Thursday, June 12, 2014

Irrational exuberance, or creativity in banking?

Most recently, we saw headlines indicating that the Federal Reserve was fretting about low volatility, according to this Reuters report:
In the Fed's eyes, a lot of uncertainty surrounds forecasts for one of the strongest years of economic growth since the recession ended, but investors appear to have priced assets for perfection.

"Volatility in the markets right now is unusually low," New York Federal Reserve Bank President William Dudley said last week. "I am nervous that people are taking too much comfort in this low-volatility period and as a consequence of that, taking bigger risks."
When volatility stays low for a long time, it can encourage people to take too much risk. With corporate and junk bond spreads at historically low levels, we have seen a number of *ahem* creative ways of financing in the market.

Social-impact bonds
Consider, as an example, the story of Goldman's "social-impact bond":
Goldman is anchoring a $21 million plan to help a Boston-area nonprofit called Roca expand its efforts to steer young men like Aguilar away from dealing drugs, stealing cars or committing assaults and murders.

Under the deal, if men targeted by Roca spend 22 percent fewer days in jails and prisons than their peers, Massachusetts would save enough to repay Goldman’s $9 million loan. An even bigger drop in recidivism would hand Goldman as much as $1 million in profit. If Roca fails and too many men end up behind bars, Goldman will lose almost everything it ventured.
The bond carries a basic coupon of 5%, with additional payouts depending on recidivism:
Regardless of Roca’s performance, Goldman will get 5 percent annual interest on its loans. As senior lender, it’s first in line to earn back its principal, triggered by the 22 percent drop in days that participants are incarcerated as well as their success in getting and keeping jobs. With a 40 percent drop in incarceration, Massachusetts would repay the investors $22 million, the same amount it would save. Above that, the state would begin keeping part of the savings. 

Burrito bond
Don't like the social impact bond, maybe I can interest you in the burrito bond?
London high street fast food outlet Chilango, favored by City types with elastic waistbands, is offering an 8% coupon on a four-year corporate bond that gives some buyers a free burrito* every week for the lifetime of the debt. All you have to do is cough up £10,000 pounds ($16,800) and trust that it is as good at servicing its debt as it is at serving bankers their lunch.
(Hmmm, an investment with an 8% coupon that comes with burritos...what if I played the carry trade and levered that position up 10-1, could I eat that many in a week?)

One of the signs of the terminal phase of a bubble is the falling quality of new issues. The questions for investors are:
  • Are investors reaching a little too much for yield?
  • If so, are these kinds of issues examples of irrational exuberance, or just smart and creative investment banking?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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