Why Every Fixed Income Investor Needs To Consider Bitcoin As Portfolio Insurance: Part Two

In the first part of this series – The Introduction -, I detailed my history in financial markets together with some detail on why Bitcoin is the best asymmetric trade I have seen in my 32yrs of trading.  I stated that I believe EVERY fixed income investor needs exposure to Bitcoin in order to reduce portfolio risk.  Obviously, this is a big claim.  In order to back up my assertion, we need to be on a similar footing regarding our understanding of fixed income, and the various instruments that exist in the marketplace that allow for investors to take risk, manage risk (hedge), earn returns, and/or experience losses.

This is a deep subject.  The “Bible” for fixed income investing is “The Handbook of Fixed Income Income Securities” by Frank Fabozzi.  This “Handbook” is 1400 pages of green eye-shade reading.  It was required reading for my CFA, and it was usually visible, in multiple editions and stages of dis-repair, on every trading desk that I have worked.  I talked with Mr Fabozzi once on the phone.  I had submitted a research piece to his Journal of Portfolio Management publication.  I was proud that his journal responded and that he (the Editor) wanted to further consider my research paper but in doing so, would require that I agree not to have the piece published in any competing Journal.

My article had already been accepted for publication in the Financial Analysts Journal (FAJ) and I had gratefully accepted.  I called Mr. Fabozzi to tell him about my situation and see if perhaps the research could be published in both spots.  The conversation started nicely until I informed him of the FAJ situation.  At that point he got salty.  “You applied to MY Journal and the FAJ as well?  Don’t you EVER submit another article to my Journal again!”, and he hung up. That was the end of my conversation with the person whom I viewed as “The Man of fixed Income Research”. 

My article was published in the FAJ in March 1995. It was titled “Quantifying Risk in the Corporate Bond Markets”.  It was based on an exhaustive study of 23 years worth of data (18,000 data points) that I painfully accumulated at the McGill Library in Montreal.  This was before electronic data of corporate bond prices was available, and the data was compiled manually from a history of a phone book like publications that McGill had kept as records.

The data and results were awesome and unique.  I was able to sell this data to the Royal Bank of Canada to help with their Capital allocation methodology for credit risk exposure. I had worked for RBC, and I was aware of all banks’ need to better understand and price credit risk.  As detailed in the introduction, when I started at RBC in 1988, it was insolvent due to bad loans (defaulted) made to Lesser Developed Countries (LDC).  Price credit poorly, reap the dangerous consequences.

You can access a scanned copy of the FAJ article here.  The report was cited by a research group at JPM, on the subject of pricing Credit risk and the Bank for International Settlements capital allocation guidelines. This research is important because it will formulate the basis of our conclusion on Credit Default Swaps (CDS) and why I believe that Bitcoin should be considered as default insurance on a basket of sovereigns/Fiats. 

I will also take a stab on what the current market valuation of that basket and come up with one valuation methodology for Bitcoin.  It will be a dynamic calculation, somewhat subjective; however, it will also be one of many rebuttals to the oft suggested claim by no-coiners that Bitcoin has no fundamental value. 

This summary is fairly general and does not dive into the subtleties of various fixed income structures or investments.  The purpose is to get everyone on a similar footing so that I can propose a framework that will help future generations avoid the mistakes of the past. 

“Those who don’t learn from history are doomed to repeat it”


2.1 - What are Fixed Income Instruments?

As the name implies, a fixed income instrument is a contractual obligation that agrees to pay a stream of FIXED payments from the borrower to the lender.  There is a payment obligation called the coupon in the case of a bond contract, or the spread in the case of a loan contract.  There is also a term on the contract where the principal amount of the contract is completely repaid at maturity. 

Accordingly, the value of the contract can change over the life of the term as reflected in the price, and the resulting internal rate of return (IRR) is termed the yield to maturity (YTM).  This yield calculation is the basis of ALL return considerations when comparing the relative attractiveness of various fixed income instruments.  They are CONTRACTUAL but they are NOT GUARANTEED.

The payments (or loan spreads) are FIXED.  This is important for a couple of reasons.  Firstly, if the risk profile of the borrower changes, the payment stream does not change to reflect the changed risk profile.  In other words, if the borrower becomes more risky, due to poor financial performance, the payments are too low for the risk, and the value/price of the contract will fall.  Conversely, if the risk profile has improved, the payment stream is still fixed, and the value of the contract will rise.

Secondly, the fixed stream is contractual and binding.  If the contract cannot be fulfilled by the borrower, a default of the contract occurs, and a settlement between the borrower and lender needs to be consummated.  This can be an in-court, or out-of-court settlement, and typically involves the transfer of ownership of the equity of the company, or an asset that was provided as security against the payment obligation.

