Monthly Archives: June 2013

Random Walk of Share Prices

A somewhat abstract term, random walk in finance is commonly used to describe the movement of share prices. Share prices are said to follow a random walk which can be represented by what is called Brownian motion, a scientific term commonly referred to when describing atomic movements.


In short, random walk says that shares take a random and unpredictable path. The chance of a shares future price going up is the same as it going down

Share prices take on similar movements in that they are ‘random’, and this essentially forms the foundation of option pricing models through the modeling of share price movements. Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell the underlying financial instrument at a specified price on or before a specified future date.

Frontiers Markets

A new market of investment is Frontiers Markets.

Investing in these territories means greater risks, but potentially higher rewards. These markets are Nigeria, Saudi Arabia, the UAE, Sri Lanka, Ukraine, Kazakhstan, Mexico and Vietnam.

The MSCI Frontier Market index has gained 13.3 per cent in the first five months of the year.

To access to these markets are easy. This fund, The BlackRock Frontier Markets Fund and The Franklin Templeton Frontier Markets Fund:-



All give exposure to these exciting markets that of course offer that higher reward with the added excitement of risk.

The Strength of the HSBC Balance Sheet

The 2012 Annual report that was published in March 2013.


Looking at the figures, one can see the strong position that the bank is in, good news for UK plc, good news for worried depositors and good news for borrowers.

Total assets US$ 2,692,538 million [US$ 2.692 Trillion] = UK£ 1.745 Trillion = UK £1,745 Billion
Total liabilities 2,509,409 million [US$ 2.509 Trillion] = UK£ 1.626 Trillion = UK £1,626 Billion
Total equity 183,129

Customer deposits US$ 1,340,014 million [US$ 1.340 Trillion] = UK£ 0.686 Trillion = UK £868 Billion
Loans and advances to customers US$ 997,623 million = UK£ 626,724 Million = UK £626 Billion

In short the bank has more cash on deposit (UK£ 868 Billion) than loans advanced (UK £626 Billion)

A bank with more cash than loans. A strong capital position.

How big is HSBC ?
Well, it is massive.

UK HMRC (Her Majesty’s Revenue and Customs) collected UK £469 Billion in taxes in 2012-13.
UK Government spent UK £694.89 Billion in 2012.

Japan and Abenomics

The Japanese prime minister is called Shinzo Abe. He has created a new form of Economic Policy in Japan since coming to power that is is now known as Abenomics. It is brutal strategy to kick start Japan’s stagant economy, that has delivered next to zero growth for 20 years.

In essence, Abenomics is a policy designed to deflate the yen to boost exports. The policy is based on simply unprecedented monetary stimulus by the Bank of Japan undertaking huge bond purchases (Quantative Easing), extra budget spending by government borrowing and pro-growth policies such as an offer of tax breaks to companies investing in new equipment and facilities. What this has done, is to force down the value of its currency to give its domestic exporters a competitive advantage.

Thus it should be no suprise, that the Japanese Stock Market Index of the Nikkei 225 has done incredibly well in the past few weeks.

Others could think, Japan is embarking on a currency war, to drive down the value of the Yen to make its Japanese exports cheap. The debate will rage, but one question that is very hard to answer, with the Bank of Japan owning all these JGB’s (Japanese Government Bond’s) how will the BoJ sell these bonds (unwind / exit) ?

Gresham’s Law

Near St. Paul’s in the City of London, literally, a one minute walk is Gresham Street

It is named after Thomas Gresham was a financial agent and representative of the English Crown during the 16th Century. King Henry VIII had replaced 40% of the silver content in the English shilling with lower value base metals, effectively devaluing the shilling by 40%. Thus what happened was that business folk and merchants were hoarding the old shillings and using the new devalued shillings for trade. “Bad money crowds out good money.” The old shilling had far more value than the new shilling and the masses began to hoard the old ones.

Gresham’s law is an economic principle that states, “when a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation.” It is commonly stated as: “Bad money drives out good” – Gresham’s Law.

Modern examples are seen in the post financial crisis.

1. In Zimbabwe, shop keepers would sells items in shops, accept South African Rand or US dollers during the days of hyperinflation, and give change back to the customers in Zimbabwe Dollars.

2. In Iceland, shop keepers would sells items in shops, accept Euros during the Icelandic bankruptcy, and give change back to the customers in Icelandic Krona.

