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This is cool: Capital Structure Arbitrage-Implied Index Trading:

In this paper, we develop long-short trading strategies derived from the work of Merton [1974], which provides theoretical relationships between equity, equity volatility, and credit. We then apply the strategies to index products structured primarily based on U.S. investment grade assets.

We find that an optimized Merton-based strategy results in significant trading profits when applied over the span of time for which data is available. Furthermore, we find that trading profits can be enhanced by incorporating information derived from short-term volatility. Given the unlimited number of index combinations spanning different asset classes, geographies and tranche levels, we recommend that further work be allocated to the promising area of capital-structure arbitrage implied index trading.

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Figure 2 shows a graphical summary of the relationship among the CDX Investment Grade index, S&P 500, and the VIX. There are a few general qualitative observations from this graph. First of all, high levels of CDX IG are typically accompanied by high levels of volatility. This suggests that volatility may be a reasonable predictor for the credit spread. Another important observation is that the slope of CDX.IG as a function of SPX changes over time and over different market conditions. The time-varying relationship is expected, since credit spread is fundamentally a stationary process, while the equity index is obviously non-stationary. This time-varying relationship makes it difficult to directly use the slope as the hedge ratio in the credit-index index arbitrage.

Overview of Merton Model

In a seminal paper, Merton [1974] proposed a structural model that provides a theoretical relationship between a firm’s equity value and its credit risk. The key concept behind the Merton model is that default occurs when the firm’s asset value falls below its debt value. Hence, investment in a firm’s equity can be viewed as purchasing a call option on the firm’s assets, with the value of the debt as the strike price. The Merton model makes the same assumptions as in the Black-Scholes options pricing framework, such as the log-normal distribution of asset value.

Italian regulators are ratcheting up pressure on short-sellers:

Italy’s market regulator has recommended to stakeholders who have lent shares in Italian companies to retrieve them, Consob head said on Wednesday, confirming reports of a move aimed at curbing short-selling. “Yes, we’ve exercised moral suasion by asking all those who have lent shares to retrieve them,” Consob Chairman Giuseppe Vegas told journalists on the sideline of a conference.

He added the request was not binding.

More opinions on the Yellow / Trader / Apax deal:

Moody’s has trouble wrapping its head around the [Trader] company’s strength as it moves into the digital environment.

“While this is a plausible proposition that has been successfully executed in the U.K. and elsewhere using the Trader brand, there is some uncertainty that the same formula can be applied in Trader’s circumstances in Canada,” the rating agency noted.

“Trader will have to grow its per digital customer yield and increase market penetration, neither of which is a given.”

Moody’s ultimately slapped a B3 rating on the name.

Speaking of Moody’s they put the US on Review Negative:

Moody’s Investors Service put the U.S. under review for a credit rating downgrade as talks to raise the government’s $14.3 trillion debt limit stall, adding to concern that political gridlock will lead to a default.

The Aaa ratings of financial institutions directly linked to the U.S. government, including Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Federal Farm Credit Banks, were also put on review for cuts, Moody’s said in a statement today.

The U.S., rated Aaa since 1917, was put on review for the first time since 1995 on concern the debt limit will not be raised in time to prevent a missed payment of interest or principal on outstanding bonds and notes even though the risk remains low, Moody’s said. The rating would likely be reduced to the Aa range and there is no assurance that Moody’s would return its top rating even if a default is quickly cured.

DBRS has released its Split Share Funds Quarterly Report – Q2 2011:

Q2 2011 was the first quarter since Q2 2010 that the average downside protection for split shares rated by DBRS decreased. Notwithstanding the declines over the past three months, the average downside protection of DBRS-rated preferred shares was about 51% at the end of Q2 2011, a signifi cant increase over the 45% and 40% averages at the end of Q2 2010 and Q2 2009, respectively. As a result of the additional buffer of downside protection built up over time, it is expected that the negative performance during Q2 2011 will generally not result in negative rating actions for preferred shares or securities rated by DBRS.

It was a mixed day in the Canadian preferred share market, with PerpetualDiscounts winning 25bp, FixedResets up 16bp and DeemedRetractibles down 8bp. Not much volatility. Volume was average.

