Palmerston, Kondratieff and Me. Long waves in British financial markets.

The Victorian statesman Lord Palmerston once observed of the Schleswig-Holstein question that it was so complex that only three men had ever fully understood it. One of them had gone mad, the second had since sadly died, and the third was himself – but it was so long ago that he had completely forgotten the answer.

Sometimes I feel as if the long waves that drive capitalist development have also, like the Schleswig-Holstein question, only ever been understood by three men. The first, Nikolai Kondratieff, disappeared long ago into one of Stalin’s Gulags, never to be heard of again. The second, Joseph Schumpeter, has long since passed on. The third is myself, and my only published analysis of it was in The Age of Illusions more than 30 years ago.

Actually, I’ve undertaken much research since then, not with a view to publication, but rather to apply the analysis as a framework for trading in the securities markets. It worked, thus reinforcing my confidence in the existence of the long waves that Kondratieff first identified 90 years ago.

The secrets to success in surfing the long wave are threefold: firstly, to recognise that it exists; then, to anticipate its movement going forward; and finally, to take a position to ride it and avoid being overwhelmed and submerged.

Going through each in turn:

1. Recognising the wave. Conventional wisdom as taught in academic textbooks and finance courses is that capitalist development is a process of incremental change within an inherently stable system. Kondratieff and Schumpeter realised that the real world doesn’t work like this. Market economies have no natural tendency to equilibrium. As Schumpeter wrote in Capitalism, Socialism and Democracy, “The capitalist economy is not and cannot be stationary. Nor is it merely expanding in a steady manner. It is incessantly being revolutionized from within by new enterprise or new methods of production or new commercial opportunities” which sweep away existing market structures in what he termed a “gale of Creative Destruction”.

2. Anticipating the movement of the wave. We are currently in the downswing of the Internet Revolution – the fifth long wave in the UK since the Industrial Revolution. The upswing of the Internet Revolution lasted from the late 1980s to 2007, driven by major innovations including the mobile phone, laptop computers and the worldwide web. As the upswing gathered pace, imitators keen to emulate the success of entrepreneurs like Steve Jobs and Bill Gates entered the market, driving a speculative bubble fuelled by lax monetary policies. The bubble fed on itself in a reflexive process (in George Soros’s phrase), pushing asset prices ever further from their economic values particularly in Internet-related businesses and property, until they crashed during the international financial crisis of 2007–09. We are now in the downswing of the Internet Revolution, which will evolve in two phases. The first phase is Recession, when poor investments made during the final speculative bubble and the loans that financed them are progressively purged from the economic system. The Recession will be succeeded by a Recovery, as insolvent enterprises are liquidated, surviving enterprises consolidated, and new enterprises emerge.

3. Investment positioning through the long wave. In general, the long wave upswing tends to be inflationary, while the downswing is deflationary or disinflationary. So the upswing is generally positive for equities, whose prices rise in an inflationary environment. But it is bad for bonds and other financial assets whose nominal value is fixed and whose real value falls as the general price level rises. Conversely, the long wave downswing is generally bad for equities but good for bonds.

This has been the story since 2007: Equities have suffered while bondholders have prospered. When the Internet Revolution approached its peak back in March 2007, the FTSE 100 Index stood at 6300. Today, 8½ years later in mid-October 2015, it stands at…..around 6300. At the risk of stating the blindingly obvious, equities as an asset class have gone absolutely nowhere during the Recession phase of the current long wave. In fact, in real terms, they have fallen significantly in value, as over the same period the UK Retail Price Index has increased almost a quarter from 210 to 260.

By contrast, bond prices have shown significant gains over the period. The yield on the benchmark 10-year UK gilt stood at 5% in March 2007. Today, it is just 1.9%. As bond yields have fallen, bond prices have risen.

At some point, as Recession metamorphoses into Recovery, one would expect bond prices to fall and yields to rise, but only slowly and by modest increments. In such circumstances, bonds as an asset class may continue to outperform equities. In any event, with the UK inflation rate currently at 0%, the yield of 6½% offered by the eighth bond acquired for the High Yield Bond Portfolio appears attractive, being 4½% higher than the 10-year gilt yield. Its details are as follows:

Issuer: Enterprise Inns plc
Coupon: 6.375%
Maturity Date: September 26th 2031
Payment Dates: 6-monthly on March 26th and September 26th
Offer Price: 99.85
Running Yield (at Offer Price): 6.38%
Yield to maturity (at Offer Price): 6.39%
Nominal Amount: £1,000
Cost: £998.50 + £3.59 accrued interest + £20 commission = £1,021.09

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Premier Oil and the High Yield Hypothesis

During market dips, it is worth recalling the words of Warren Buffett –

“Be fearful when others are greedy; be greedy when others are fearful.”

Security prices go up and security prices go down, but the coupons paid on bonds go on forever – steady, predictable and reliable. While they offer no upside beyond the prospect of redemption at par, their downside is also limited, always provided that they do not default. And even in default, bonds rank ahead of shares, so while the equity of a company running into serious financial difficulties is likely to be worthless, bondholders may still recover something from the wreckage.

