Man Wants Bonds to Be More Complicated
Here is a delightful story about a man, John "Mac" McQuown, who invented a method of combining a bond with a credit default swap. There are other ways to do that -- you could buy a bond, and then buy a credit default swap! 1 -- but he likes his way. You can find the long version of his way in his patent application, and the short version in the diagram in that Bloomberg Markets article, but here is I guess the medium-length version:
- Issuer sells an xBond -- that's just a regular bond with an "x" in front of it -- to a box.
- Dealer sells an eCDS -- that's a credit default swap with an "e" in front of it -- to the box.
- The xBond and eCDS have matching terms (same maturity, same issuer and seniority, etc.). 2
- The eCDS is centrally cleared at ICE, so it's as safe as a centrally-cleared thing is. 3
- The box is now in possession of a risk-free-ish security: the combination of an xBond, which might default, and an eCDS, which will pay off if the xBond defaults. This combination is called an "eBond," with the "e" standing for "enhanced," and is guaranteed to pay off at par (unless the clearinghouse defaults!).
- The eBonds are sold out of the box to investors as a risk-free-ish security.
So it's sort of a wrapped bond, with the wrap coming from a derivatives clearinghouse instead of an insurance company. There's a bunch of gunk about pricing in the patent application, but for our purposes it's sufficient to guess that the eBond should be sold at par, with a yield that should look risk-free-ish: That is, it should yield like a Treasury bond, plus some (smallish?) premium to account for residual credit risk (clearinghouses can go bust), complication, annoyance and of course fees. If you want to pause for a discussion of the gunk, you know where to go. 4
Up here though, I feel like we need an analytic framework to decide whether and when wrapped corporate bonds might be a good thing. It might go something like this: There are people with cash who want to fund stuff, and there are people with risk appetite who want to take credit risk, and sometimes those are the same people and sometimes they're different people.
Where they're different people, crisply separating funding from credit risk allows risk to flow where it's wanted, money to flow to risk-free assets and the system to be more efficient. This is a story about jittery cash pools and a shortage of safe assets. It's a story about the information insensitivity of debt. It's a story that ought to sound pretty familiar.
Where they're the same people, though, crisply separating funding from credit risk increases the cost and complexity of getting the exposure -- just a bond! -- that those people want. If you want to invest your money and get paid for taking corporate credit risk, a corporate bond is a great thing to invest in, and an eBond unnecessarily mucks that up. This is a story about, you know, bond mutual funds and so forth that actually want to take credit risk. It's a story about investors reaching for yields in an environment where risk-free assets have negative yields. You get higher yields by taking more credit risk. You don't get higher yields by paying someone else fees to facilitate the transfer of credit risk away from you.
It is not clear which of these stories predominates, and that seems like the sort of thing you'd want to find out. 5 But, I mean, I don't know, it seems like no one has gone broke overestimating the market demand for risk-free debt? (They've gone broke overestimating its risk-free-ness, obviously.) Lots of risk-free debts these days have negative yields, which suggests that there's demand for more of them. A good healthy chunk of modern financial engineering has been about taking risky complicated differentiated asset classes and wrapping them in a promise of safety and fungibility. Because that seems to be what the people want.
Of course pre-modern financial engineering worked the same way: You took risky complicated differentiated asset classes, like residential mortgages and small-business loans, wrapped them in a promise of safety called a "bank" and issued risk-free liabilities against them called "deposits." One fundamental impetus to the modern boom in shadow banking -- and eBonds are shadow-banking-esque -- is that people don't really trust banks to be risk-free and information-insensitive anymore, but they continue to need risk-free and information-insensitive places to put their money. 6 So those places are created for them. 7
The theory breaks down a bit here on the fact that public corporate bonds are not, in the scheme of things, a particularly risky complicated differentiated asset class. Corporate bonds are just pretty normal! There are bond index funds and exchange-traded funds and gigantic mutual funds whose managers go on television a lot. There are tons of people whose job it is to decide which corporate bonds are good credits, and then invest money in them. So this is not an obvious asset class for de-risking and standardization in the way that, say, peer-to-peer loans are. Corporate bond issuance is a problem that has already found a well-defined and robust solution.
On the other hand, people do complain incessantly about the fact that the corporate bond market isn't liquid enough. 8 That is a problem that still seems to want a solution, and McQuown and his backers seem to think it might be eBonds:
“It’s an important idea that deserves to get off the ground,” says David Booth, co-founder and co-CEO of Dimensional Fund Advisors, an Austin, Texas-based investment firm with $381 billion in assets and another backer of the venture. “The way bonds trade now is abysmal, and if we can make the bond market as liquid and transparent as the stock market, that’s a socially desirable outcome.”
Traditionally people complain about bond market liquidity as a problem of too many bonds per issuer: If you want to invest in General Electric credit, you have 905 bonds to choose from, and each of those is a little different, so instead of trading easily in and out of a big GE bond complex you have to hunt for buyers and sellers of specific small bonds.
But eBonds seems to come at the problem from the other direction: Each issuer might still have 1- and 2- and 5- and 6- and 20-year bonds, but now you won't care about issuers. Every 5-year eBond will be the same as every other 5-year eBond, 9 in that it will have about the same credit risk (none-ish), and therefore about the same yield (Treasuries-ish). So you won't care if you're buying a 5-year bond from GE or from RadioShack; the actual issuer doesn't matter to you. 10
I guess? If you read the patent application, it sounds more like further fragmentation than simplification: Every bond issue could be fragmented into an xBond (with credit risk), an "e-100 Bond" (the thing I described above, with no credit risk) and an assortment of in-between eBonds with customized slices of credit risk. That seems like a move in the wrong direction, though I suppose the point of the patent application is to cover all your bases, and maybe in practice if this thing ever happened it would be all 100-percent-credit-protected eBonds.