Default is the over-riding risk in lending.  The terms credit risk and default risk are often used interchangeably but there are subtle differences as will be described below.  For now, it is important to realize that lending is an asymmetric (to the downside) endeavor.  If a borrower is doing well, the borrower does not increase the coupon or fixed payment on the obligation.  That benefit accrues to the equity owners.  In fact, if the risk profile has changed for the better, the borrower will likely pay down the obligation and refinance at a lower cost, which again benefits the equity.  The lender can be out of luck since their more valuable contract is paid down, and they are not able to reap the attractive risk-adjusted returns (i.e. asymmetric).

On the other hand, if the risk profile of the borrower has deteriorated, it means that the fixed payments are likely too low to reward the lender for the true credit risk.  Accordingly, the value of the contract will fall.  The lender does not have to absorb any actual losses unless they sell the contract into the secondary market, or unless an event of default occurs.  If the borrower eventually pays the contract down, and the lender has received all of its money back, any losses are avoided but the lender has earned a sub-par return on risk.

For these reasons, fixed income lenders tend to be pessimists.  The asymmetric risk/return exposure leads them to ask, “How much can I lose?” rather than the popular refrain from equity investors: “How much can I make?”.  Generally, lending portfolios need to be well diversified to offset the natural asymmetric returns when credit risk is involved.

Two final notes when considering equity versus fixed income investing.  Firstly, in the event of default, fixed income instruments have a priority of claim over the equity.  The fixed Income investor is entitled to 100% return of principal and accrued interest before the equity claim has value.  There can be restructurings where there are creditor classes and equity classes that agree on some residual value for the outstanding equity, but generally, the recovery on equity is small.  For this reason, hedge funds can reduce the risk of losing money on their credit claims, by shorting subordinate claims in the capital structure of a company.  Long the debt vs short a (delta) weighted amount of equity is a logical, risk-reducing position for exposure to a company experiencing financial hardship.  Smart equity investors/analysts will take clues from the debt markets.  Unfortunately, it is only a few who ever do.

Secondly, if the common equity pays a dividend, this dividend is NOT a FIXED income instrument. The dividend is NOT contractual, and the repayment of principal is not a consideration, thus there is no term and no contractually binding payment. Preferred shares notwithstanding, it is important to understand the difference between a contract, and a voluntary distribution of capital to equity stakeholders. 

The income trust market in Canada was built on this false premise.  Equity analysts would calculate the “dividend or distribution yield” on the equity instrument and compare it to the YTM of a corporate bond and proclaim the relative value of the instrument.  Problem was, it was not contractual and did not incorporate the repayment of principal.  Furthermore, it ranked lower in the capital structure than a bond.  Too many investors in income trusts were fooled by this narrative, not to mention the companies who were using valuable (potential) growth capital and maintenance CAPEX on distributions.  Far too many companies who embraced this structure in order to get a short-term pop in their enterprise value (EV) ended up destroying shareholder capital.  Always understand the CONTRACT and its relative RANK in the capital stack of an enterprise.

Finally, notice that we have yet to express our agreed-upon unit of account in our “contract”.  I imagine everyone just assumed the contract was priced in dollars or some other Fiat denomination.  There is no stipulation that the contract has to be priced in Fiat; however, almost all fixed income contracts are priced using a Fiat as a unit of account.  There are problems with this as will be discussed in future sections.  For the time being, keep an open mind that the contracts could also be priced in units of gold (ounces), or units of bitcoin (Sats), or in any other unit that is divisible, verifiable, and transferable.

2.2 - Government borrowers, interest rate risk, and brewing Credit dangers

According to the Institute of International Finance, in 2018 total global debt was about US$250T.  Within that pool, the largest borrowers are Federal, State, Provincial and Municipal Governments.  The publicly traded instruments, the Bonds, have varying terms to maturity.  The fixed income obligations are issued in terms as short as 30 days (t-bills) up to lengths as long as 100yrs.  Terms of longer than 30yrs are not common although a German State just issued a 100yr bond.  Smart State treasurer.  Long-term funding at ultra-low rates locks in funding costs and moves the price risk burden to the buyer.  Interestingly, Janet Yellen, today mentioned the Fed is considering issuing 50yr bonds.  This is a smart move, for the issuer.  As will be shown in subsequent sections below, the buyer is exposing themselves to huge price risk.  Not just because of the inflation risk, but more because of the credit risk.

The term “long bonds” generically refers to 30yr bonds.  The term “bonds” tends to apply to the ten-year term, and “notes” to the two-year and five-year terms. 

There is NO difference in the structure of fixed income instruments with greater than one-year terms.  They are contractual obligations that pay semi-annual interest coupons.  There is generally a very fluid secondary market in these securities with each instrument trading for a price that drives a YTM.  If you were to chart a graph of the yields of the obligations relative to their maturities, you obtain a “yield curve”.

The shape of the yield curve is a subject of great economic analysis, and in an era when rates were not manipulated by Central Bank interference, the yield curve was useful in predicting recessions, inflation, and growth cycles.  Today, in an era of quantitative easing (QE) and yield curve control (YCC), I believe the predictive power of the yield curve is vastly diminished.  It is still a critical graph of government rates and the absolute cost of borrowing, but there is an elephant in the room.