So bonds tend to outperform equities in bear markets, but underperform during a bull market. Thus, while the FTSE 100 has dropped by 13% since the end of May from 7000 to around 6100 today, the average price of the bonds quoted on the LSE’s Order Book for Retail Bonds (ORB) has fallen by less than 4%. The capital value of our embryonic High Yield Bond Portfolio has fallen by 8%, or about half-way between equities and investment grade bonds, with the worst performer being the Rea Holdings preference shares acquired last month, which tanked by 20% when the company announced disappointing interim results a couple of weeks later.

Clearly, a fall in the portfolio’s capital values is never welcome. But realistically it is to be expected at some point, and is compensated by the annual yield of 7.4%. As long as the bonds continue to pay interest on the due dates, then short term market fluctuations have limited relevance.

The more fundamental question is whether the portfolio yield accurately discounts default risk or, as the High Yield Hypothesis (HYH) postulates, over-discounts this risk, offering the potential for returns superior to those that could be secured on equities or investment-grade bonds over the longer term.

Even after the recent falls in security prices, only three bonds are trading below their par value on ORB – Eros, EnQuest and Premier Oil. The first two are ready in the high yield portfolio. The third, Premier, is, like EnQuest, an oil exploration and development company, and as such has been hit not only by general market risk but also by sector-specific risk as global oil prices have tumbled. With global oil production running at around 97 million barrels per day, against consumption of 94 million bpd, oil stocks are building up and there is downward pressure on prices. At some point, the market will be brought back into balance. If demand does not increase, then some sort of a crisis is likely to occur on the supply side, potentially including severe cutbacks in production, the bankruptcy of marginal producers, and defensive mergers among the survivors.

The crisis could go wider than that. In an uncharacteristically lurid leader published on Thursday August 13th entitled “The world’s producers are boiling in cheap oil”, the Financial Times predicted that continued low oil prices could inject dangerous volatility into international politics and destabilize major oil producers including Russia and Saudi Arabia. “Countries in dire financial straits may feel forced into aggressive responses,” according to the FT’s jeremiad. “Periods when the global balance of power is changing are also times when international tensions can flare up. We are perhaps in just such an era today. Policymakers around the world need to be on the alert for the conflicts and upheavals that may yet result.”

The test of the true contrarian is whether he or she is prepared to buy when the Barbarians are at the gate. According to the FT, that moment may be fast approaching for the oil industry. Right now, investing in the bonds of a relatively small, highly leveraged oil exploration and production company has all the appeal of the Loony Dook on a freezing New Year’s day.

Is the high yield bond portfolio the construct of an ice cool contrarian keeping his head while all about lose theirs? Or is it the reckless gamble of a foolish speculator who rushes in where more prudent investors fear to tread?

Only time will tell. In the meantime, following the precepts of the HYH, Premier Oil’s 5% bonds become the seventh investment within the portfolio.

Issuer: Premier Oil Plc
Coupon: 5%
Maturity Date: December 11th 2020
Payment Dates: 6-monthly on June 11th and December 11th
Offer Price: 81.18
Running Yield at Offer Price: 6.1%
Yield to Maturity at Offer Price: 9.5%
Nominal Amount: £1,000
Cost: £811.80 + £12.98 accrued interest + £5.75 commission = £830.53

September 11th 2015

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In Praise of Preference Shares

Preference shares are today a relatively neglected instrument of corporate finance. The current conventional wisdom of the City is that they offer none of the upside of ordinary shares and none of the tax advantages of loan notes.

I have an alternative perspective. True, preference share dividends are not tax deductible, unlike loan interest payments. But this is less of a disadvantage today, with corporation tax now 20% and due to fall to 18%, than when the rate of corporation tax stood at 30% back in 2007. And preference shares offer two major advantages over senior bonds or loans from the viewpoint of the companies that offer them:
• they do not need to be repaid – they are a form of permanent capital; and
• if the issuing company runs into temporary financial difficulties, it can pass the dividend payment on its preference share without risking insolvency.

For the investor, preference shares offer a steady and predictable source of income, with a higher yield than corporate bonds – more than 3% higher today, in fact, with prefshares generating an average yield of 6¼% at their Offer prices, compared to an average yield of barely 3% on bonds quoted on ORB. In addition, preference share dividends are more secure than those on ordinary shares. Overall, they occupy a useful position on the risk–return spectrum, which is why it is somewhat disappointing that my research identified just 22 preference shares which are suffiicently liquid to be easily purchased by a retail investor. For the record, the 22 prefshares, with their offer price and yield at August 10th 2015, were as follows:

