Macaskill on markets: Finding the next big short
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Macaskill on markets: Finding the next big short

It’s hard out there for a short, even with a multi-year credit and equity rally looking increasingly fatigued.


Shorting debt instruments is particularly problematic, despite expectations that global interest rates will eventually rise and hurt fixed income values. And investment banks like Goldman Sachs have appeared wary of taking a proactive role in enabling short positions, given the reputational bruising they suffered after helping hedge funds such as Paulson to profit from the 2008 credit crisis.

Recent indications of market frothiness could signal an increase in viable shorting opportunities, however, including a revival of highly complex credit structuring techniques that feature none other than Goldman as a lead player.

Selling Japanese government bonds short has been known as the widow-maker trade for two decades, given the persistent failure of yields to rise. The US Treasury market has taken over the worldwide widow-maker title this year, as near-unanimous predictions of higher yields by analysts in late 2013 were confounded by a further rally. Thirty-year Treasuries had delivered a return of 16% by the time of a well-received long bond auction in mid August, and even short-end Treasuries remained in positive territory for 2014. With Bunds also touching historically low yields and peripheral European bonds anchored by German rates, there seemed to be few opportunities to short government bond paper.

Structurally suspect credit deals appear to offer better opportunities for shorting, though even sectors with a large divergence in views on valuation face uncertainty over whether central banks will act to head off market disruption, or whether underwriting dealers will try to hold up prices in markets where they are also issuers of debt.

Loco for CoCos

The market for contingent convertible bonds (CoCos) issued by banks seems like an ideal shorting candidate in some ways. The instruments, which are structured like bonds but are designed to convert to equity in the event of the breach of a trigger such as a fall in a bank’s capital below a certain level, have been a big hit with investors looking to buy highly rated paper that offers some yield in a low-return environment.

In what can be seen as an impressive sleight of hand, bank issuers of CoCos have been able to focus the debate over valuation of the deals on minor structural differences in what are relatively complex hybrid bonds. This has served to mask the fact that banks are selling CoCo deals with yields far below their own cost of capital, despite the plausible view that the trades should be valued as close in form to equity, albeit with some debt-like features. The cost of capital for major banks is conservatively viewed as a minimum of 10% nowadays, and is arguably closer to 12% for most firms. But CoCo deals have been sold with yields to call dates that were under 5% this year, as issuing banks found willing buyers among both institutional and retail investors.

Signs of concern about the popularity of CoCos emerged in July and August, when the UK’s Financial Conduct Authority said that their sale to retail investors would be banned from October onwards, days after Bank of America Merrill Lynch announced that CoCos would be ineligible for inclusion in its global corporate debt indices from the end of September.

This prompted some selling, but only took blended yields for the sector to a level a little over 6%.

That presents a clear opportunity to profit from a more substantive repricing of the sector to a level closer to the actual cost of equity for an issuing bank, according to some investors.

It also looks suspiciously like one of the
collateralized debt obligations that performed
so poorly during the 2008 credit crisis…

“I think that CoCos could trade off by 20 points or more from here, as yields are still too low in the 6% to 7% range,” says Brad Golding, a managing director at hedge fund Christofferson Robb. “Pricing what is effectively equity risk with a 6% yield seems far too low compared to a bank’s cost of capital.”

A price fall of this magnitude that pushed CoCo yields to a range of 8% to 9% would offer a healthy return for a short seller, though profiting from cash bond selling is complicated by the ability to trade paper with dealers.

There are over 50 bank CoCo deals outstanding, most of them substantial in size, but the sector suffers from the secondary market illiquidity that is prevalent across the entire corporate bond universe.

Investment banks took a cue from regulators and slashed their corporate bond inventories well ahead of formal implementation of the Volcker Rule, which aims to curb proprietary dealing by banks.

This has made dealers less able to transact substantial secondary bond trades, even when they are willing to service trades that undermine the value of deals they may have underwritten, including bonds in sectors where their parent institutions are debt issuers.

Ironically, one source of downward pressure on CoCo prices could prove to be banks quietly trying to shift existing retail investors out of the sector for fear of eventual accusations of mis-selling.

But in general dealers have little incentive to disturb the cycle of the last few years where corporate bond prices remain stable and investors looking to add exposure are forced to compete for new issues, in turn boosting underwriting fees for banks.

Dealers have a strong interest in reviving demand for credit derivatives trading and related fixed-income revenues, however. This is where their attitude towards enabling aggressive short selling in the credit markets will be most interesting.

A sign that dealers are unable to resist the siren call of potentially disruptive credit trades came with the move in June by Goldman Sachs to establish a programme of up to €10 billion of issuance that uses total return swaps on an opaque pool of asset-backed debt to provide investors with synthetic exposure to covered bond returns.

Sudden spike

The deal will offer exposure to investors while covered bond issuance is low, as the European banks that traditionally sell debt secured by their mortgages can currently find better terms elsewhere. And it received a triple-A rating from S&P.

It also looks suspiciously like one of the collateralized debt obligations that performed so poorly during the 2008 credit crisis, when complex terms and a high credit rating served to mask underlying collateral quality issues.

There was a sudden spike in mainstream corporate credit derivatives trading volumes soon after Goldman unveiled its structuring blast from the past. This was not directly related, but it is probably not coincidental either. The appeal of derivatives trades compared to cash bonds is obvious to both investors and dealers. Liquidity and the embedding of leverage – for trades that are either long or short – can be supplied far more easily via derivatives than bonds. That is good news for traders looking to put on the next big short. It might make regulators and mainstream investors feel distinctly uneasy, however.

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