Macaskill on markets: Vorsprung durch Vorschrift
Volkswagen’s bonds head into the red.
Illustration: Kevin February
Confidence in car emissions measurement has been undermined by the disclosure of test cheating by Volkswagen, but there is no doubt that auto company securities can provide an extremely effective way to lose money.
After Volkswagen’s systematic evasion of regulatory emissions tests became public in mid-September, the company lost close to 40% of its stock market value, or roughly €25 billion.
The volatility in Volkswagen’s stock was not quite as dramatic as the short squeeze in its shares seen in October 2008, when its price briefly more than doubled after option market manipulation by Porsche, which at the time was plotting a takeover of its bigger rival, and would eventually end up as part of the same group.
But more value has been destroyed by the recent fall in Volkswagen stock than in the 2008 squeeze that cost short-selling hedge funds such as Elliott Associates and Greenlight Capital, along with proprietary dealers at banks, at least €5 billion and likely nearer to €10 billion.
Volkswagen’s bonds were also marked down sharply as the recent emissions scandal began to unfold and the cost of its credit default swap protection trebled from around 70bp to 215bp. Hybrid bonds issued by Volkswagen, which was a pioneer in corporate issuance of securities with both debt and equity characteristics, were hit particularly hard, falling by as much as 10 full cash points.
That is a substantial dip in price for a corner of the corporate debt markets that generally enjoys price stability and was a reminder of the difficulty in anticipating or hedging against idiosyncratic credit risk.
The fallout from the Volkswagen scandal may end up being felt disproportionately in the credit markets, partly because it is a bellwether issuer, but also because investors increasingly see corporate bonds as a safe-haven asset class, despite issues with liquidity and transparency compared to equities.
The big surprise is arguably why so many people trusted
This could lead to closer oversight of the credit markets, especially if the European Central Bank (ECB) decides to extend its quantitative easing programme with purchases of corporate bonds in a bid to stimulate growth in the region.
The ECB is well aware that direct purchases of corporate bonds would create moral hazard and bring an array of technical challenges. It is therefore likely to accompany any shift in policy with increased supervision of credit instruments, if only to provide itself with some cover against accusations of unwise investment.
The central bank was quick to suspend the eligibility of Volkswagen asset backed securities for its limited and ineffective programme of purchases of securitized instruments after the emissions scandal began. It will presumably wish to put other controls in place before any move to buy unsecured corporate debt.
Volkswagen’s test cheating could accordingly end up causing increased regulation in the financial markets, as well as a tightening of standards within auto manufacturing and selling.
Volkswagen was well known to viewers of TV ads in Europe in previous decades for selling its Audi cars with a slogan of ‘Vorsprung durch Technik’, or advancement though technology.
Its chief contribution in the coming years may be to the cause of ‘Vorsprung durch Vorschrift’, or advancement through regulation.
The firm’s recent troubles may also serve as a wake-up call to private investors in corporate credit, if only because its fall from grace was so unexpected.
The other great corporate value destruction story of 2015 has been the decline of Glencore. The 75% fall in Glencore’s stock since the start of the year and the widening of its credit default swap protection spreads to over 700bp – a level signalling great distress if not imminent default – has shocked many investors with the ferocity of the price movement.
But there is nothing inherently surprising about financial stress for a leveraged trading company that also owns physical mining assets during a slump in prices for the commodities that Glencore produces and deals.
The big surprise is arguably why so many people trusted CEO Ivan Glasenberg’s assurances that trading profits would mysteriously manage to make up for any shortfalls caused by the plunge in commodities, regardless of market direction. This type of magical thinking has since been replaced by a much simpler rule of thumb, as Glencore’s stock price has become virtually correlated with the price of copper.
Glencore is an investment grade credit, at least for now, but it was not viewed as a core holding for buyers of corporate bonds in the same way as Volkswagen. The Volkswagen emissions scandal, and its effect on securities prices, is therefore likely to have a greater impact on attitudes among credit investors.
The two worst-performing sections of the European credit markets this year are now the auto sector, where Volkswagen accounts for over 20% of outstanding debt, and the corporate hybrid market, where the firm looms similarly large as an issuer.
Total returns for both European auto credit and corporate hybrids fell by 3.8% for the year to late September, and the knock-on effect from the Volkswagen scandal on prices of BMW and Daimler debt took the spread over bunds for auto credit from 85bp at the start of the year to almost 200bp.
The problem for investors who might want to trim their holdings of corporate credit is the lack of viable alternative places to park money. Even corporate treasurers, who might be expected to place surplus cash in short-term government securities, seem increasingly comfortable holding the debt of other corporations. A recent survey found that more than half the cash held by US corporates in August was kept in investment grade corporate bonds, which may not be especially risky from a credit loss perspective, but certainly sounds like a trend that regulators might want to start monitoring.
If the logic of ever-extended quantitative easing is pursued in the form of central bank purchases of corporate credit, regulators could end up contorting themselves as they increase prudential supervision while also edging into a new market as direct investors, however.
There would certainly be a hall of mirrors effect from a move towards central bank purchases of corporate bonds. If the Volkswagen emissions scandal has enough of an effect on consumer confidence in major corporations to depress sales activity in the already sluggish European economy, that might help to push ECB President Mario Draghi and his colleagues closer to using unorthodox measures to revive demand.
And any resulting hint of approaching QE for corporate credit would almost inevitably force spreads in liquid bonds down, helping to reverse the effect of the Volkswagen scandal on debt prices.
That would certainly mark advancement through regulation, at least for some lucky investors.