[1] Aviva 8.75% Cumulative Irredemable Preference Shares [EPIC: AV.A]. Offer Price 139.5. Yield 6.27%.
[2] Aviva 8.375% Cum Irr Pref [AV.B]. Offer Price 136.5. Yield 6.12%.
[3] Balfour Beatty Cumulative Irredemable Preference Shares [BBYB]. Offer Price 119. Running Yield 8.03%. Yield to Maturity: 4.91%. (Note that the Balfour Beatty convertible issue is repayable on July 1st 2020 at 100, implying a loss of 19% on the current offer price, and for this reason their yield to maturity is significantly lower than their running yield).
[4] BP 8% Cum Irr Prf [BP.A]. Offer Price 152.75. Yield 5.24%.
[5] BP 9% 2nd Cum Irr Prf [BP.B]. Offer Price 169. Yield 5.33%.
[6] Bristol & West 8.125% Pref [BWSA]. Offer Price 127.5. Yield 6.37%.
[7] Bristol Water 8.75% Cum Irr Prf [BWRA]. Offer Price 152.5. Yield 5.74%.
[8] Ecclesiastical Insurance 8.625% Non-Cum Irr Prf [ELLA]. Offer Price 133.5. Yield 6.46%.
[9] General Accident 8.875% Cum Irr Prf [GACA]. Offer Price 139.5. Yield 6.36%.
[10] General Accident 7.875% Cum Irr Prf [GACB]. Offer Price 131.0. Yield 6.01%.
[11] Lloyds Bank 9.25% Non Cum Irr Prf [LLPC]. Offer Price 142.75. Yield 6.48%.
[12] Lloyds Bank 9.75% Non Cum Irr Prf [LLPD]. Offer Price 151.0. Yield 6.46%.
[13] Lloyds Bank 6.475% Non Cum Irr Prf [LLPE]. Offer Price 109.0. Yield 5.94%.
[14] National Westminster Bank 9% Non Cum Prf [NWBD]. Offer Price 142.0. Yield 6.34%.
[15] Northern Electricity 8.061% Cm Irr Prf [NTEA]. Offer Price 146.5. Yield 5.50%.
[16] Raven Russia 12% Cum Red Prf [RUSP]. Offer Price 135.0 Yield 8.89%.
[17] Rea Holdings 9% Cum Red Prf [RE.B]. Offer Price 118.5. Yield 7.59%.
[18] RSA Insurance Group 7.375% Cum Irr Prf [RSAB]. Offer Price 125.5. Yield 5.58%.
[19] Santander 10.375% Non-cum Prf [SAN]. Offer Price 156.5. Yield 6.63%.
[20] Santander 8.625% Non-cum Prf [SANB]. Offer Price 130.5. Yield 6.61%.
[21] Standard Chartered 7.375% Non-cum Irr Prf [STAB]. Offer Price 121. Yield 6.10%.
[22] Standard Chartered 8.25% Non-cum Irr Prf [STAC]. Offer Price 130. Yield 6.35%.

Easily the highest yielding preference share on this list is the Raven Russia issue, which is already included in the high yield bond portfolio. The next highest yield is offered by the 9% preference shares issued by Rea Holdings, an Indonesian plantation owner and palm oil producer. For the most recent financial year ended December 31st 2014, the company generated revenues of just under £81 million, with pre-tax profits of £15 million. The dividend on the ordinary shares was covered 3.5 times, providing very solid protection for the preference share dividend. So the 9% preference shares become the sixth investment of the high yield bond portfolio.

Issuer Rea Holdings Plc
Coupon 9%
Maturity Date Undated
Payment Dates 6-monthly on June 30th and December 31st
Offer Price 118.35
Yield at Offer Price 7.6%
Nominal Amount £1,000
Cost £1,183.50 + £5.75 commission = £1,189.25

August 10th 2015

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The Structure of the London Fixed Income Market

A rapid recapitulation of the high yield bond system:

The objective of the system is to establish whether a diversified portfolio of high yield bonds outperforms other major asset classes. This premise is being tested through a designated Isa, into which one-twelfth of the annual Isa allowance is subscribed each month, and then used to invest in 12 high yielding fixed-income securities in blocks of £1000 nominal.

The monthly trades are executed on or about the 15th day of each month, and reported on this site immediately thereafter. This is to ensure complete transparency, and to avoid the risk of “backfitting”, or manipulating a theory to fit the historic facts after the event

The London fixed-income securities market comprises four main segments:

1. The gilt-edged market, comprising bonds issued by the British Government to fund its expenditure programme and managed on its behalf by the Bank of England’s Debt Management Office. There are currently 42 gilts listed on the Order Book for Retail Bonds, of which 18 are indexed linked and 24 conventional. Their yields are distinctly unappealing – the five-year gilt has a yield to maturity (YTM) of 1.1%, the 10-year gilt offers a YTM of 1.65%, and the 15-year gilt currently has YTM of just over 2%. At these yields, there is a real risk of capital loss should interest rates rise, and little upside. As one City wag has remarked, “Once, gilts offered return without risk; now, they offer only risk without return.”

2. The corporate bond market, which has become much more accessible to the small investor since the Order Book for Retail Bonds was set up in 2011. There are now more than 100 corporate bonds listed on ORB, offering an average YTM of between 2.5% and 3.0%.

3. The market for preference shares, once a popular security, but now with relatively few available to the small investor. By my reckoning, there are currently no more than 20 preference shares that are sufficiently liquid to include in an Isa portfolio. Although many more prefshares are listed on the LSE, they seldom trade and have little price transparency. The average YTM of the 20 liquid preference shares currently stands at just under 6%.

4. The market for subordinated debt and Permanent Interest-Bearing Shares (PIBS) issued by financial institutions as part of their risk capital base. My list currently includes some 40 subordinated loan notes and PIBS available to retail investors, offering an average YTM of approximately 6%.