What you see in both cases, is the effective hoarding of what is perceived the more valuable asset, the South African Rand or the Euro.

With the levels of Quantative Easing, one has to think about whether governments are effectively trying to de-base the currency.

The US Federal Reserve Balance Sheet.

The US Fed Balance Sheet, shows the assets and liabilities of the US Central Bank.
Do you want to see a large number ?

Checkout the US Federal Reserve website :-


This is the balance sheet of the US Federal Reserve (The Fed).

Total Assets = Total Liabilities (The famous account equation).

United States Federal Reserve Total Assets: $3,410,842 million.
YES, that is a large number, what I will explain that number.
$3.410842 Million Million dollar$
$3410.842 Billion dollar$
$3.410 Trillion dollar$.

To keep things in perspective, US GDP is about $15 Trillion dollars. However, that balance sheet is huge.

Thank goodness “In Fed We Trust

The Debt Laden Co-Operative Bank

The Co-Operative Bank The restructuring of Co-Op Bank shows how exposed the bank had become. A classic example of excessive borrowing during good times, but when the economic times got tough, the debt burden was simply too much. (over leverage)


When one looks at the all bonds that are being re-structured:-

*9.25% Non-Cumulative Irredeemable Preference Shares GB0002224516  £60,000,000  Tier 1
13% Perpetual Subordinated Bonds  GB00B3VH4201  £110,000,000  Upper Tier 2
5.5555% Perpetual Subordinated Bonds  GB00B3VMBW45  £200,000,000  Upper Tier 2
Floating Rate Callable Step-up Dated Subordinated Notes due 2016  XS0254625998  €34,980,000  Lower Tier 2
5.875% Subordinated Callable Notes due 2019  XS0189539942  £37,775,000  Lower Tier 2 
9.25% Subordinated Notes due 28 April 2021  XS0620315902  £275,000,000  Lower Tier 2
Fixed/Floating Rate Subordinated Notes due November 2021  XS0274155984  £8,747,000  Lower Tier 2
7.875% Subordinated Notes due 19 December 2022  XS0864253868  £235,402,000  Lower Tier 2
5.75% Dated Callable Step-up Subordinated Notes due 2024  XS0188218183  £200,000,000  Lower Tier 2
5.875% Subordinated Notes due 2033  XS0145065602  £150,000,000  Lower Tier 2

[* – Tier 1 is the most junior ranking of Target Securities. Lower Tier 2 is the most senior ranking of Target Securities]

Count these numbers and guess what you get :- £1,306,782,200 (£1.306 Billion) of debt that is crippling the bank. The interest rate on some of these bonds is 9.25% and thus the interest repayments are effectively breaking the bank.

The Shadow Banking System

There is term that global banking regulators have been talking about, since the Federal Reserve Bank of New York in 2008 “generously lent” AIG $182 Billion, the term is known as The Shadow Banking System.
[It was Tim Geithner the former US Treasury Secretary who was the head of the New York FED in 2008 that approved the AIG rescue].
Princeton academic Paul Krugman is the economist who coined the term, The Shadow Banks.
Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) vehicles, limited-purpose finance companies, structured investment vehicles, money market unit trusts, securities lenders, and even supermarkets, UK has Tesco Bank and Sainsbury’s Bank for example. All are able to take deposits and enter the financial market and trade.
Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitisation and secured funding techniques such as ABCP, asset-backed securities, collateralised debt obligations, and repo.

This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis of 2008.
In essence, a failure in a Shadow Bank like AIG would have hadmassive effects, such as contagian, or US savers with 401k plans loosing life savings, so regulating these institutions is a key issue that governments and regulators are trying to address.

Peer to Peer Lending

In these historically low interest rate times, looking for a better interest rate is hard. Also when credit is constrained, and banks are unwilling to lend, their is new source of credit. That is Peer to Peer lenders.

A new innovation is Peer to Peer lending, where people pool deposit money together with effectively a broker, who then credit assesses potentials lenders, and then lends the money out for a small management fee.

In the UK, Zopa and The Funding Circle are making great inroads into this market place.

What is now interesting, that this ability to create a new pool of lenders from new creditors, is a force that is actually being seen as a force for change in the banking world.