Almost all government debt, from the same borrower, ranks parri passu, that is to say, there is no priority of claim within the debt structure of governments because there is no subordination and no equity.

Government bonds are the most widely held fixed-income instrument.  Every insurance company, pension fund, and most large and small institutions own government bonds.  Federal government bonds of the USA have typically been called “risk-free” benchmarks.  The yield curve of the USA sets the “risk-free rate” for all given terms.  As we will see in the discussion on CDS, it is NO LONGER the case that Govies are risk-free, and opens some real dangers for investors as well as risk managers.

Historically, investors have primarily been concerned with interest rate risk on Govie bonds.  Interest rate risk and inflation risk are synonymous.  Both have been declining for my entire trading career.  That is because, over the last forty years, the general level of interest rates (YTMs) have declined globally, from a level in the early 1980s of 16% in the USA to today’s rates of close to zero, or even negative in some countries.

A negative-yielding bond is no longer an investment.  In fact, if you buy a bond with a negative yield, and hold it until maturity, it will have cost you money, to store your “value” at a negative yield.  At last count, there was close to US$19T of negative-yielding debt globally.  Most were “manipulated” government debt, due to QE by Central Banks, but there is negative-yielding corporate debt too.  Imagine having the luxury of being a corporation and issuing bonds where you got money back.  Those CFOs should focus on that anomaly all day long!

Going forward, interest rate risk due to inflation will be one-directional - Higher.  And due to bond math (explained in an upcoming section), when interest rates rise, bond prices fall. But there is a brewing bigger risk than inflation for Govie bonds…Credit risk

Heretofore, credit risks of governments of developed G-20 nations have been de minimis.  That is starting to change and CDS on sovereign debt will become a much larger consideration for ALL investors.

2.3 - Credit Risk, and Default

Credit risk and default risk are sometimes used interchangeably, but there are important differences.  The credit risk of a company can change due to systematic pressures; however, the idiosyncratic default risk remains unchanged.

Credit risk is the implicit risk of owning a credit obligation that has the risk of defaulting.  When G-20 government balance sheets were in decent shape, and operating budgets were balanced, and accumulated deficits were reasonable, the implied risk of default by a government was almost zero.  That is for two reasons.  Firstly, their ability to tax to raise funds to pay their debts.  Secondly, and more importantly, their ability to print Fiat money.  How could a Federal government default, if it could just print money to pay down its borrowings?

In the past that argument made sense, but eventually printing money will/has become a credit boogie man.  For the purpose of setting a “risk-free rate” let’s continue to assume that the benchmark is set by the Federal government.

In markets, credit risk is measured by calculating a “credit spread” for a given entity, relative to the risk-free government rate of the same maturity.  Credit spreads are impacted by the relative credit riskiness of the borrower, the term to maturity of the obligation, and the liquidity of the obligation.  We could get fancy and try and separate out the liquidity risk component but that is beyond the scope of this paper.

When credit-sensitive instruments trade on a spread basis, traders will typically quote a market on a bid/offer basis as “18 – 15” which means that the trader will buy paper at an 18bps discount to the risk-free benchmark, and sell paper at a 15bps discount. (There are 100bps in 1%).  Since all bonds always trade for a price, the calculation of that 3bp market on a ten-year bond will typically translate to about a twenty-five cent bid/offer price spread.  On a thirty-year bond, because of bond math, that same spread market would translate to a larger bid/offer price spread of approximately seventy cents. 

Notice that a higher spread on the bid side translates to a lower price (see section 2.6 on bond pricing. A higher spread (absolute rate) translates to a lower bond price, everything else being equal).  So the bid price is lower than the offer.  Traders may be wingnuts, but they are not fools.  18-15 sounds inverted until you do the bond math.

For very liquid securities you can execute tens of millions of dollars of trade on a very tight market.  While equity markets have the semblance of liquidity because they are transparent and trade on an exchange that is visible to the world, bond markets are actually far more liquid even though they trade over-the-counter (OTC).  Bond markets and rates are the greases of the financial plumbing system and for that reason, central banks are very sensitive to how the liquidity is working.

Liquidity is reflected in the bid/offer spread as well as the size of trades that can be executed.  When confidence wanes and fear rises, bid/offer spreads widen, and trade sizes diminish as market makers withdraw from providing their risk capital to grease the plumbing.  What tends to happen is everybody is moving in the same direction.  Generally, that direction is as sellers of risk or buyers of protection.  Dealers will retreat from the market because they don’t want to be left holding a bag of risk for which there are no buyers (in the context of the last trade) and they will just get buried.