No high yield portfolio would be complete without the inclusion of at least one Permanent Interest-Bearing Share. Yields on PIBS have fallen significantly from their peaks during the financial crisis, when at one point in July / August 2009 they spiked to over 14%. This was just after Northern Rock and the West Bromwich Building Society had suspended interest payments on their PIBS, the Dunfermline Building Society had collapsed, and the price of the 6% PIBS issued by the Bradford & Bingley had fallen to less than 10p in the £ (by mid-2014 they had recovered to more than 90p – whoever said that investing in fixed-income securities was boring?!).

The highest yielding PIBS currently quoted on the LSE are those issued by the Newcastle Building Society. In last weekend’s Money section of the Financial Times, two PIBS were listed as having higher running yields (RYs): the 11.5% Ulster Bank issue, and the 13.5% Yorkshire Building Society issue. However, this is misleading, because the Ulster Bank notes are subject to a 20% withholding tax, while the Yorkshires mature in April 2025, so their YTM is only 6.2%, compared to the 8.8% running yield quoted by the Financial Times.
The Newcastle PIBS avoid both of these bear traps. Note 12 to the Newcastle Building Society’s 2014 accounts confirm that the 12.625% and 10.75% PIBS are issued for an indeterminate period and only repayable in the event of a winding up of the Society.

The 10.75% PIBS (NBSP) have a coupon of 10.75% and are currently offered at a price of 156.1 giving an RY of 6.89% [= 10.75%/1.561], while the 12.625% issue (NBSR) is offered at 187, giving an RY of 6.75%. The 10.75% PIBS offer a marginally higher yield, so those are the ones added to the portfolio.

Issuer: Newcastle Building Society
Security: 10.75% Permanent Interest Bearing Shares
Coupon: 10.75%
Coupon Payment Dates: June 22nd and December 22nd
Maturity date: Undated, redeemable only in the event of a winding up
Offer Price: 156.1
RY at Offer Price: 6.89%
YTM at Offer Price: 6.89%
Nominal Amount: £1,000
Date of Purchase: July 15th 2015
Cost: £1,561 + £5.75 commission = £1,566.75

July 15th 2015

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The Euro’s Existential Crisis

Extract from Chapter 11, ‘The Euro’s Existential Crisis’, in ‘The Golden Guinea. The International Financial Crisis, 2007-2014: Causes, Consequences and Cures’ (2012). Final section, ‘The Long Goodbye: Requiem for the Euro’.

“The inevitable conclusion is that the Euro cannot survive indefinitely in its current form…..Rigidly fixing national currencies to a single currency at an overvalued rate leads inevitably to deflation, which can only be brought to an end if the currency peg is sundered. That seems to be the most likely outlook for the Euro, although it is impossible to predict precisely when and how the single currency will finally break up.

The case put by supporters of the Euro for maintaining the single currency was that the alternative was so much worse. A research note issued by UBS in November 2011 commented that any nation exiting the Euro would face “corporate default, collapse of the banking system and collapse of international trade,” and probably experience a decline in GDP of between 40% and 50%. The scribes of UBS went on to add that, “almost no modern currency monetary unions have broken up without some form of authoritarian or military government, or Civil War.” In a separate research note, HSBC commented that “a breakup of the Euro would be a disaster, and in a worst-case scenario could trigger another Great Depression”. The economist Willem Buiter, and many others, painted a similar apocalyptic picture of a world without the Euro.

The narrative put forward by apologists for the European single currency completely discounted evidence of the damage done by the Euro in generating unsustainable Payments imbalances between Eurozone Member States, causing a destabilising asset price bubble that led to significant losses threatening the solvency of the European banking system. The Eurozone authorities then sought to address this threat by successive bailouts, adding to the national debt of sovereign states that were already over-borrowed. This led onwards to attempted fiscal consolidation on a scale that drove the continent of Europe into the most severe and prolonged recession seen since the Great Depression.

This was the legacy of the failed Euro experiment.

Throughout the Euro’s prolonged and painful death throes, Europe’s political elite asked the wrong question.

The question they were asking was, “How can we save the Euro?”

In reality, the ultimate fate of the Euro was already sealed. As Tolstoy wrote in ‘War and Peace’,

“Just as in the clock, the result of the complex action of countless different wheels and blocks is only the slow, regular movement of the hand marking the time, so the result of all the complex human movement – of all the passions, hopes, regrets, humiliations, sufferings, impulses of pride, of fear, and of enthusiasm of those men – was only… the slow shifting of the registering hand on the dial of the history of mankind.”

The question that needs to be asked is not how the Euro can be saved, but rather how it can be restructured in an orderly manner, to minimise its negative impact.

And, following from this, what should be put in its place.”

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Greek Tourism VAT and Greece’s future in the Eurozone

An article in today’s Times on Greek VAT on hospitality services entiled ‘Tourists will pay the price the Greek surrender on VAT’ reports that the rate of VAT on restaurants in Greece is likely to increase from 13% to 23%, while for hotels the rate will increase from 6.5% to 23% as part of a package of measures to improve the country’s fiscal position. For the Greek islands, which benefit from further concessions, the rate will increase from 9% for restaurants and 5% for hotels.

It is not difficult to forecast the likely consequences of these increases – namely a slump in the Greek tourism industry, and very likely a sharp increase in the cash or “shadow” economy.