Andrew Haldane at the Bank of England, is quoted as saying “innovations in commercial peer-to-peer lending, again using the web as a conduit, could make some bank functions surplus to requirements”

A good article from the Bank of England:-


and a paper:-


In the low interest climate, a peer to peer lender can get 5%.

Mortgage Backed Securities

In 2008, the term MBS was common when referring to the banking crisis that gripped the western world, when Lehman Brothers collapsed. They held a portfolio of Mortgage Backed Securities that turned out to be of much lower value, and were also highly illiquid. These Mortgage Backed Securities, are effectively collections of mortgages, and thus are ‘debt instruments’.

With the growth in the sophistication of mortgage finance, a home owner today, that has financed the home purchase by a mortgage, that debt (the mortgage loaned against the house)could be backing up a publicly traded security. Yes a mortgage could form a part of a Mortgage Back Security traded on the stock market. Today a high percentage of individual mortgages originated by banks and other lenders are ultimately pooled and used as collateral to issue mortgage-backed securities (MBS), which are then sold to investors, like investment banks, pension funds, insurance companies who then derive an income.

The mechanism to create a Mortgage Backed Security is a process called Securitisation of an asset. That was covered in an earlier article I published.

A mortgage-backed security are bonds that are backed by pools of mortgage loans. In the most basic type of MBS, homeowners’ mortgage payments are passed through to the bondholder, meaning the bondholder receives monthly payments that include both capital and interest. This is a key difference between mortgage backed security and other bonds such as UK Gilts, which pay interest every six months or annually and return the whole capital principal at maturity.
In the USA, the mortgage backed security market is the largest component of the U.S. Bond Market, with about £ 5.6 Trillion [$8.9 Trillion] in mortgage-related debt outstanding. (interesting comment that £5.6 Trillion is 4 times the UK GDP !!) As I said, mortgages are the largest segment of the U.S. bond market, accounting for 26% of all bond market debt outstanding.
However the trading of these securities, that then were passed from bank to bank, all turned sour, when the deck of cards collapsed. What do I mean by that ?
Simple, as soon as the mortgage holder stops paying the mortgage, the whole stack collapses, and the holder of the mortgage backed security, is effectively holding a worthless asset (or a lot less in value) as in the US, where this started, the actual underlying asset, the property that the loan is secured against, had sharply fallen in price, so the loan is larger than the property (bricks and mortar) thus negative equity.

These mortgage backed security then become a lot less valuable, and the media has referred to them as Toxic Assets.

Investment Benchmarks

A benchmark serves a crucial role in investing. Often a market index, a benchmark provides a starting point for a portfolio manager to construct a portfolio and directs how that portfolio should be managed on an ongoing basis from the perspectives of both risk and return. It also allows investors to gauge the relative performance of their portfolios; an annual return of 6% on a diversified bond portfolio may seem strong, but if the portfolio’s benchmark returns 7% over the same time period, the bond portfolio has fallen short of its goal. The number of benchmarks is virtually endless, and selecting the right one is not always easy. To try to simplify the selection process, we examine in this blog what a benchmark is, how it is calculated, and why portfolio performance may differ from that of the benchmark. Benchmarks should be investable, but it is possible that a universe of shares and bonds (securities) in a benchmark may be so broad that it would not be practical to purchase all of them. In other cases, a benchmark may contain securities that are difficult to purchase.
In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company shares. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.
These are among the most widely followed stock indexes, or benchmarks:

FTSE100: U.K. Market capitalisation-weighted index of the 100 largest U.K. companies traded on the London Stock Exchange (e.g. BT Group PLC, GlaxoSmithKline PLC, Rolls Royce PLC, BP PLC, Vodafone PLC, AstraZeneca PLC)

DJIA : U.S. Price-weighted average of 30 large publicly traded U.S. “blue chip” stocks (e.g. Intel, Alcoa, IBM)

Hang Seng Index: Hong Kong. Free float-adjusted market capitalisation-weighted index of the 45 largest companies on the Hong Kong stock market. (e.g. Cathy Pacific, FoxConn)

MSCI World Index: Global Equities. Free float-adjusted market capitalisation index consist of 24 developed market country indexes, 6000 companies.