Perhaps the most important component of the credit markets is the banking system.  Confidence in the banking system is paramount.  Accordingly, there are a few open market rates that measure the confidence in the system as being the basis for floating-rate debt facilities.  These rates are Libor and BA’s. Libor is the London Interbank offered rate, and BA’s is the banker’s acceptance rate in Canada.  Both rates represent the cost of funds between counterparties in the banking system and the rates at which a bank will borrow or lend funds in order to satisfy loan demand.  When these rates rise meaningfully above the Fed’s target for overnight lending (reflected in the TED spread (t-bill vs Eurodollar - for example)), it is an alarm that represents stresses in the system and that credit risk is rising and confidence is falling in the stability of the bank plumbing.

During the GFC, these funding rates were sounding the alarm bells when equity markets were hitting all-time highs because the Fed was cutting rates.  When in doubt, look to the financial markets to determine stresses, not to equity markets than can get a little irrational when the punch bowl is spiked.  As stated previously, the turmoil in the GFC essentially transferred excess leverage in the financial system to the balance sheets of Governments.  The can was kicked to the Govies.  Printed money was the painkiller.  Unfortunately, we are now addicted to pain medicine.

State, provincial and municipal debt tends to come next of the credit ladder.  Since none of the entities have equity in the capital structure, much of the implied credit protection in these entities flows from assumed Federal government backstops.  These are certainly not guaranteed backstops, so there is some degree of free-market pricing, but generally, these markets are for high-grade borrowers and low-risk tolerance investors, many of whom assume “implied” Federal support.

Corporate risk is the final stop on the credit ladder.  Banks are quasi-corporates and typically have low credit costs because they are assumed to have a government backstop, all else being equal.  Most corporates do not have the luxury of a government backstop, although lately, airlines and carmakers have been granted some special status.  But in the absence of government lobbying, most corporations have an implied credit risk that will translate into a borrowing spread, or an absolute borrowing yield (that is not dependant on the term) in the case of very risky credits, that reflects a return on risk dynamic.

High-grade corporates in the US market currently trade at an option-adjusted spread (OAS) to treasuries of 99bps according to BoAML.  High yield (HY) corporates trade at a yield of 4.33% and an OAS of 373bps.  When I started trading HY 25yrs ago, the yield was actually “high”.  Generally, an over 10% YTM with spreads of 500bps and higher.  However, because of a 20-year “yield chase” and, more recently, the Fed interfering in the credit markets, these days HY looks pretty low yield to me.

My FAJ article shows a nice pictoral, of risk in the corporate markets.  The dispersions of the credit spread distributions measure true risk.  Notice, as the credit quality decreases the dispersion of the credit spread distributions increases.  You can measure the standard deviations of these distributions to get at a relative measure of credit risk as a function of the credit rating (see below).  This is the basis of allocating capital for credit risk on a bank’s balance sheet.

2.4 - Credit Metrics and Credit Rating Agencies

To help investors evaluate credit risk and thus price credit on new issue debt, there are rating agencies who perform the “art” of applying their knowledge and intellect to rating a given credit. Note that It is a subjective rating, that qualifies credit risk.  The rating does NOT QUANTIFY risk.

The two largest rating agencies are S&P and Moody’s.  In general, these entities get the relative levels of credit risk correct.  In other words, they correctly differentiate a poor credit from a decent credit.  Notwithstanding their bungling of the credit evaluations of most structured products in the GFC, investors continue to look to them not only for advice but also for investment guidelines as to what determines an “investment grade” credit versus a “non-investment grade” credit.  Many pension fund guidelines are set using these subjective ratings, which can lead to lazy, and dangerous behavior such as forced selling when a credit rating is breached.

For the life of me, I can not figure out how someone determines the investment merits of a credit instrument without considering the price (or contractual return) of that instrument!   However, somehow they have built a business around their “credit expertise”.  It is quite disappointing and opens the door for some serious conflicts of interest since they are paid by the ISSUER in order to obtain a rating.  (The unraveling of structured products in the GFC was precipitated by faulty credit opinions.)

I worked very briefly on a contract basis for DBRS, Canada’s largest rating agency.  I heard a story amongst the analysts of a Japanese bank who came in for a rating because they wanted access to Canada’s commercial paper (CP) market, and a DBRS rating was a prerequisite for the new issue.  The Japanese manager, who upon being given his rating inquired, “If I pay more money, do I get a higher rating?”  Sort of makes you think eh?

Rating scales are as follows:  S&P / Moody’s highest rating to lowest rating:  AAA/Aaa, AA/Aa, A/A, BBB/Baa, BB/Ba, CCC/Caa, and D for default.  Within each category, there are positive and negative fine tunings of opinion.  Any credit rating of BB+/Ba+ or lower is deemed “non-investment grade”.  Again, no price is considered and thus I always say, if you give me that debt for free, I promise it would be an “investment grade” to me.  