Going back to 2012, I expressed the view in The Golden Guinea and on this site that the best way forward for Greece would be to exit from the Euro and reintroduce the drachma at a competitive exchange rate, with the support of transitional assistance from the IMF and EU to cover a temporary balance of payments deficit, until the positive effects of a more competitive exchange rate fed through to higher foreign-exchange earnings from tourism and other exports. This remains my view. My article on The Economic Consequences of Greek Exit from the Euro, published on June 7th 2012, is reproduced below. Plus ça change…

“June 7th 2012.

With just over a week to go before the Greek General Election, it is reported that the left-wing Syriza Party may emerge with the most seats and be invited to form a government led by Alexis Tsipras. His economic policy is based on two pillars:

1. Greece should remain within the Euro.

2. However, Greece should not continue the policies of austerity pursued by the government of George Papandreou to comply with the EU’s fiscal compact, which would require Greece to balance its budget. Instead, Mr Tsipras proposes the creation of 100,000 public sector jobs and writing off part of the country’s debt.

There is a logical third implication of this syllogism:

3. Germany and the other Eurozone countries should transfer sufficient resources to Greece to enable the Government to meet its public spending and debt servicing obligations. Without this, the Greek Government could become insolvent.

[3] is not going to happen. In an excellent presentation given to the David Hume Institute in Edinburgh yesterday evening, the Prime Minister of Lower Saxony, Mr David McAllister, made it very clear that, whatever his personal sympathy for the predicament of the Greek people, there was no possibility that he or his national party leader, Angela Merkel, could sell such a proposal to their voters. He pointed out that the retirement age in Germany had only recently been raised to 67, against strong trade union opposition, and there was absolutely no way that German voters would support subsidies to the Greek Government to enable it to maintain an average retirement age of 61.

Given these political realities, the most likely outcome is eventual Greek exit from the Euro.

The consequences of such an exit are a matter for debate. Nikolaos Karamouzis of Eurobank was quoted in the Sunday Times on May 20th as saying, “We depend on EU and European Central Bank funding to pay our back our debts and keep everything from banks, to hospitals, to the traffic lights working. If the EU stops funding us, we will simply run out of money and the economy will stop functioning.” In the “armageddon scenario” painted by the Sunday Times, “an implosion in Greece would spread to Portugal, Ireland, Italy and Spain, sparking runs on their domestic banks….Stock markets would crash….There would be a flight of capital from weak to strong countries, necessitating exchange controls. Governments might seize assets held by foreigners. Inflation would soar in Europe’s periphery, but core nations could suffer deflation….Unemployment would soar. Public services would fail….House prices would plummet…”

However, such a nightmare scenario is not borne out by historic precedent. Twenty years ago, Britain exited the European Exchange Rate Mechanism – the precursor to the Euro. Sterling did indeed drop significantly in value, as a new Greek Drachma would against the Euro. But Britain did not descend into social and economic chaos. On the contrary, the years following ERM exit saw a sustained recovery in output, income and employment in the UK. I believe that the same would happen in Greece. The price of Greek agriculture, manufacturing and tourism would fall as a result of a Drachma devaluation against the Euro. After an initial shock, the Greek balance of payments would gradually improve – just as the UK balance of payments did in the mid-1990s – as exports became more competitive, while domestic production became cheaper relative to imports. As in Britain after the ERM exit of September 1992, the most likely scenario is that the Greek economy would trace a “J” curve – an initial downturn followed by gradual and sustained recovery.

The adjustment process would be eased if transitional assistance were provided to Greece by the IMF as part of an orderly exit, as proposed by the highly respected Chairman of the House of Commons Treasury Select Committe, Andrew Tyrie MP, in a paper published by the Centre for Policy Studies on June 5th (2012).”

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Eros International – the paradox of a low risk, high yield bond

It is a sign of the times, and the remarkably benign conditions prevailing in the London securities market, that no less than 103 of the 106 corporate bonds quoted on the LSE’s Order Book for Retail Bonds (ORB) are trading above their par value.

This isn’t entirely good news for a bond investor. First and foremost, it means that any investor buying one of those one hundred and three bonds at their current prices is locked into a capital loss if they are held to maturity. This capital loss would be compensated by interest earned during the lifetime of the bond, and a bond could be sold before maturity at a profit in the event that prices rise further. However, as prices increase, so do the downside risks. In general, it is safer to buy bonds trading below par value than those trading at a premium.

Of the three bonds trading below par, two – EnQuest and Premier Oil – have been hit by the downturn in global oil prices. The third is Eros International, which describes itself as “a leading global company in the Indian film entertainment industry.”

This short description flags up two immediate risk factors.

Firstly, Eros’s dependence on the Indian market could be regarded as higher risk than a film company operating in the UK, given the apparently erratic interpretation that the Indian authorities have of their own tax laws.

Secondly, film production itself is widely regarded as a risky venture.

However, the Law of Large Numbers gives some reason for confidence. If Eros knows what appeals to the Indian public, while individual movies they back may fail, their overall film portfolio should make money. The fate of Eros does not depend on a few blockbusters. The company has spread its risk over 2,000 films and has produced 220 new films over the last three fiscal years. The company comments that, “New film distribution across theatrical, television and digital channels, along with library monetization, provide us with diversified revenue streams.”