NASDAQ Composite: U.S. More than 3,000 technology and growth domestic and international based companies on the NASDAQ stock market (e.g. Oracle Corporation, Cisco Systems, Yahoo, Google, Sybase)

Nikkei 225: Japan. 225 leading stocks traded on the Tokyo Stock Exchange (e.g. Sony, NTT, Toshiba, NEC)

S&P 500: U.S. 500 leading companies in the Large-Cap segment of the U.S. equities market. (e.g. AT&T, JP Morgan Chase, ExxonMobil)

Numerous other equity indexes have been designed to track the performance of various market sectors and segments. Because stocks trade on open exchanges and prices are public, the major indexes are maintained by publishing companies like Dow Jones and the Financial Times, or the stock exchanges. Fixed income securities do not trade on open exchanges, and bond prices are therefore less transparent. As a result, the most commonly used indexes are those created by large broker-dealers that buy and sell bonds, including Barclays Capital (which now also manages the indexes originally created by Lehman Brothers), Citigroup, J.P. Morgan, and BofA Merrill Lynch. Widely known indexes include the Barclays U.S. Aggregate Bond Index, tracking the largest bond issuers in the U.S., and the Barclays Global Aggregate Bond Index of the largest bond issuers globally. Actually, bond firms have created dozens of indexes, providing a benchmark for virtually any bond market exposure an investor might want. Barclays Capital alone publishes more than 30 different bond indexes. New indexes are often created as investor interest grows in different types of portfolios. For example, as investor demand for emerging market debt grew, J.P. Morgan created its Emerging Markets Bond Index in 1992 to provide a benchmark for emerging market portfolios.
Indexes also exist for other asset classes, including property (real estate) and commodities


In the bond market (fixed interest market or debt market as it is sometimes referred too), there is methodology to turn an asset into a debt instrument, that pays a yield (income or coupon) like a bond. This is called securitisation.

Securitisation is a well-established methodology used in the global debt markets. It was introduced initially as a means of funding for mortgage banks. Iike HBOS or Building Societies. Subsequently, the technique was applied to other assets such as credit card payments. Barclaycard do this with their creditcard portfolio. It has also been employed as part of asset/liability management, as a means of managing balance sheet risk. The excellent book that explains Securitisation is by Somsekhar Sundaresan:

The process of securitisation creates asset-backed bonds. These are debt instruments that have been created from a package of loan assets on which interest is payable, usually on a floating basis. The asset-backed market was developed in the United States and is a large, diverse market containing a wide range of instruments. Techniques employed by investment banks today enable an entity to create a bond structure from any type of cash flow; assets that have been securitised include loans such as residential mortgages, small business loans, commercial property mortgages, car loans, and credit card loans. The loans form assets on a bank or finance house balance sheet, which are packaged together and used as backing for an issue of bonds. The interest payments on the original loans form the cash flows used to service the new bond issue. Traditionally mortgage-backed bonds are grouped in their own right as mortgage-backed securities (MBS) while all other securitisation issues are known as asset-backed bonds or ABS. Let me give you an example ‘closer to home’.

Take the hypothetical company, Asad Karim Telecoms PLC. This business has a retail operation, called AK Retail, and delivers a broadband service to its 1000 customer base, and charges a monthly fee of £100, and the service is 0.5Mb. (A high quality operation as you can see…) Asad Karim Telecoms PLC, decides to securitise the AK Retail broadband business to raise cash, get the business off the balance sheet, so creates an special purpose investment vehicle called AK Retail Broadband PLC, that pays a monthly income to investors based on those 1000 customers each of which pay £100. Thus Asad Karim Telecoms PLC has “unlocked” the cash flows of the AK Retail business, and investors of course get access to the cash flows on the broadband business. Simples….
The securitisation process involves a number of participants. In the first instance is the originator, the firm whose assets are being securitised. The most common process involves an issuer acquiring the assets from the originator. The issuer is usually a company that has been specially set up for the purpose of the securitisation and is known as a special purpose vehicle or SPV and is usually domiciled offshore. In the UK for example, Northern Rock had an SPV for its mortgage book called Granite that was based in the UK Channel Islands, and Halifax Bank of Scotland (HBOS) had a similar vehicle that was called Grampian Mortgages. All clever accounting mechanisms for off balance sheet reporting. The creation of an SPV ensures that the underlying asset pool is held separate from the other assets of the originator. This is done so that in the event that the originator is declared bankrupt or insolvent (or rescued my HM Government…), the assets that have been transferred to the SPV will not be affected.

