One thing that has irritated me for a long time has been the inclusion of Innovative Tier 1 Capital (IT1C) in the major bond indices. Those things aren’t even bonds! IT1C is simply preferred shares dressed up as bonds – this doesn’t degrade their utility as an investment vehicle and can make them quite attractive for non-taxable portfolios … but it doesn’t make them bonds.
However, Scotia stuck them in the index when the DEX indices were still the Scotia Capital indices, which I always presumed was just a way to make them easier to sell. There is never any shortage of pig-ignorant portfolio managers who neither know nor care about the specific risks of particular investments; the dirty part about this is that since institutional clients generally know even less and benchmark against “the index”, portfolio managers must make the choice: not buy them, and risk underperforming for 9 years out of ten; or buy them and pretend that, yes, they really are bonds.
I have previously pointed out that the lack of first-loss protection means that the Lloyds notes are not bonds. They may have merit as investments, certainly, but they are not bond investments.
Now Duncan Kerr of eFinancial News reports that UK government and regulatory authorities are teaming up to pull exactly the same trick with ludicrous index inclusions in a column titled Investor threat remains to Lloyds’ contingent capital plans:
Some of the UK’s biggest fixed-income investors are already frustrated about Lloyds’ lack of clarity over its plans, and some are even threatening to block the inclusion of the new capital securities on widely-used bond indices.
The UK Treasury and Financial Services Authority have been pushing hard for Lloyds’ new contingent capital bonds to be included on the main indices, which would make them more attractive to fixed-income investors.
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However, according to analysts some of the UK’s biggest bond investors are arguing that the new securities should not be classed as debt and therefore cannot be included on the main traded indices, which could severely dent investor demand.
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>“The Treasury and FSA have been pushing very hard for contingent capital to be in the indices, clearly because it is more attractive when it is part of a tradable index. And if it is more attractive, the more is sold to investors and the less the Treasury will have to buy of this new instrument,” the [anonymous] banks analyst said.
One factor exacerbating this crisis has been the lack of trust in the authorities: when the BoE lent money on good collateral to Northern Rock, they felt they should do so covertly, in contrast to prior practice … doubtless feeling that their word that the instution was solvent but illiquid would be doubted. How much of the current crisis would have been averted if a man with the gravitas of J.P.Morgan had simply asked his right man “Are they solvent?” and reliquified freely on an affirmative answer, as happened in the Panic of 1907? The reliquification and word of J.P.Morgan that it was indeed reliquification was good enough to stem the panic … but nowadays, that sort of statement from the authorities is regarded as just another lie. Well done with the record of integrity, guys!
And now we have the UK authorities trying to pretend that these notes are actual bonds and should be in the bond indices, right up there with 10-year Gilts. It’s a disgrace.
And so the seeds of the next disaster are sown: we’ve seen what happens when the myth that Money Market Funds are risk-free gets punctured, even by just a little bit … should the authorities be successful in weaving the myth that Contingent Capital = Bonds, we will learn the effect of an overnight drop in bond funds due to mandatory conversion to over-priced common.
James, you are a most amazing ferret — finding all kinds of obscure info that gives us a lot of insight into the quality of regulation in the world!
This latest regulatory boondoggle and the utter lack of meaningful progress in the US suggests to me that it is unlikely anything will change for the better. No progress on too big to fail; no sanity in contingent capital; ongoing regulatory “forebearance” (ostrich-like behaviour); and lots more low/no money down mortgages insured by taxpayers.
That, plus intoxicating loose monetary conditions, suggest governments and regulators still hope the initial strategy of feeding the drunk more alcohol (and other halucinogens like Tier 1 capital in bond indices) is going to get him through a serious hangover.
Yikes!
it is unlikely anything will change for the better
The financial world is like a folk-tale: details may change, but the basic story never does. The whole Credit Crunch has been eerily like the Panic of 1825 from the start.
Bonds managed to escape most of the damage from the crunch … sure, spreads widened dramatically, and some marginal players – such as CIT – were completely shut of the market, but by and large … it was just a bad couple of years, nothing like the historic drops in equity prices.
So … load the risk onto bond investors!
We saw what happens when the buck gets broken (by about 1.5% or so) in MMFs and panicky investors cash out in droves.
Will we have the same effect next time, assuming that bond indices get loaded up with pseudo-bonds? If they drop a point or two over a bad weekend, will investors panic? Bond investors aren’t quite so nervous as the Money Market guys. If they do panic, what will be the effects?
[…] reported last week that UK authorities were promoting inclusion with the presumed purpose of widening the investor […]
[…] Shades of Hades, or at least the UK! Assiduous Readers will remember the tergiversations that were the topic of the post Merrill Keeps Lloyds ECNs out of UK Bond Indices that started when UK authorities made a similar attempt to debase the bond indices. […]