The typical Bollywood storyline dates back to Cinderella and before – Boy Meets Girl, Boy Loses Girl, Boy Finds Girl Again – with the narrative played out against a backdrop of music, dance, laughter and a few tears until the two finally come together and live happily ever after.

Eros’s published accounts suggest that the old formula is working as well as ever. The company’s annual revenues have grown steadily, from $66 million in 2007 to $235 million in 2014. It has been consistently profitable – operating profits in 2014 were six times financing costs, and Eros’s profit after tax, at $37 million, represented a healthy 16% of turnover. Most encouragingly of all for a bond investor, the company had cash reserves of $145 million at March 31st 2014, equating to well over half of its annual turnover.

The storylines may be pure hokum, but there are worse ways of making a living than through the Bollywood dream machine, employed in the great enterprise of cheering us all up.

Overall, Eros looks like the Holy Grail of bond investment – a comparatively low risk, high yield investment. So Eros bonds become the fourth investment of the Experimental High Yield Bond Portfolio.

Issuer: Eros International
Coupon: 6.5%
Payment Dates: April 15th and October 15th
Maturity date: October 15th 2021
Offer Price: 97.4
Running yield [RY] at Offer Price: 6.67%
Yield to maturity [YTM] at Offer Price: 7.01%
Nominal Amount: £1,000
Cost: £984.12 (inclusive of £10.12 accrued interest) + £5.75 commission = £989.87

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High Yield Bonds and the Efficient Market Hypothesis

The proposition that investments in high yield bonds will generate returns that are greater than could be secured from other investments is contrary to the Efficient Market Hypothesis (EMH). If the EMH is correct, then it should be impossible for an investor in high yield bonds to generate excess returns.

So the performance of the experimental High Yield Bond portfolio will, indirectly, also be a test of the EMH.

Even if one believes that financial markets are not always efficient, it does not follow that they are always inefficient. My experience over the years has led to a healthy scepticism regarding the EMH in its strongest form; but most of the time, security prices quoted on a liquid and competitive market such as the London Stock Exchange seem to reasonably reflect publicly available information.

The question addressed here is whether the third addition to the High Yield Bond Portfolio is efficiently priced.

Raven Russia (RR) describes itself as “a Guernsey registered property investment company specialising in commercial real estate in Russia.” So an investor in RR is, in effect, taking a macro position on the Russian economy. In its most recent stock market update, RR sought to reassure investors that it is more than capable of riding out any temporary turbulence in Russia for three main reasons. Firstly, the vast majority of its tenants are locked into dollar-denominated leases. Secondly, the company has adequate dollar cash reserves to meet its ongoing financial commitments. Thirdly, the current turbulence in Russia has led to a general cutback in new property investment, so there is “limited new space coming onto a structurally undersupplied market.”

The way RR tell it, you could be forgiven for concluding that Vladimir Putin’s aggressive foreign policy is a positive boon for their investors.

I don’t buy it.

While RR’s tenancy agreements may be denominated in dollars, this does not tell us how easily their tenants will be able to meet their dollar obligations, or for how long. Raven Russia is by no means the only company to have been hurt by Putin’s foreign policy, which is damaging the interests of his own people and the wider region. The fact is that RR has no more control over Russia’s erratic leader than I do.

An investment in Raven Russia only makes sense if wiser and more prudent heads within the Kremlin have the courage and capability to restrain Putin, and if the honourable efforts of President Hollande of France and Chancellor Merkel of Germany to broker a peace deal in the eastern Ukraine bear fruit.

It could happen, and I hope it does. But there are no guarantees whatsoever that it will.

Furthermore, the terms accruing to Raven Russia’s preference shares are not particularly favourable to their investors. While the 12p per share dividend will remain payable for the indefinite future, the shares can be redeemed at 100p per share in the event of a winding up, takeover or merger. Although there is no immediate prospect of such an event, were it to happen, a holder of the preference shares would face an immediate and significant loss of capital, even if Raven Russia itself is solvent.
Thus, while a running yield of 8.5% may look attractive, it does not come without risks, and I believe that the current market price fairly reflects those risks – indeed, depending upon one’s view of Putin’s Russia, it may actually under- discount them. Given these considerations, normally I would not be rushing to buy these securities. However, the rules of the High Yield Bond Portfolio are set to override personal judgement. So the Raven Russia preference shares become the third security added to the portfolio.

Issuer: Raven Russia Ltd
Security: Cumulative Redeemable Preference Shares 1p
Coupon: 12.0%
Payment Dates: Quarterly on March 31st, June 30th, September 30th and December 31st
Maturity date: Undated, but redeemable at 100 in the event of a winding up, takeover or merger
Offer Price: 141
Running yield [RY] at Offer Price: 8.5%
Yield to maturity [YTM] at Offer Price: 8.5% [The YTM on perpetual or undated securities is the same as the RY]
Nominal Amount: £1,000
Cost: £1,410.00 + £5.75 commission = £1,415.75

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Rating Agencies and Bond Mispricing

As reported in March, over the coming months this site will report results of a real-time experiment in high yield bonds.

Casting an eye over potential candidates for the High Yield Portfolio, my attention was caught by two rather curious features of the Co-operative Bank’s 11% Subordinated Loan Notes.