Credit Default Swaps

A credit default swap (CDS) is the most highly utilised type of credit derivative. In its most basic terms, a credit default swap is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, corporate bond investors buy credit default swaps for protection against a default by the issuer of the corporate bond, but these flexible instruments can be used in many ways to customise exposure to corporate credit. CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle or instrument to transfer the risk of a default or other credit event, such as a downgrade, from one investor to another.

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk-who also tends to own the underlying credit asset-pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades. The characteristics of Credit Default Swaps: The credit default swap market is generally divided into three sectors:

[1] Corporates

[2] Bank credits

[3] Emerging market sovereigns.

CDS can reference a single credit or multiple credits. Multi-credit CDS can reference a custom portfolio of credits agreed upon by the buyer and seller, or a CDS index. The credits referenced in a CDS are known as “reference entities.” CDS range in maturity from one to 10 years although the five-year CDS is the most frequently traded.

Unlike total return swaps that provide protection against the loss of credit value irrespective of the cause, credit default swaps provide protection only against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk “buyer” to the risk “seller” in a CDS. The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.

The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. As the credit default swaps market became more standardised and gained credibility, particularly following smooth credit event settlements in high profile cases such as WorldCom and Enron, more investors entered the market. While banks-through broker-dealers and reinsurance companies-are still both the largest buyers and sellers of credit default swaps, investment management firms are following closely.

Today, CDS have become the engine that drives the credit derivatives market. According to the British Bankers’ Association, the credit default swaps market currently represents over one-half of the global credit derivative market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customise exposure to corporate credit. In addition to hedging event risk, the potential benefits of CDS include:

[1] A short positioning vehicle that does not require an initial cash outlay

[2] Access to maturity exposures not available in the cash market

[3] Access to credit risk not available in the cash market due to a limited supply of the underlying bonds

[4] Investments in foreign credits without currency risk

[5] The ability to effectively ‘exit’ credit positions in periods of low liquidity

The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk.

The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.

The question has to be asked, from a moral perspective, the ability to trade such instruments. So perhaps it is the interest of the CDS owner that the bond that is being insured actually goes into default, so the CDS owner can claim on the insurance. Hmmmmm, one is not allowed to take out life insurance on someone else, otherwise wise their is an incentive that the person owning the insurance policy (paying the premiums) would like the person to “snuff it” (die), and then claim (thus get the benefit) on the insurance policy.

To me, these are the fundamental questions that needed to be asked, when we look at our financial industry, we need insurance, but do we need to be able to make profits from someone elses distress ?

The Bond (Debt) Market

There has been a lot of talk about bonds in the media. Bank bonds, Government bonds, Junk Bonds, Greek Bonds, Bond Default.

[Junk Bonds are sometimes called High Yielding Bonds, as the risk is the issuer, is a risky government, or new company or an un-creditworthy institution, so certain investors like pension funds are unable to hold such risky assets, and perhaps some cynical or risk adverse investors look at the Junk Bond see the relatively high interest rate, but look at the issuer and then simply draw the conclusion that the Junk Bond is just ‘Mutton Dressed As Lamb’]

I thought it was a good opportunity to explain these financial instruments. Sometimes known as fixed income securities or debentures, or debt securities or debt instruments or income bearing securities. Yes, lots of explanations for the same thing. A financial product that promises to pay a return to the holder of the product. It is an “I Owe You”

The bond market is by far the largest securities market in the world, providing investors with virtually limitless investment options. Many investors are familiar with aspects of the market, but as the number of new products grows, even a bond expert is challenged to keep pace. While we spend a great deal of time discussing economic forecasts and how those forecasts may affect unique sectors of the bond market. So to be clear, the Bond Market (Debt Market) is many many times larger than the Stockmarket. Yes, the value of companies listed (Market Capitalisation) is dwarfed by the Bond Market.

I will now explain the fundamentals of the bond market. (sometimes known as the debt market)
First and foremost, a bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments and companies issue bonds when they need capital. If you buy a government bond, you’re lending the government money. If you buy a corporate bond, you’re lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time.

