Liquid Alternatives, the new Eldorado for active managers?

on Jun 14, 2014 in Derivative, Fixed Income, Home, Portfolio ad hoc | 2,146 comments

Thanks to the unconventional measures of central banks and the march of index investing strategies, we are in fact seeing the rise of a new, more aggressive version of active management. Investment managers are launching investment products that give them more flexibility to roam around financial markets in search of alpha. The question is whether end investors will ultimately benefit from this phenomenon. So, what are exactly Liquid Alternatives? Liquid Alternatives are complex and opaque investment wrappers that require a bit of caution. They are packaged into a fund, covering a wide-ranging category of assets, while using a hedge fund strategy. Unlike most traditional funds, they can go short, use leverage and derivatives. The rise of Liquid Alternatives opens up a vast new market and come at a convenient time for asset managers. Now with bonds looking fairly expensive and equities unstably climbing higher, asset managers are looking for an alternative that could hold its value in dangerous waters. This is where Liquid Alternatives come into play. The risk is that unconstrained funds are not being pitched correctly. They are marketed as uncorrelated assets that increase diversification or act as insurance protection. Faced with a universe of styles and possible strategies, investors ought to be doing their due diligence in a similar fashion as a hedge fund. Consider for instance, fixed income where, after three decades of declining interest rates, the normalization of monetary policy may be a headwind for returns for the coming years. In this respect, PIMCO is pursuing a push for so-called unconstrained bond funds. In practice, the funds are sold as a conservative choice, a prudent alternative to a core bond fund that might no longer be able to preserve capital. It consists of placing bets across a wider spectrum of the fixed income market, such as emerging markets, junk debt, credit derivatives, and taking bets on the direction of interest rates. Retail investors are only catching up with what is happening among institutional investors. This process will lead to more volatility in markets, and be consequently ready to tighten the seat belt. Their record is not long enough to know whether they could get credit for diversification benefits. Don’t forget to do your homework before...

Cov-Lite – Yield hunting shifts power from lenders to borrowers

on Jun 26, 2013 in Fixed Income, Home | 2,418 comments

In their pursuit of yield, investors appear to have materially increased their appetite for risk by accepting increasingly looser covenant packages. During the last credit bubble, we saw a large increase in cov-lite loans and this phenomenon is now reemerging again. The question is, what if cov-lite features are given to less worthy borrowers? I personally have some reserves for cov-lite loans being extended to companies in dubious financial health, which could be adversely affected by higher interest rates. As far as literacy is concerned, a single borrower, rather than borrowing from a single bank, would borrow from a consortium of banks, also known as syndicated loan. Since no borrowers can maintain relationship with dozens of different banks at the same time, covenants – promises the borrower would make to its lenders – replaced the trust relationship previously established between a borrower and its prevailing bank. Essentially, loans were becoming more like bonds: they were becoming debt instruments to be traded between various investors, rather than loans which a single bank would hold to maturity and beyond. Coming back to our topic, cov-lite loans are more appealing to issuers because they entail less-restrictive covenants that enable lenders to take action if a company’s financial ratios breach specific limits. If any of those ratios were violated, that would count as an event of default on the loan, and the borrower would be forced to renegotiate with the consortium. A recent Moody’s report says, “a cov-lite capital structure allows for increased financial flexibility at a time when a company needs it most, potentially allowing it to forestall default while getting through a choppy patch in its business”. But does that flexibility only serve to increase the severity of default further down the road? If banks can’t interfere early, does that mean they are going to end up taking bigger losses later? As Moody’s puts it, there’s an assumption “that cov-lite issuers are less likely to default, but once they do, value may have deteriorated to a greater degree than it would have if lenders had been able to step in earlier to address a breached covenant”. Is the recent surge in cov-lite a source of concern for...

Exchange Traded Note explained

on Nov 8, 2012 in Fixed Income, Home | 2,009 comments

Exchange-traded notes (ETNs) are structured products that are issued as debt securities by banks and are linked to the performance of various assets, indexes or strategies. Though linked to the performance of an asset, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted and similarly to index funds, they are linked to the return of a benchmark index. When you buy an ETN, the underwriting bank promises to pay the amount reflected in the index or strategy upon maturity, like a bond investor would. Instead of being backed by the assets that are in the investment fund like ETFs are, ETNs are simply backed by the full faith and credit of the issuer. For instance, if you buy an ETN covering oil and the value of oil appreciates during the time you are holding the ETN, your investment will consequently benefit from the uptrend and you will receive a higher payment at maturing. ETNs have less than a decade history! The lack of tracking record could be a concern for investors who are considering adding ETNs to their portfolios. In addition, the investment and its return will depend on the bank ability to deliver what it has promised to investors. Better pray the bank will still be around 20 years from...