These notes were issued in December 2013 as part of a major refinancing exercise to save the bank from the threat of extinction. The funding raised was used to repay the Bank’s preference shares and perpetual subordinated bonds, which were redeemed at a significant discount. The Notes have two maturities – one repayable on December 20th 2023 (EPIC 42RQ), offered at a price of 120 on April 9th, and the other maturing on December 20th 2025 (42TE), offered at a price of 127.

Here’s the first curious feature. At the offered prices, the 2023 Notes have a yield to maturity (YTM) of 7.8%, compared to a YTM of 7.3% on the 2025 Notes. The implication would seem to be that the Co-operative Bank has a negative expectation of default between 2023 and 2025. But that is a logical impossibility.

But it is not just the relative yield that looks odd. The absolute yield is high, indicating a high risk of default. It is as if the December 2013 refinancing never took place. Or, perhaps more accurately – since, as a matter of historic fact, it did take place – it is very likely to fail.

How has the bond market arrived at such a conclusion?

My suspicion is that it is with the help of a couple of leading ratings agencies.

Fitch awards the bank a “B” rating, which “indicates that material default risk is present…Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.” Moody’s assigns a Caa2 rating – “Obligations rated Caa2 are judged to be of poor standing and are subject to very high credit risk.”

But is this fair? Neither Fitch nor Moody’s have proved exactly infallible in the past, having failed to identify financial stress in a number of major banks during the run-up to the financial crisis of 2007/08. For that reason, I prefer to apply my own forecasting model of financial stress, as set out in the fourth chapter of The Golden Guinea. I benchmarked the Co-op Bank’s final accounts for the year to December 2014, published a couple of weeks ago, against Northern Rock’s accounts for the year to December 2006, applying the seven leading indicators of bank failure set out in The Golden Guinea:

1. Extremely rapid growth of its loan portfolio. The value of Northern Rock’s portfolio more than tripled between 2003 and 2006, suggesting deteriorating loan quality. By contrast, the Co-op Bank’s loan portfolio has fallen by a fifth over the past four years, from £34 billion to £28 billion, suggesting tighter loan control.

2. Increasing loan to value (LTV) ratios. In Northern Rock’s case, the bank advanced mortgages with a value of 100% or more of the properties against which they were secured. The days of 100% mortgages are now long over, and the Co-op bank is lending on far more prudent LTV ratios.

3. Falling interest margins. Northern Rock’s net interest margin – the difference between the interest earned on its loans and the interest it had to pay on its own funding as a percentage of its total loan portfolio – narrowed from 1.53% in 2003 to 0.98% in 2006. Applying the same formula, I calculate the Co-op Bank’s net interest margin as 1.28% for the year to December 31st 2014, up from 0.94% the year before and moving in the right direction.

4. Falling administrative and staff costs as a proportion of the total loan portfolio. This suggests less thorough due diligence of new loans and less intensive monitoring of existing loans. Northern Rock’s staff costs fell significantly as a proportion of its loan portfolio in the lead up to its financial collapse. By contrast, the Co-op Bank’s staff costs rose from 0.92% of its loan portfolio in 2013 to 1.20% in 2014. Unless the bank’s staff are making cups of tea all day (which hopefully is not the case), this suggests that greater resources are being committed to loan monitoring and appraisal.

5. Rising leverage and a falling equity buffer. Northern Rock’s equity fell from 3.6% of its gross assets in 2003 to 1.8% by the end of 2006. By contrast, the Co-op Bank’s shareholders funds have increased from 3.7% of its gross assets at December 31st 2012 to 5.4% at December 31st 2014.

6. Increased dependence on wholesale funding, and reduced support from customer deposits. Northern Rock’s wholesale funding increased from 35% of its gross assets in 2003 to 64% by the end of 2006, leaving it dangerously exposed when the wholesale funding markets froze in July 2007. The Co-op Bank relies on wholesale funding for less than 10% of its total funding, with customer deposits accounting for more than 75%, a much more stable funding structure.

7. Declining cash and liquid reserves. Northern Rock’s cash reserves were less than 1% of its gross assets at December 31st 2006, leaving it desperately short of ready funds to meet customer withdrawals and the loss of access to the wholesale funding market in July 2007. By contrast, the Co-op Bank’s cash reserves represented 12.7% of its gross assets at December 31st 2014, with the Bank holding £4.8 billion of cash within its gross assets of £37.6 billion.

You will notice that a bank’s bad debt provisions are not among the leading indicators that I have identified for bank failure. Banks facing financial distress are very likely to “extend and pretend” – extend further credit to borrowers in difficulty, and pretend that their loans will be repaid. It turns out that bad debts are a lagging rather than a leading indicator of bank failure.

Given these statistics, how can Fitch and Moody’s have assigned an investment grade rating to Northern Rock in 2006, while assigning a junk bond rating to the Co-operative Bank nine years later?

My guess is that they are looking mainly through the rearview mirror, basing their assessment on the Co-op Bank’s historical record under its previous, now departed, management team, rather than on its position and prospects under new owners and managers. My impression is that the bank’s chief executive, Niall Booker, who took up his post in June 2013, is a steady hand on the tiller, steering his stricken vessel to calmer waters after a period of turbulence.

Only time will tell whether I am right, or whether the ratings agencies more pessimistic view is correct. In the meantime, the Co-op bank’s 11% 2023 Notes become the second investment of the high yield bond portfolio.