This “Junk” debt is where big moves in price can occur.  It is an exciting market that opens the door for some equity-like moves and equity-like returns.  Remember though it is still a bond.  It has prior claim to any equity of the same entity.  If the bond price is distressed, the equity should be even more distressed.  “Junk” bonds equal “super-junk equity”, all else being equal.  In the introduction chapter, I detailed the absurdity of all the Canadian investment accounts who owned the equity of Rogers Communications, the largest HY borrower in the world (not just in Canada) yet they would not buy the bonds at any price because the bonds were junk. 

Wow.  Head scratching moments.  Sell equity, buy the bonds, treat interest coupon like a dividend that is not being paid on the common, increase the priority of claim, and reduce risk.  It is a risk manager's absolute duty to reduce risk AND increase return!  The typical response: “Can’t do it, Foss, I would have to report to my investment committee that I own a junk bond. Please don’t call again”.  For the love of our kids, we cannot let this type of foolish money management ideology fester.  Poor math skills are one thing, but adhering to subjective evaluations of credit risk is another.  This danger will be further examined when we touch on Modern Monetary Theory (MMT) in section 2.8.

In the case of corporate debt, there are some well-defined metrics (see back page of FAJ article) that help to provide guidance.  Ebitda/interest coverage, total debt/Ebitda, and EV/Ebitda are great starting points.  Ebitda (earnings before interest taxes depreciation and amortization) is essentially pre-tax cash flow.  Since interest is a pre-tax expense, the number of times operating cash flow covers the Pro-forma interest obligation makes a lot of sense.  In fact, it was this metric that my FAJ paper determined to be the most relevant in relating to a credit spread for a given issuer.

There are also subjective evaluations such as “business risk” and “staying power”.  Business risk can be defined as the volatility of cash flows due to your product pricing power.  Cyclical businesses with commodity exposure such as miners, steel companies, and chemical companies have a high degree of cash flow volatility and therefore, their maximum credit rating is restricted due to the business risk.  Even if they had low debt leverage, they would likely be capped at a BBB rating level due to the uncertainty of their Ebitda.  Staying power is reflected in the industry dominance of the entity.  There is no rule that big companies last longer than small ones, yet there is certainly a rating bias that reflects that belief.

The respective ratings for governments are also very, if not completely subjective.  While total debt/GDP metrics are a good starting point for relative leverage, it ends there.  In many cases, if you were to line up the operating cash flows of the government and its leverage statistics compared to a BB corporate, the corporate would look better.  The ability to tax, raise taxes and print money is paramount.  Since it is arguable that we have reached the point of diminishing returns in taxation (raise tax rates but actual revenue decreases since more of the economy goes underground) then the ability to print is the only saving grace.  That is until investors refuse to take freshly printed and debased Fiat as payment….This has happened in plenty of Fiat abusing jurisdictions…

2.5 - Corporate Bonds, terms, covenants, and subordination

Corporate debt obligations are structured in a myriad of terms, degrees of subordination, and restrictive covenants.

The term to maturity of corporate bonds tends to be a function of its credit rating.  IG rated corporate credits can typically issue commercial paper (CP) with short terms to maturity.  To do so they also need backup lines of credit with commercial banks, should the CP market seize up.  These facilities tend to form part of the lending relationships that banks provide IG credits that include loan facilities and non-funded banking services such as treasury management, payroll, and fee-based services.

The banking relationship is key for liquidity at the corporate level.  Any bank debt is the most senior claim in the lending stack. It is generally floating-rate debt (it can be swapped to fixed) that uses a floating rate benchmark such as Libor or the “Prime“ lending rate.  A spread, which reflects the credit risk of the IG corporate is attached.  “Libor plus 1.5%” rate is a credit cost which “floats” with Libor.  It will reprice every 30-90 days based on the Libor rate, but the spread will remain fixed, provided any covenants regarding credit metrics are not breached. 

Loan facilities are repayable at any time.  The corporate also usually pays an ongoing line of credit (LoC) fee, so that they can draw on the facility at any time.  Pricing these LOCs is very important for a bank since corporates will only drawdown their lines when enduring financial uncertainty.  When a company hits a rough patch, the first thing a smart CFO does is draws all their bank lines so that the bank cannot restrict access to the funding.  It is a tough job for a loan officer and again reflects the asymmetric credit risk relationship.

Bank debt will include covenants such as negative pledge provisions that dictate that the corporation cannot issue any prior ranking debt.  For this reason, most bank facilities are for shorter terms than public issue bonds.  While the public bonds of IG corporates rank parri passu with the bank debt, they are for longer maturities and are usually fixed coupons.  Banks have comfort when their credit decisions are buttressed by a market that is willing to lend to the same borrower for extended periods.

Typical IG corporate bonds are for five, ten, and 30yr terms.  A big new issue for new public borrowers like Apple or Microsoft’s first issues will include tranches in all three terms that appeal to buyers with different risk and maturity buckets.  These bonds will rank parri passu with bank debt, but could also include second lien tranches where the priority of claim is subordinated.  In a second lien issue, a larger spread is paid as compensation for the increased risk.  This happens when covenants such as total first-lien debt/Ebitda need to be respected.