Suppose a hypothetical world class company (Asad Karim PLC) that wants to build a new global telecommunications network for £1 million and decides to issue a bond to help pay for the network. Asad Karim PLC might decide to sell 1,000 bonds to investors for £1,000 each. In this case, the “face value” of each bond is £1,000. Asad Karim PLC—now referred to as the bond “issuer”—determines an annual interest rate, known as the “coupon,” and a timeframe within which it will repay the principal, or the £1 million. To set the coupon, the issuer takes into account the prevailing interest-rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. Our hypothetical company (a world class operation of course…..) may decide to sell five-year bonds with an annual coupon (the yield or interest rate payable) of 5%. At the end of five years, the bond reaches “maturity” and Asad Karim PLC repays the £1,000 face value to each bondholder. (Asad Karim PLC honours its debts of course)

Vodafone has issued bonds:


You will see that Vodafone have 3 programmes of Bond Issuance (Debt Issuance) in the form of a European, US and Commercial Paper programme. The European programme has raised €30 Billion. Quoting Vodafone the reason for the Bond programme:

Our financing strategy is to provide timely, cost efficient and secure financial resources to the Group and to manage Vodafone’s capital structure in line with its targeted low single A credit rating. The Group’s policy is to borrow centrally using a mixture of long-term and short-term capital market issues and borrowing facilities to meet anticipated funding requirements. In respect of certain emerging markets we may elect to borrow on a non-recourse basis. Risk management is at the core of our financing policies. We use derivative instruments to manage our currency and interest rate risk and collateral support agreements to mitigate the credit risk of banking counterparts. Liquidity risk on long term borrowings is managed by maintaining a disciplined maturity profile. Our mid to long-term debt is primarily financed via corporate bonds programmes. Our short-term funding requirements are met through our commercial paper programme’

In essence, buyers of Vodafone bonds, are lenders to Vodafone, (Vodafone creditors) and lend cash to Vodafone, and and have to trust Vodafone to repay them. That is the risk.

How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A £1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period. The additional risk incurred by a longer maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk.

Every bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. Independent credit rating services assess the default risk of most bond issuers and publish credit ratings in major financial newspapers. These ratings not only help investors evaluate risk but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.

It is an bond investor today, with a large appetite for risk who today buys Greek Government Bonds or Spanish Bonds for example.

Quantifying the U$ National Debt

There has been a lot of talk in the past 12 months, about the level of U$ National Debt.
Question: But how large is it ?
Answer: 100% of GDP.
The debt ceiling, the amount the US is legally allowed to borrow is 100% of GDP (a self imposed limit)

The numbers…..

The current limit (debt ceiling) is $14.294 Trillion.
That is $14,294,000,000,000 dollars to be mathematically elegant.

Or in Engli$h: Fourteen Million Million Dollar$. In UK Sterling that is only £8.737 Trillion of course.

To be global, I will try and be equitable to all….

[$14.294 Trillion = EU 9.88 Trillion = AUD$ 12.96 Trillion = Chinese Yuan CNY = 91.87 Trillion = Singapore $SGD 17.17 Trillion = Hong Kong $HKD 111.35 Trillion]

Useful to quantify the $14.294 Trillion figure with some good comparisions.

The assets of Bank of New York Mellon under custody are $26.3 Trillion. So the US ‘only’ owes 54% of the assets under custody at Bank of New York Mellon.

The assets at State Street under custody are  $22.8 Trilllion . So the US ‘only’ owes 62% of the assets under custody at State Street.

The assets of Blackrock are $3.66 Trillion. Thus the assets of Blackrock are 25% of the US National Debt.

The assets of HSBC (UK largest bank based on assets) are $2.597 Trillion. Thus the assets of HSBC are 18% of the US National Debt.

The assets of the world’s largest pension fund (The Government Pension Investment Fund of Japan) are $1.315 Trillion. Thus the assets of The Government Pension Investment Fund of Japan are 9.1% of the US National Debt.

BT’s Pension Fund according to Towers Watson, is the largest pension in the UK, and is the world’s 40th largest pension fund with assets on March 31st 2011 of $57.211 Billion (£34.97 Billion)
The BT Pension Fund (assets $57.211 Billion / £34.97 Billion) equates to 0.4% of the US National Debt.

Big numbers.

UK Debt Issuance: Very Term Bonds….

I saw on the UK Debt Management Office [] that the UK HM Government are going to borrow using Gilt Issuance. (A bond issue)

Nothing new with this, but what is interesting, is the fact, that this Gilt Auction is for long term gilts. The Gilts to be issued will mature in 2068. Yes, a 55 year maturity.