Issuer: Co-operative Bank plc
Coupon: 11.0%
Coupon Payment Dates: Quarterly on March 20th, June 20th, September 20th and December 20th
Maturity date: December 20th 2023
Minimum Denomination: £100
Offer Price: 120
Running yield (at Offer Price): 9.1%%
Yield to maturity (at Offer Price): 7.8%
Nominal Amount: £1,000
Cost: £1,207.17 (inclusive of £7.17 accrued interest) + £11.75 commission = £1,218.82

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A Real Time Financial Experiment in High Yield Bonds

Over the coming months, I am conducting a real-time financial experiment designed to test the validity of the hypothesis that investments in high yield bonds (so-called “junk bonds”) systematically outperform investments in apparently safer options such as gilt-edged securities or investment grade corporate bonds.

The High Yield Hypothesis emerged from research undertaken by W Braddock Hickman, who studied corporate bond performance in the USA between 1919 and 1943. He found that a high-yield bond portfolio, provided it was sufficiently large, diversified, and held for a sufficient period of time, generated greater returns than a portfolio held in investment grade bonds. Although the high yield portfolio suffered more defaults, in aggregate the greater yield more than compensated for the losses. Hickman’s findings were updated by T. R. Atkinson, who confirmed that the same result held for the period between 1944 and 1965.

My experiment is intended to address three questions:

1. Is the hypothesis valid for the UK as well as the USA?
2. Does it apply in the peculiar monetary circumstances of 2015, when bond yields have been compressed to artificially low levels by Quantitative Easing and other Central Bank interventions in the financial markets?
3. Can the hypothesis be profitably applied by a retail investor, as opposed to a large investment bank?

The third question is, from a purely selfish viewpoint, the most interesting. During the period covered by Hickman and Atkinson, bonds were often issued in minimum blocks of £50,000 or £100,000, well beyond the means of the average retail investor. But two recent developments have enabled retail investors to participate in the corporate bond market on more or less equal terms with large institutions. The first was the creation of the Order Book for Retail Bonds (ORB) on the London Stock Exchange in 2010, which considerably increased the universe of bonds available in small denominations to the retail investor. The second was the development of Individual Savings Accounts (Isas), and an increase in their annual investment limits to £15,240 for the 2015/16 financial year. These two developments have made it possible for a small investor to build up a diversified bond portfolio in a tax-sheltered fund. The Isa incentives in particular are very important for high yield bonds. A £1,000 investment in an 8% bond would generate a net annual income of £80 if it is held within an Isa, but less than £50 if held outside an Isa by a higher rate taxpayer.

The rules of my High Yield system are as follows:

1. An equal amount will be invested in the portfolio on or about the 15th day of each month, equal to 1/12th of the annual Isa allowance. This equates to approximately £1,300 per month in 2015/16. In practice, the actual sums may be slightly higher or lower, as bonds will be bought in blocks of £1,000 each.

2. The monthly amount will be placed into the highest yielding bond eligible for an Isa, provided that there has been no prior purchase of the same bond during the financial year. This rule implies that 12 different bonds must be purchased in any financial year.

3. Bonds will be sold either when they mature, or when their yield has fallen to less than half the yield on the next bond due to be purchased under Rule 2. The funds raised from the sale will then be reinvested in this “next best bond”.

As far as possible, these rules will be applied on a purely mechanical basis.

Of all the bonds currently listed on ORB, one stands out as offering the highest yield by a clear margin – the bonds maturing in February 2022 issued by North Sea oil producer EnQuest Plc. These bonds currently trade below 70p, implying a running yield above 8% and a gross redemption yield above 12%.

Yields at this level imply that the bond market has priced in a distinct possibility of default, and with good reason. Reports suggest that EnQuest needs a crude oil price of around $80 per barrel to break even, against a current level closer to $55. The recent slump in oil prices has already claimed one casualty this month, with African oil explorer Afren defaulting on a $15 million interest payment due on March 4th “in order to preserve cash while a review of the company’s capital structure and funding alternatives is completed.” Translated into the vernacular: “Can’t pay, won’t pay.”

So there is a genuine risk of default on the EnQuest bonds. This could be averted if the crude oil price recovers, or if the company is able to reduce its cost base. The company’s senior debt providers have already relaxed their lending covenants to give EnQuest some breathing space. A White Knight may ride to the rescue, taking over the company and its liabilities; or the company’s shareholders may agree to rescue rights issue to help EnQuest through a temporary bad patch.

It must be admitted that these are an awful lot of “ifs”, “buts” and “maybes”. Yet the High Yield Hypothesis, if correct, would indicate that, if a sufficiently wide number of high risk bonds like EnQuest are built into a diversified portfolio, overall their return should more than compensate their risk of default.

So, with a degree of trepidation, the first investment of the experimental High Yield Portfolio is committed.

Issuer: EnQuest plc
Coupon: 5.5%
Coupon Payment Dates: 6-monthly on August 15th and February 15th
Maturity date: February 15th 2022
Minimum Denomination: £100
Offer Price: 67.845
Running yield (at Offer Price): 8.1%
Yield to maturity (at Offer Price): 12.3%
Nominal Amount: £2,000
Cost: £1,366.32 + £10 commission = £1,376.32

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