actual value will vary according to the cash flows it pays (interest and repayments) and the prevailing rate of interest for the type of bond. The fair price is the present value of the future interest and final capital payment.

Value of a Bond = Present Value of the interest payments + Present Value of the principal value

Present Value

In simple terms the present value of any cash flow is the current worth of such future cash flows, As you often hear people say “€100 today is not the same as €100 in 10 years time”.  This is all related to the concept of the Time Value of Money. There is a price to lending money to a firm by buying a bond. Therefore, the return paid by a bond must reflect the time value of money, and it comprises:
(a) the risk-free rate of return rewarding investors for forgoing immediate consumption,
plus
(b) compensation for risk and loss of purchasing power.

Yield to Maturity (YTM)

To understand the concept of yield or yield to maturity we must first recognise that the return an investor received form a bond is not just the regular coupon payments (which we will assume are always fixed), but also the capital gain or capital loss that the investor would benefit from or lose from. This capital gain or loss is directly related to the price at which the bond is purchased. So if for example I buy a regular bond that has a €100 maturity value, but I buy it at a price of €95, then at maturity I will eventually make a capital gain of €100-€95 = €5 per 100 bonds I own. On the other hand, if I buy the same bond at a price of €105 per 100 then at maturity I will eventually make a capital loss of €100-€105 = -€5 per 100 bonds I own.

When one buys a bond below its par value it is said that one has bought the bond at a discount. On the other hand if the bond is bought above the par value then it has been bought at a premium. This is why the YTM is such an important concept. The YTM tells you the true return that you will make if you buy a certain bond that has a certain interest for a certain price. An example will clarify this better.

YTM – an Example

Imagine company LOL Ltd had issued a 5% bond last year with a maturity in 2024 and the bond is currently trading at a price of €109 per 100 on the market. As an investor I would know that if I buy this bond today I will be losing €109-€100=€9 per 100 bonds I buy. I also know that I will lose this value once the bond matures in 9 years time and pays the €100 back to me. In the mean time I am earning 5% on every bond that I bought. So if we ignore the present value complication we can estimate that roughly I will be losing around 1% per year (€9 capital loss that will be realised in 9 years time) but I will be gaining 5% per year from the coupon. Hence my true interest rate is roughly 5%-1%=4% per year. This 4% is the yield or YTM on this bond. In reality the calculation is a bit more complicated but you can easily get the figure by using a YTM calculator.

Therefore, when an investor wants to decide if it is worth investing into a bond that is trading on the market it is important for that investor to consider the YTM and not simply the coupon rate. The YTM gives you the full picture since it considers both the interest income and the capital gain or loss.

YTM and Bond Price Movements

By understanding this very important concept it is now easy to understand why bond prices go up when interest rates go down and vice versa. Lets go back to our example of the 5% LOL Ltd 2024 bond. When LOL Ltd issued the bond last year the price it issued it at was €100 per 100 bonds. At that time, 5% was the market rate of interest on a bond issued by any company with the same risk as LOL Ltd, that also had the same maturity in years as this particular bond. Now lets us consider that the central bank decided to increase interest rates and so the market interest rate on a bond issued by LOL Ltd that also matures in 2024 is now 6%. What would a rational investor do in such a situation?

So you have the following options:

  1. Bond A – 5% LOL Ltd 2024
  2. Bond B – 6% LOL Ltd 2024

Any investor who held the original bond would want to sell it immediately so that they could buy the second bond. Why? Simple really, for the same risk and the same amount of years the rational investor would prefer to earn 6% rather than 5%. This brings us to the most basic concept in finance – any price of any investment is ultimately determined by demand for and supply of that investment.

Bond YTM

Therefore, as investors start to sell the 5% bond the supply of this bond on the market will increase which will consequently bring about a fall in the price of that bond. Conversely, as many investors are now trying to buy the 6% bond the demand for this bond is increasing and ultimately its price will go up.

How much will the price of the 5% bond go down and how much will the price of the 6% bond go up? The answer to this should be simple now, the prices will change until the yield on both bonds is the same, why? Since both bonds are issued by the same company and are for the same amount of years (i.e. they have the same risk), they should technically pay the same return. In our example, we can assume that the price of the 6% bond will rise until the yield on it is 5.5%, while the price of the 5% bond will fall until the yield is also 5.5% on this bond.

A simple video to help you understand YTM better:

A final word of caution is that YTM is valid only, as the name states, assuming that the bond will be held until maturity. If an investor sells a bond before its maturity date that bond could be trading at a higher or a lower price to what it would had been bought at. Therefore, the YTM should only be considered when the intention is to keep the bond until maturity and of course, assuming there is no default.

A great use of the YTM is to be able to compare the expected return an investor could earn from different bonds that have different coupon rates and different prices. Since the YTM gives you an annual ‘total’ return figure, you can easily compare the YTMs of different bonds to see which one would give you the highest return. Of course return is just half the story, one also has to consider the risk involved – but that is a total other discussion in itself which will be covered in a separate post.

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KD