The TIPS spread

on Sep 13, 2012 in Fixed Income, Home | 1,456 comments

The US Treasury sells notes of different yields and maturities. One type of those notes is known as TIPS or Treasury Inflation Protection Securities. A TIPS note’s yield moves based on changes in the level of CPI or consumer price inflation. If CPI or inflation is rising, the face value of a TIPS note increases and similarly the face value may fall if CPI falls. This means that TIPS are a hedge against inflation! Comparing the yields between Treasury securities and TIPS can provide a useful measure of the market’s expectation of future CPI inflation. Why? The yield-to-maturity on a Treasury bond that pays its holder a fixed nominal coupon and principal must compensate the investor for future inflation. Thus, this nominal yield includes two components: the real rate of interest and the inflation compensation over the maturity horizon of the bond. For TIPS, the coupons and principal rise and fall with the CPI, so the yield includes only the real rate of interest. Therefore, the difference, roughly speaking, between the two yields reflects the inflation compensation over that maturity horizon. The wider the spread between the two yields, the higher investors’ expectations are and vice versa. From a fundamental perspective it seems that we can count on higher levels of inflation in the long term. From a portfolio management perspective TIPS are a good way to add protection against inflation and to insert an element of fixed income to your diversification strategy. Bottom line: Higher rates of inflation can be turned into an opportunity at the investor’s...

Coco bond susceptible to systemic risk

on Jul 12, 2012 in Fixed Income, Home | 2,676 comments

Put simply, a coco bond is a security similar to a traditional convertible bond and becomes convertible only when a specific event occurs, rather than being simply convertible at the option of the bondholder. For banks, the triggering event may be that it will convert to equity if the issuer’s tier one capital falls below a limit. The conversion will then re-capitalise the bank. In this aspect coco bonds resemble more catastrophe bonds than convertible bonds. Credit Suisse priced the first contingent capital in February last year. The Credit Suisse bonds convert into equity if the bank’s common equity tier one ratio falls below 7%. The main purpose of coco bonds is to increase a bank’s capital in times of distress. If the trigger is never met, coco bonds are considered as debt instruments which are included in bank’s core capital. Thus, instead of the bank looking at the government for a bailout, it can bail itself out by getting a new injection of capital from conversion of the cocos. Coco bonds are a smart way of protecting tax payers in case of a financial meltdown. At the same time they shall aid banks in meeting the Basel 3 requirements. However, let’s assume that a bank decides to issue half of its capital via a coco bond. If the bank runs into trouble, those bonds would convert into equity, diluting existing shareholders. The share capital of the bank would now be equally split between the former bondholders and shareholders. In such a scenario, conversion of the bond would lead to a halving of value of the share price. This would wipe out existing shareholders of 50% of their wealth. Bottom line: a coco bond creates a barrier effect, in other words, a drop in equity value at the trigger level. This is what caused me to question the real benefit of the instrument. But another implication of this barrier effect is that any new coco issue has an impact on the position of existing coco holders and shareholders, as it could trigger further drop in equity value. But investors and regulators alike have voiced concerns that these bonds, by design, convert into equity at a time when the bank’s share price is likely to already be under pressure. The presence of such a convertible in the capital structure may create a self-fulfilling death spiral. Investors concern about potential dilution as well as bank’s health may generate panic selling. To conclude, such products would definitely not replace the need for banks to raise permanent...

Yield pickup through preferred shares

on Jul 5, 2012 in Fixed Income, Home | 1,964 comments

Investors looking for income vehicles have increasingly focused on preferred shares. Since interest rates are at bottom levels, yield oriented investors have turned to such hybrid securities with the properties of both bonds and shares. Additional feature sometimes includes right to convert preferred shares into common shares at a prearranged price. Like bonds, preferred shares are commitments by a company to pay an attractive interest to shareholders. But understand the downside, too. Like bonds, preferred shares are interest rates sensitive. These securities will either never mature or not within the next 50 years, which is ideal for investors interested in locking a dividend for a long period. However you can expect the value of the shares to fall quickly if rates are on the rise. At the same time, your upside potential with preferred shares is capped because of issuer redemption rights. They generally include a call provision, meaning that the company has the option to purchase the shares from shareholders at face value after five years from the issue date if the price gets too juicy. Preferred shares are also exposed to credit risk meaning that you are never assured of getting your capital back intact. For preferred shares, the only way you can get your principal back is to sell your shares on the open market. Like shares, preferred shareholders are subordinate bond holders for a company’s assets if it runs into financial distress. This adds a default risk component to preferred shares, even though they have priority dividend distribution over common shares. The bottom line: preferred share can be an attractive investment for investors looking for additional income. But, they are definitely riskier than traditional bonds, so you will experience larger price fluctuations for the given yield pickup, which may be unacceptable for risk-averse...