So the UK government are able to borrow at very low interest rates, and the maturity is way in the future, 22nd July 2068 to be precise. By reading the press release, this very long-dated bond, that expires in 2068, is actually going to being issued through a syndicate of banks rather than a normal auction process, thus meaning there is no set amount to be raised, it will be interesting to see how much cash will be raised, and what the coupon rate is (interest rate).

Pressures on Pension Funds

Quantative Easing (creating new credit by the Central Bank) is having major effects on Pension Funds.

Let me give you a real example.

In June 2013, BT (a FTSE-100) giant, published the 2012-13 Annual Report

Look at page 25 of the annual report.

“Government bond yields have fallen since the valuation at 30 June 2011, with real yields being negative at times. This has been caused by a number of factors, including the Bank of England’s Quantitative Easing programme. If the fall in yields is maintained and reflected in the next funding valuation, due as at 30 June 2014, this would increase the value of the BTPS

What this is telling us, in very clear terms, as the Bank of England creates new money in the form of new credit, it is thus forcing down the cost of borrowing for HM Treasury, by reducing the yield on UK Gilts (UK Soverign Bonds), and the effect of this, is that BT’s Pension Fund run by Hermes Investment Management for example [] that holds UK Gilts, is getting a reduce return on its holding (investment) in UK Gilts, and this now means, the effective gives the pension fund a headache, as the investment returns are reducing, and thus increasing the overall liability.

This pressure on bond yields is resulting in pension funds globally to look for new sources of investment, which is why we are seeing pension funds and insurance companies looking to other forms of investments in alternative assets classes, such as infrastructure, long term university accomodation or raw materials like commodities. Of course QE is only one pressure, people living longer is another demand and pressure in pension funds, QE just makes the situation worse.


The Consequences of Quantitative Easing

I saw the Bank of England released the 2013 Annual Report


Makes interesting reading, see page 44. This shows the massive growth in the BoE balance sheet.

The reason for this growth is down to the BoE increasing the Quantitative Easing programme, (BEAPFF = Bank of England Asset Purchase Facility Fund).

What this means is that Bank of England has been buying UK government bonds (Gilts) with new money, thus growing the monetary base. A consequence of this, is that yields on Gilts are falling, and thus investors have been forced to look for other yielding assets (equities & corporate bonds), so reducing the price of the long-term cost of capital for businesses. Thus we see booming stock markets and real estate assets increasing in value, as investors move out of cash and government bonds. Thus creating a wealth effect to investors fortunate enough to hold financial assets, and thus their wealth rises, as share prices and property prices are rising.

The truth be known, it is about reducing the value of savers cash on deposit. That is the told story.

The Role of The Central Bank.

If you get a chance, it is worth listening to Radio 4’s Desert Island Discs, as it features this week, Sir Mervyn King, the outgoing Govenor of The Bank of England.


In the UK, the central bank is the Bank of England. In the US, the central bank is The US Federal Reserve. In the Euro Zone, the central bank is the ECB, The European Central Bank. The distinctive feature of a central bank derives from its role as the monopoly supplier of outside money, comprising notes and coin and commercial banks’ reserve deposits.
These constitute the ultimate settlement asset for an economy and mean that a central bank has a unique ability to create or destroy liquidity through the use of its balance sheet. Setting the interest rate in the country and the primary objective is to ensure that the supply of that liquidity is consistent with the smooth functioning of the real economy. From this follows the two core tasks of a central bank: the maintenance of broad stability in the price level, nowadays often enshrined in a formal numerical target for inflation; and supporting the process of financial intermediation during times of stress, including acting as Lender of Last Resort to solvent, though temporarily illiquid, financial institutions. The best example of this was when in 2007, the lender Northern Rock suffered a run, where savers (depositors) formed queues to get their money out. To plug the gap, when wholesale funding / money markets / credits markets froze for Northern Rock. The Bank of England, lent £30bn to The Northern Rock. Later it was disclosed after the collapse of Lehman Brothers, The Royal Bank of Scotland and Halifax Bank of Scotland got £62bn in secret emergency loans in the October 2008, showing the Bank of England was the lender of last resort (and HM Government = The UK Tax Payer being the investor of last resort in the merged LloydsTSB & HBOS (Lloyds Banking Group) and RBS with the £37bn in equity stakes in RBS and Lloyds Banking Group owned by UK Financial Investments (UKFI) the government institution charged with running and managing the UK Tax Payer stakes in RBS and LBG)