Corporate bond terms can be as long as 100 years, but that is not common.  In 1997, JC Penny issued a 100yr bond due in 2097.  Its fixed coupon was 7.625%.  The buyers would have been insurance companies that needed long term assets to match long term liabilities.  In May 2020, JCP filed for bankruptcy.  Hard to imagine that in 1997, lenders could claim they could price JCP credit risk with confidence over the next 100yrs, but they did.  Many likely figured it will be someone else’s problem.  Play stupid games, win stupid prizes…

HY corporates are a bit of a different animal.  HY credits cannot issue CP since the market is not open to them as CP buyers are looking for high quality, lower risk exposure.  Additionally, bank facilities are usually the most senior claim and have negative pledge provisions, but they will also limit the issuance of parri passu debt.  For this reason, most HY corporate debt is subordinate to bank debt.  Terms are limited to 10yr maturities, and the debt is non-callable for periods equal to one half the term so that lenders who have made smart risk-adjusted contracts don’t get these contracts called away in short order.  This attribute somewhat levels the asymmetric lending field, but it is still hugely biased in favor of the borrower.

An example of a capital structure of an HY borrower could look something as follows.  Bank debt equal to three turns of Ebitda.  Public first-lien debt equal to an additional one turn of Ebitda.  Second lien debt of another two turns of Ebitda, Convertible debt of another one turn of Ebitda, and common equity with a market cap equal to three times Ebitda.  The EV of this company is 10x Ebitda and it is 7 times leveraged.  Credit focused hedge funds salivate over this type of capital structure.  The CDS market would be wild too.  Plenty of ways to hedge and wedge yourself.  There is always a price for each tranche of the capital structure and it is a dynamic process. 

Sharpen your credit pencils.  P.S. the common equity is the whipping boy.

2.6 - Bond Pricing and Contagion

Every bond that trades in the secondary markets started its life as a new issue (or a restructured obligation).  It has a contractual term, and semi-annual interest coupon.  Generally, new issues are brought to market with a coupon that equals its YTM.  In other words, a 4% YTM new issue, generally is brought at a price of par (100 cents on the dollar) with a contractual obligation to pay two semi-annual coupons of 2% each

After a new issue, there is usually a fairly liquid secondary market that develops for the issue.  Future bond trades are impacted by supply and demand due to such considerations as a change in the general level of interest rates, a change in the actual or perceived credit quality of the issuer, or a change in overall market sentiment (risk appetite changes impacting all bond prices and implied bond spreads).  A bond price is determined in an open market OTC transaction between a buyer and a seller.  Accrued interest is not included in the price but is calculated after the trade and added to the settlement amount.

The price of a bond is impacted by the YTM that is implied in the transaction.  If the YTM has increased due to credit risk or inflation expectations, the implied interest rate increase means that the price of the bond will trade lower.  If the bond was issued at Par, then new trades will occur at a discount to Par.  The opposite also applies. 

Calculating a change in bond price using sensitivity analysis makes use of its first derivative (duration) and its second derivative (convexity) to determine a price change.  For a given change in interest rate, the price change in the bond is calculated as negative duration times the change in interest rate plus one half the convexity times the change in interest rate squared.  If readers remember their physics formulas for distance, the change in price is like the change in distance, the duration is like the velocity, and convexity is like acceleration.  It is a Taylor series.  (Math can be cool.)

At low-interest coupons, duration approaches the term to maturity.  A ten-year bond would have an approximate 8yr duration for example.  Ignoring convexity, this means that if rates change by 100bps, the price of the bond will change by 8%.  Eight percent changes in bond prices can cost many people their year and their job.  The rates can change because of a change in the general level of interest rates, or because of a widening spread.  Imagine if a spread widens by 200bps on a ten-year bond.  Down by 16%, everything else being equal.  On a thirty-year (duration is 20 ish) a 200bps widening can cost close to 40points, ignoring convexity.  Who said credit wasn’t fun?  Imagine if you had a strategic short in that bond.  Until now, most of these “fun” credit moves were confined to the corporate bond markets.  But enter stage right, the new breed of sovereign risk…CREDIT.

Contagion in the bond market is much more pronounced than in equities.  For example, if provincial spreads are widening on Ontario bonds, most other Canadian provinces are widening in lockstep, and there is a trickle-down effect thru bank spreads, car paper spreads, high-grade corporate spreads, and even junk spreads.  This is true in the US market too with the impact of IG indices bleeding into the HY indices.  If US HY is widening, there is a flow-through to the C$HY market.  The reverse is not generally true since most Canadian markets do not really register in the US and global playgrounds.  Canada is smaller and less important than the State of California after all.