But even then someone would own the credit risk. In the first instance -- in the patent application -- a derivatives dealer, i.e., a big bank, would be the one selling the credit protection on the eBonds. I suppose it would lay off that risk in cleared CDS transactions to ... whoever wants credit risk? Now that's, you know, bond mutual funds and ETFs and hedge funds. In an eBond world, would mutual funds have to write CDS to invest in corporate credit? And would that be any more liquid than the current corporate bond market that they love to complain about? Or would the risk sloughed off by bond investors end up concentrated somewhere else -- in big banks, in central clearinghouses or in goofball specialized risk warehousers like AIG Financial Products? And would those credit risk concentrators be better or worse than the current system at evaluating that risk? It's not obvious that either credit or liquidity risk would be reduced in that world: It would just be allocated differently, and it might be allocated worse.
I'm not especially holding my breath for eBonds, but who knows. It's easy to associate them with bubbles and crises: Turning junk into AAA assets with risk-shifting alchemy was a hallmark of the last credit crisis, and the particular flavor of alchemy associated with that crisis -- subprime residential mortgage securitization -- has never really recovered. But the dream of separating money from risk was not invented in the mortgage bubble, and it's not always a bad thing. McQuown should get some points for trying.
As his patent application puts it (diagram reference omitted), "One skilled in the relevant arts will appreciate that the CDS contracts can be obtained by dealer through other means."
Actually the patent application offers other possibilities, including CDS that matures after the bond. More broadly it seems to contemplate an indenture allowing for multiple issuances of xBonds within the broad eBond framework. I'm simplifying from that.
I realize that there's a difference between "clearing" and a "central counterparty," but "central counterparty" (or "CCP") is such an unlovely term. The important thing here is that ICE will stand in between the buyer and the seller of the CDS contract to guarantee performance, and demand collateral from the seller. From the patent application:
Notably, in the case of CDS contracts, central clearing houses or central counterparties (“CCPs”) have been created which act as the counterparty to both the CDS seller and the CDS buyer. CCPs are, at present, government-approved entities that meet certain requirements to guarantee their stability. The CCPs, as counterparty to both buyer and seller of CDS contracts, bear responsibility to each party should the other default.
From the patent application (diagram references omitted):
As a non-limiting example, assume a bond issuer wishes to issue an xBond that, when exchanged into an e-100 eBond, is priced at 100% par value with a yield of 2.75% over five years. In this non-limiting example, a CDS contract for the same five year period can be purchased for 200 basis points with a 1% coupon. The total cost of this exemplary CDS contract 204 is therefore 5% (5 years at 1% coupon) plus the remaining upfront cost associated with the 200 basis point CDS pricing. In this case the upfront cost is calculated to be 4.42%, using industry standard CDS calculations. The total cost of CDS contract over the five year period would therefore be 9.42%.
In accordance with an embodiment of the present invention, bond issuer will need to issue an xBond with a price discounted to 90.58% of par value (100% par value for the e-100 eBond minus the 9.42% total cost of CDS contract) and a 4.90% yield.
There are two oddities here, and they both have to do with the pre-funding of the CDS coupons. First: Why do you need to pre-fund the CDS coupons? You could instead have the issuer issue a closer-to-par bond with a higher interest rate, and then have the special purpose vehicle fund the recurring CDS coupon payments out of the xBond coupons, pre-funding only the up-front cost of the CDS (and maybe one extra coupon to cover default grace periods). That might look a bit more normal for issuers than doing deep discount bonds.
Or maybe not, that's a small point. (Though bigger for longer-dated bonds.) The other weird thing is that this contemplates pre-funding the CDS coupons with undiscounted cash. That seems ... inefficient? Wouldn't you rather buy Treasury Strips to fund the future CDS coupons? Does the cash sitting in the SPV earn a return for the SPV investors? For the structurer?
There's a lot of gunk, and I'm only scratching the surface. That passage I quoted mentioned an "e-100 Bond," because in the patent application you can protect 100 percent of principal ("e-100"), or 80 percent, or whatever your heart desires.
There seems to be around $7.5 and $2.1 trillion of gross notional of (respectively) investment grade and sub-investment-grade single-name credit default swaps outstanding, versus "the $8 trillion U.S. corporate bond market." Those CDS gross notionals are not just U.S., or just corporate, and net notional is of course a lot less than gross. But it's not super obvious that unfunded credit risk, on the one hand , or "risk-free corporate debt," on the other, are niche products.
Another impetus is of course regulation that makes it more expensive for banks to give the impression of being risk-free than it is for non-banks. This does not particularly seem to apply in the eBond case.
I mentioned it this morning, but I continue to be tickled by Toby Nangle's Vault Cash ETF, which is the worst imaginable bank, a reductio ad absurdum of the concept of a bank. It seems reasonable to assert the following about the Vault Cash ETF: Many people would prefer to put their money in the Vault Cash ETF than in an actual existing bank. (This is a plausible conclusion from negative short-term interest rates in many parts of the world.) That is a weird state of affairs. You'd think the Vault Cash ETF would be sort of a lower bound on bank unattractiveness, but it seems not to be.
Though you can find people who say that about Treasuries too.
As long as the clearinghouse is creditworthy! Since every eBond is sort of a best-of-issuer-and-clearinghouse credit. If the clearinghouse is risk-free then the issuer credit doesn't matter. If it's not, then it does.
Arguably bond exchange-traded funds serve a similar purpose: They're just undifferentiated glops of corporate credit, rather than specific credits, and so they are more liquid than individual bonds.
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