Low interest rates are disguising the fragility of Europe's recovery. Photographer: Getty Images

Hunt for Exotic Yields Is Dangerous

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Feel happy for Portugal, which just raised 750 million euros ($1 billion) with a bond yielding just 3.57 percent, despite still being in an international bailout caused by a near-bankruptcy. And pop some champagne for French cable operator Numericable, which recently issued $21 billion (no, not a typo) worth of junk bonds of various durations, yielding from 4.875 percent to 6.25 percent - the order book was subscribed for more than $100 billion.

These credit windfalls, however, smack of desperation among investors. Tortured by low interest rates, they are snapping up increasingly exotic and risky securities in the hunt for returns in a trend that is quite simply dangerous. Cheap credit is inspiring the same kind of financial creativity that led to the 2008 crisis.

Europe is seeing a boom in so-called CoCo, or contingent convertible, bonds issued by banks to shore up capital. Investors in these securities are wiped out or forced to convert the bonds to stock, if the issuer's capital falls under a certain threshold, or if regulators consider the bank ripe for a bailout. Banks have sold about $75 billion of the securities since 2009, and about $100 billion worth are expected to hit this market in this calendar year. German banks such as Deutsche Bank AG and Commerzbank AG, as well as some smaller players, are about to join the fun: Germany's finance ministry has made coupons on CoCos tax deductible.

The CoCo idea is fashionable among regulators and in line with Europe's new bank failure resolution mechanism, under which investors, rather than tax payers, should be first in line to pay for saving faltering banks. Yet investors may be underestimating the risks. Asset managers have bought more than 60 percent of seven recent issues by big banks like the U.K.'s Barclays PLC and Spain's Banco Santander SA, which means that retail investors - those same taxpayers - are unwittingly on the receiving end of the risk, the scale of which is hard to pin down.

The big agencies are only beginning to rate this class of securities and Standard & Poor's guidelines say CoCo ratings have to be at least two notches below the issuers' main ones. The only way to hedge the risk is to buy put options on the issuing banks' stock or short it, creating the potential for a "death spiral" should things go wrong. Credit default swaps on CoCos will only become available in September.

Another booming asset class is catastrophe bonds, sold by insurance companies to pass on all sorts of natural disaster risks. This is a much smaller market than the CoCos, with only $1.585 billion of the bonds issued in the first quarter of 2014, according to the specialized research company Artemis, but the quarter set an all-time record in cat bond issuance with 11 transactions. This quarter will see even more capital raised in this way. Payouts on most of these bonds depend on the absence of damage in the U.S. from storms serious enough to have a name. Though the quarterly yields on cat bonds have dropped to about 5.2 percent from almost 10 percent two years ago, this is still an attractive proposition these days, an alternative to corporate junk bonds that now offer returns too low to be compatible with the traditional meaning of "junk."

Low interest rates are great for European governments happily increasing their already oppressive debt burdens. They are also nice for creating the impression that European economies are growing - at rates scarcely discernible from zero. Yet glorified bets on U.S. weather patterns and the capital levels of European banks are inherently shaky investments. And blockbuster junk bond issues such as Numericable's are downright scary - no matter how good the company's prospects may look after winning a bidding war to buy the French mobile operator, SFR, from Vivendi SA.

The markets, especially European ones, are full of potentially misunderstood risks. That is the underwater part of the iceberg they call Europe's economic recovery. The only clear beneficiaries of the trend are the ratings agencies, which are reporting record first-quarter profits. They are happy to see more issuers and products in the market because these, rather than investors, are cash cows for the ratings agencies. Just like before the crisis.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Marc Champion at mchampion7@bloomberg.net