PerpetualDiscounts now yield 5.45%, equivalent to 7.08% interest at the standard equivalency factor of 1.3x. Long Corporates now yield about 5.2% (!) so the pre-tax interest-equivalent spread is now about 190bp, a significant widening from the 175bp reported on July 6, as preferreds did not participate in the extraordinary 15bp week’s decline in long corporate yields.

Trader Corporation is issuing USD junk bonds:

One deal has launched in the high-yield market this morning as issuance remains slow. Trader Corporation, a Canadian online automotive marketplace, announced a US$275m seven-year non-call three senior secured offering via RBC sole books. The roadshow begins tomorrow with pricing expected late next week. Proceeds will fund the acquisition of Trader Corp by Apax Partners.

So what’s the better bet for junk? Yellow Media, Trader Corp, or Ireland?:

A late-day rally in U.S. stocks faded after Ireland’s debt rating was cut to junk at Moody’s Investors Service, overshadowing signs the Federal Reserve had not ruled out further stimulus efforts.

The Standard & Poor’s 500 Index lost 0.1 percent to 1,318.06 at 3:33 p.m. in New York after climbing as much as 0.6 percent. The benchmark gauge tumbled 2.5 percent in the previous two days, its worst back-to-back slump since March. Moody’s cut Ireland’s government bond rating one notch to Ba1 from Baa3, spurring concern Europe’s debt crisis is worsening.

DBRS confirmed CM:

CIBC’s current strategy should contribute to earnings stability and improved capital levels, thereby better positioning the Bank for future downturns. As capital is freed up from the reduction in the run-off book, DBRS would like to see resources deployed in less volatile businesses that are a natural extension of existing capabilities. The latest financial crisis provided CIBC with the opportunity to purchase CITI Cards Canada Inc.’s Canadian MasterCard portfolio which DBRS believes is consistent with CIBC’s desire to accelerate growth in its core banking business by strengthening its number one position in credit cards and being a dual credit card issuer in Canada.

DBRS assigned some Allied Irish notes as Default:

In respect of the Notes, the High Court has declared that the subordinated liabilities order (SLO) issued by the High Court on 14 April 2011 under the Credit Institutions (Stabilisation) Act 2010 is effective as of 22 April 2011. The SLO amends the terms of the subordinated debt, including interest due, so that it is payable only at the option of AIB; and the maturity date of the Notes has been extended to June 2035. Additionally, in accordance with the amendments, AIB announced that no payment of interest that would have been due to holders of the Notes on 25 June 2011 will be made by AIB.

The downgrade reflects the halting of interest payments on the Notes by AIB and DBRS’s expectation that the future interest payments of these outstanding subordinated instruments will be halted, as allowed by the High Court. Further, the downgrade considers the aforementioned extension of the final maturity date. Given that bondholders are unlikely to receive interest as agreed upon and that the expected maturity has been extended, DBRS views these actions as disadvantageous to bondholders, which is considered a default under DBRS policy.

Thre was similar action on Irish Life & Permanent:

DBRS Inc. (DBRS) today has downgraded the Dated Subordinated Debt rating of Irish Life & Permanent plc (IL&P or the Group) to “D” from “C”. Today’s downgrade follows the execution of the Group’s note tender offer.

The default status for the purchased and now-extinguished notes reflects DBRS’s view that bondholders were offered limited options and that a distressed exchange has now occurred, which is considered a default under DBRS policy, as discussed in DBRS’s press release dated 8 June 2011.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts winning 12bp, FixedResets up 1bp and DeemedRetractibles down 8bp. Volatility was good. Volume remained very low.

Is your country falling apart? Blame the short sellers!

Italy’s financial-market regulator moved to curb short selling after the country’s benchmark stock index fell the most in almost five months and bonds tumbled on investor concern Italy would be the next victim of the region’s debt crisis.

The regulator known as Consob ordered last night that short sellers must reveal their positions when they reach 0.2 percent or more of a company’s capital and then make additional filings for each additional 0.1 percent. The measure takes effect today and lasts until Sept. 9.