The border between “investment grade” and “non-investment grade” debt is a sweet spot for many credit market participants.  The reality is that this inefficient and arbitrary designation still sets the border for how many players can participate in the ownership of certain debt.  The IG market is many times larger than the HY market.  Thus the “crossover credit” space is a lively place.  Improving credits from HY to IG are called “rising stars”.  If a company is upgraded from HY, the universe of buyers increases substantially and it is certain that its credit spread will narrow meaningfully.  The resulting price gain on the bonds is rewarding. 

Conversely, “falling stars” have the reverse impact.  And this is an area of grave concern.  It was rumored that one of the main reasons the Fed stepped into the credit markets to be able to buy HY debt in 2020, was due to the impending downgrades of four very large IG borrowers who are on the cusp of crossing over (to the dark side?).  General Motors, Ford, AT&T, and GE have cumulative debt that is larger than the entire HY market.  Downgrades of any one of these names likely imply a downgrade of the others.  The forced selling would rock the HY market, which would start a domino effect and a negative feedback loop that would reach all credit and equity markets globally.  Pretty scary stuff.  Follow inefficient investment guidelines, win stupid prizes.

2.7 - (Equity) Volatility and Credit Risk

The correlation between equity markets and credit markets is causal.  Notwithstanding the debtholder’s priority of claim versus equity, there is a dynamic that overrides the idiosyncratic risk components of credit versus equity within a capital structure.

When you are long credit you are short volatility.  Therefore, if equity vol starts to increase (a measure of increased risk) then credit spreads will also widen in lockstep, and vice versa.  Credit hedge funds who need to dampen their credit exposure will want to purchase more vol thereby exacerbating the increase in vol.  It becomes a negative feedback loop, as wider spreads beget more vol buying begets more equity price movements (always to the downside).  When Central Banks decide to intervene in the equity markets to stabilize prices and reduce vol, it is not because they care about equity holders, it is because they need to stop the negative feedback loop and its ultimate impact on widening spreads and the seizing of credit markets.

Remember, Credit is a dog.  Its tail is the equity markets.  Think of the levered HY credit example used in Section 2.5 above.

2.8 - Credit Default Swaps (CDS)

CDS spreads and contracts are a relatively new financial engineering tool.  They can be thought of as default insurance contracts where you can own the insurance and effectively be short the credit.  Each CDS contract has a reference obligation that trades in a credit market so there is a natural link to the underlying name.  If CDS spreads are widening on a name, bond spreads are widening too as arb players will play that basis trade.

CDS contracts start with a five-year term and roll down the curve. Every ninety days, a new contract is issued and the prior contract is 4 and ¾ years old and is now the of the run contract.  Five-year contracts eventually become one-year contracts that also trade.  When credit becomes very distressed, many buyers of protection will focus on the shorter contracts in a practice that is referred to as “jump to default” protection.

The spread or premium is paid by the owner of the contract to the seller of the contract.  These contracts are the components of various credit indices in the developed credit markets in New York and Europe.  There can be, and usually is, a much higher notional value of CDS contracts amongst sophisticated institutional accounts, than the amount of debt outstanding on the company. The CDS contracts can thus drive the price of the bonds, not the other way around. 

There is no limit to the notional value of CDS contracts outstanding on any name, but each contract has an offsetting buyer and seller.  This opens the door for important counter-party risk considerations.  Imagine if you owned CDS on Lehman Brothers in 2008 (a winning trade) but the counterparty was Bear Stearns?  You may have to run out and purchase protection on Bear, thereby pouring gas on the credit contagion fire.

I believe it was Warren Buffet who said, CDS enables you to buy fire insurance on your neighbor’s home and then you try and help him burn his house down.  That is a little harsh, but it is not altogether untrue.  The sellers of CDS can use hedging techniques where they use equity put options on the same name to manage their exposure.  This is another reason that if CDS and credit spreads widen, the equity markets can get punched around like a toy clown.   This dynamic is extremely important for corporate credit and it is a well-worn path.  What is not so well worn, is CDS on sovereign credits.  This is relatively new, and in my opinion, could be the most dangerous component of sovereign debt going forward.

Inflation risk considerations for sovereigns will become overwhelmed by credit concerns.  Two years prior to the GFC, you could buy default insurance on Lehman Brothers for 9bps.  That meant you could insure 10MM of debt against default for a premium of 9k per year.  Two years later that same contract was worth millions of dollars.  Are we headed down the same path with sovereigns, where an implosion in CDS is contagious and blows all MMTers out of the water?

Think of the potential for long-dated sovereign bonds to get smoked if credit spreads widen by hundreds of basis points (see bond pricing section 2.6 above).  This will cause many bond managers and many economists indigestion.  Most sovereign bond fund managers and economists are still focused on interest rate risk rather than the brewing credit focus.  And if CDS on the USA is widening, the CDS of Canada is bound to follow suit.  This is how markets work in credit land.  Hedge and wedge yourself.