The secret support began for HBOS on October 1st 2008, two weeks after the collapse of America’s Lehman Brothers and when financial markets were at their most panicky, and peaked at £25.4 billion on November 13 2008. The money was eventually repaid on January 16 2009. RBS began tapping the Bank for liquidity on October 7 2008 and at its peak borrowed £36.6 billion. It paid back all the money by December 16 2008. Both banks eventually provided the Bank with collateral with a value in excess of £100 billion. They were also charged fees by the Bank of England. It was clear, the emergency loans from The Bank of England were to ensure smooth functioning of the UK economy as if RBS or Lloyds Banking Group failed, perhaps a depression would have occurred.

Of course, central banks sometimes carry out other tasks too. The Bank of England, for instance, manages the government’s foreign exchange reserves and used to manage our national debt. And in some countries, central banks are responsible for banking supervision, such as the MAS, The Monetary Authority of Singapore, but such tasks do not by their nature have to be carried out by the central bank. In the UK currently banking supervision is undertaken by the FCA, the Financial Conduct Authority.

The search for 5% yield

In these crazy times of extra-ordinary low interest rates, where does one look to find an investment that gives a decent rate of return ?

For pension funds or retired people, looking for a regular rate of return, these times are very hard to secure a reliable source of income. However one can find investments that do yield 5%, so there are ways to make your hard earned savings pay a decent yield with a level of risk, as it is not possible to get 5% on a deposit account, but I can show you some investments that do yield 5% provided you have an appetite for risk.

HICL Infrastructure PLC []

John Laing Infrastructure PLC

Individual stocks that give exposure to hard assets that give a return of 5%.
There are investment funds that pay monthly and are yielding 4%.

The Legal & General Monthly Income Fund:

One has to look hard, but as you see, one can get an income if one is willing to take a risk.

Dark Pools

Today the stockmarket is dominated by High Frequency Trading and Algorithmic Trading operations. Both these types of trading have made the global stock markets very volatile, but also investors trying to buy or sell securities (shares or bonds) such as long term investors like pension funds, can have their trade distorted by high frequency or algorithmic trading computers, which means the investor trying to buy or sell, may not get best pricing.

Thus, as global stock markets gyrate wildly in these volatile times, institutional investors like pension funds or unit trust managers, have had to shift trading from public stock exchanges to private networks that are called dark pools. These “Dark Pools” are specialist communities that are known in the industry as “electronic crossing networks ” that offer the institutional investors many of the same benefits associated with making buy or sell trades on the public stock exchange but all done in a private environment, so the price is never publicly disclosed, as when one trades publicly on a stock exchange, as this tells the whole public market the buy or sell price, thus potentially tips platforms like an Algorithmic platform, that could negatively affect the trading price. So these Dark Pools are effectively a private market, thus meaning publicly quoted prices aren’t affected. This is the capital markets’ version of a godsend – especially for traders who desire to move large blocks of shares without the public investors ever knowing and getting an agreed price that can not be affected by other players in the market like a high frequency trading platform.

Some examples of Dark Pools are Liquidnet Inc and the SIGMA X unit of Goldman Sachs.
In simple terms, Dark Pools bring buyers and sellers together in a private environment, to trade and only the two parties know the price.

UK Debt: June 2013 Borrowings

The UK Goverment borrows money on the open market, the agency responsible for raising money for HM Government is The UK Debt Management Office.


The DMO can issue Gilts or Treasury Bills to raise cash. These are effectively “I Owe You’s” that mature in the future.

Looking at May 2013, we had 4 Gilt auctions:

Wednesday 8-May-2013: 0 1/8% Index-linked Treasury Gilt 2044: Raised: £1,335.4556 Million
Tuesday 14-May-2013: 1¼% Treasury Gilt 2018:  Raised: £5,297.7305  Million
Thursday 16-May-2013: 3¼% Treasury Gilt 2044: Raised: £2,727.0145 Million
Wednesday 29-May-2013: 4¾% Treasury Stock 2015: Raised: £1,922.4556 Million

This equates to £11.282 Billion for May 2013 on issuing gilts only

Or to put it simply, The UK Goverment borrowed (using Gilts) £363 million a day to bridge the gap of its income (tax collection) and government spending.