Another good technique is to bury the critics in paperwork:

Credit-ratings companies may be forced to disclose the internal analyses they use when they decide to cut a European Union government’s rating, the region’s financial services commissioner said.

Nations may win the right to check the data used by the companies in advance of downgrades of their sovereign ratings, Michel Barnier said in the text of a speech in Paris speech today. The measures may be included in legislation to rein in the ratings firms, he said.

But life is tough when you’re squaring the circle:

European finance chiefs clashed over how to dig Greece out of its financial hole just as markets battered the bonds of Spain and Italy, opening a new front in the debt crisis.

Finance ministers weighed how to get private bondholders to maintain their exposure to Greek debt in a way that doesn’t prompt credit-rating companies to declare a formal default.

Forcing bondholders to chip in would be “fatal,” Austrian Finance Minister Maria Fekter told reporters before a crisis meeting in Brussels today.

Late news is that maybe the taxpayers will foot the bill:

European finance ministers revived the prospect of bond buybacks to ease Greece’s plight and declined to rule out a temporary default, struggling to contain the debt crisis as investors pounded Italy, the continent’s third-largest economy.

Prodded by investors and the European Central Bank, the euro’s guardians said a bailout fund set up last year may be used to buy bonds in the secondary market or enable Greece to retire its debt at a discount. They offered another cut in rates on its emergency loans.

For all their recent problems, US brokerages have always been a far better and far more profitable place to work than those in Canada. Here’s why:

A headhunter put Muller in touch with Morgan Stanley, which was then looking for a quant strategist to drum up business. Muller had bigger aspirations and cut a deal with Derek Bandeen, a prop-trading executive. Muller had two years to get a profitable trading system running. If he failed, he would perform the strategist’s job. PDT was born.

The CSA has released a staff notice titled MARKETING PRACTICES OF PORTFOLIO MANAGERS:

We identified a number of deficiencies in the preparation, review and use of marketing materials by the PMs we reviewed.
Generally, the deficiencies were grouped into one of the following areas:
1. Preparation and use of hypothetical performance data
2. Exaggerated and unsubstantiated claims
3. Policies, procedures and internal controls
4. Use of benchmarks
5. Performance composites
6. Holding out and use of names
7. Other performance return issues
8. Disclosure related issues

Interesting piece on ETFs:

Using Deutsche Bank’s numbers, and then comparing them to a recent McKinsey & Co. analysis of Europe’s fund management industry, the Financial Times found that ETF’s likely account for 13 per cent of the Europe’s €9-billion in fund profits. More importantly, the profit margins on ETFs are sky high — 55.5 basis points of assets under management for ETFs versus 12.5 basis points for traditional funds.

And within ETFs, there’s a difference in profit margins between synthetic ETFs and physically replicated ETFs. The first type posts profit margins of 69 per cent, while the latter has profit margins of 64 per cent.
…
Past studies have found that over 50 per cent of assets under management in European ETFs are now placed in synthetic ETFs.

Makes sense. All the MER on funds goes to the salesman.

It was a mixed day on the Canadian preferred share market, with PerpetualDiscounts up 13bp, FixedResets ahead 1bp and DeemedRetractibles losing 9bp. Volatility was good. Volume was extremely light.

IOSCO would like to protect incompetent traders from evil High Frequency players, but has not yet found a plausible excuse:

In a new consultation paper, the International Organization of Securities Commissions lays out what it knows about high frequency traders, and the upshot is not much — but the regulatory body is voicing some significant concerns. Chief among them is that the technological advantage of high-frequency traders gives them an unfair edge, causing other investors to drop out of markets, and whether their speed and sophistication make it too hard for regulators to ensure they aren’t gaming markets.

The full report notes that the comment period closes August 12, 2011.

In a similar vein, Europe is hoping to punish rating agencies for being independent:

The head of the European Commission says the practices of the three top credit rating agencies will come under scrutiny and that Europe could benefit from having its own agency.

Rating agencies have had a central role in warning about Europe’s debt crisis, though many politicians have criticized them for fanning fears.

Jose Manuel Barroso said the Commission “will come up with some proposals in the autumn” on regulating the agencies, but did not give any detail.

He said the agencies sometimes anticipate risks but can also “overrate” them.

There was a nice jobs number in the US … nice for bonds:

American employers added jobs at the slowest pace in nine months in June and the unemployment rate unexpectedly climbed to 9.2 percent, sending global stocks tumbling on concern the world’s biggest economy is faltering.

Employers increased payrolls by 18,000 workers, less than the most pessimistic forecast in a Bloomberg News survey of economists, which called for growth of 105,000. The increase followed a 25,000 gain that was less than half the initial estimate. Hiring by companies was the weakest since May 2010.

What a difference a day makes!

[Yesterday]

Treasuries ended a two-day rally as a private report said U.S. companies added more jobs than forecast and economists said government data tomorrow will show nonfarm payrolls gained, fueling bets economic growth is accelerating.

Ten-year yields rose from a one-week low as stocks climbed after the European Central Bank signaled it will ease Portugal’s access to emergency funds. ADP Employer Services said U.S. firms’ payrolls increased by 157,000 jobs in June, and unemployment claims fell for the first time in three weeks. The U.S. said it will sell $66 billion in notes and bonds next week.

DBRS confirmed GWO:

Like its major peers, the Company is anchored by its Canadian operations which benefit from an oligopolistic industry structure which limits the worst of price competition. Increasing scale in the U.S. retirement saving administration and focused niches in Europe, primarily in the United Kingdom, represent stable sources of earnings contributions. The Company avoided the adverse reserve development which was experienced by a number of competitors on account of Guaranteed Minimum Withdrawal Benefits (GMWB) segregated funds inasmuch as GWO did not begin to offer the product until it had arrived at an efficient and effective hedging strategy which complemented its conservative product design.
…
Fixed charge coverage ratios at GWO nevertheless remain healthier than those of its peers, reflecting stronger profitability, albeit lower than historical. GWO also continues to employ a higher proportion of innovative/hybrid capital instruments which keep its adjusted debt ratio (giving equity treatment to certain capital instruments) relatively low. The Company is actively retiring capital instruments issued at its operating companies in order to have a higher proportion of capital issuance at the holding company level which will serve to reduce its double leverage ratio. In short, DBRS considers the Company’s financial leverage and capital position to be consistent with the current rating category as long as it continues to operate conservatively. However, financial flexibility is limited at this rating category.

As an integral component of the Power Financial group of companies, GWO benefits from its parent’s financial support and its strong governance and risk management controls and procedures, which reinforce the conservative bottom-line focus of the Company.

DBRS also confirmed BMO:

BMO’s capital ratios were solid and the quality of capital was strong relative to its Canadian bank peers at the end of Q2 2011. However, the acquisition of M&I resulted in a reduction in the pro forma Basel II tangible common equity (TCE) and Tier 1 ratios to 9.4% and 11.9% (based on April 30, 2011), respectively, which are at the low end of BMO’s Canadian bank peer group, albeit still well in excess of regulatory requirements. On a Basel III basis (also based on April 30, 2011), the pro forma TCE and Tier 1 ratios were 6.9% and 9.2%, respectively.

BMO’s long-term Deposits & Senior Debt rating at AA is composed of an intrinsic assessment of AA (low) and a support assessment of SA2 (reflecting the expectation of systemic and timely external support by the government of Canada). The SA2 status results in a one-notch benefit to the senior debt and deposits and subordinated debt ratings.

What happened to Yellow this week? TD Newcrest doesn’t like the common any more, which is important to some:

TD Newcrest analyst Scott Cuthbertson threw in the towel on Yellow Media Inc. (YLO-T2.40-0.29-10.78%), slashing his price target by half to $2 and downgrading it to “sell” after having recommended investors hold it since the beginning of March 2010, when the stock traded around $6.

It was an uneven day in the Canadian Preferred Share Market, with PerpetualDiscounts flat (exactly!), FixedResets up 1bp and DeemedRetractibles winning 16bp. Volatility was muted. Volume was low.