Moreover, the level of sovereign CDS effectively sets a base spread for which all other credits will be bound.  In other words, it is unlikely that the spreads of any financial institution will trade inside the CDS for the jurisdictional sovereign.  Same all down the line.  Therefore, a widening of sovereign CDS leads to a cascading effect down the credit spectrum.  CONTAGION, both inter-country and within a specific country.

I am certain most MMTers have never traded credit.  They also appear to be poor at math.  This is a dangerous combination because in credit markets it starts as a slow drip, and then it becomes a flood.  Slowly then suddenly….

Relying on an economics professor to opine that “Deficits are a Myth” is tantamount to a junior chef saying that the recipe is easy, no cooking experience necessary. It is the equivalent to managing credit risk using ONLY subjective rating agency opinions.  No prices are considered!  Remember, there is always a price, on both fronts.  

It is also antithesis to open market participants who view real, un-manipulated hurdle rates for true risk, to be a market dynamic.  The allocation of capital in an efficient and prudent manner is the basis of capitalism.  Culling the herd/cleansing leads to sustainable business models without walking Zombie companies or countries. Manipulated credit and support can sustain Zombie companies and countries and delay default, thereby diverting scarce capital from investment-worthy entities.

Copied below is an MMT quote by influential Bloomberg Editor -Joe Weisenthal.  Joe is the same reporter who tweeted that there may be value in Hertz equity when the bonds were trading at 40% of Par and the company was in restructuring.  He clearly has little experience in credit markets.  This is the kind of blind commentary that leads to extremely dangerous beliefs.  It is now about CREDIT RISK.  In an expanding debt burden, Govie bonds do not mature, they need to roll over.  When that confidence to roll ebbs, the marginal buyer cannot hold back the flood.  You can get your money back but that will require more printing, Fiat will debase faster, and eventually, bondholders will realize they are holding a “circular logic” error. 

On Jan 19, 2021, Joe W. wrote to a worldwide audience:

The MMT view is that government spending is always based on monetary financing. This is key. It doesn't matter whether deficits are high or low. It doesn't matter whether rates are 0% or 5%. It doesn't matter whether the Fed is buying bonds or shrinking the balance sheet. The MMT view is that a country like the U.S., which issues and spends its own currency, always finances spending the same way: by creating money. This is as true now as it was during the Clinton surplus years.

As such, conventional notions of spending sustainability (like the size of the deficit or debt-to-GDP) are useless. Instead, the main constraints on spending are political (will politicians allocate the money?) and real (are there enough real resources in the economy to absorb the spending?). If there is a shortage of real resources, we would expect to see inflation. Inflation is the indicator that spending is unsustainable, not some arbitrary ratio.

Total debt/GDP ratios are useless?  Why pay taxes then Mr. Weisenthal?  Just print our way to prosperity.  Remember the “circular error” message in Lotus 123 and excel?  This is exactly what needs to be flashing in the bottom left of his brain.  Perhaps he never tried to balance a budget or design a spreadsheet based on mathematics and code.  He obviously prefers subjective analysis.  However, his opinions carry weight.  And danger.

In a debt/GDP spiral, the Fiat currency is the error term.  That is pure mathematics.  It is a spiral to which there is no mathematical escape.  If you are holding a Fiat obligation, it is debasing as fast as the MMTers can “finance spending in the same way: by creating money”.  Creating money out of thin air.  I wish I had a printing press in my basement to pay my mortgage the “same way”.

This chapter ends with five famous quotes:

  1. “Credit without default is like religion without Hell” – Howard Marks,
  2. “Communism only works until you run out of other people’s money” – Margaret Thatcher,
  3. “Trust but verify” – Ronald Reagan (Sounds like the Gipper was a Bitcoiner?!)
  4. “Capitalism is where risk is rewarded AND punished” -- Jeff Booth – The Price of Tomorrow
  5. “The best way to destroy capitalism is to debauch (debase) the currency”  -- Vlad Lenin

Our “Minsky Moment” could be on the horizon. American economist Hyman Minsky theorized that a tipping point occurs where the debt-fuelled asset bubble collapses, and assets become difficult to sell at any price.  A market collapse ensues.  (hat-tip Jeff Booth – The Price of Tomorrow).  That is a real risk that will begin to be reflected in the CDS of sovereigns.

Ed Yardeni, a macro strategist at Yardeni Research, famously coined the term “Bond Vigilantes”.  It was in reference to the free market bond investors keeping the Fed “honest” in its responsibility of minding inflationary pressures.  Yardeni was recently on CNBC where he stated “The Fed tried to bury the bond vigilantes, but they are not dead.  The Fed did not succeed.” 

It is my assertion that bond vigilantes will become sovereign CDS vigilantes.   

Absolute interest rates can move higher because of inflationary concerns AND because of credit concerns.  Credit concerns will overwhelm inflationary concerns, particularly if the deflationary impact of technological advances continues.  However, technology does NOT solve credit risk in sovereigns/Fiats.  What technology does solve is Store of Value problems with Fiats….BITCOIN.

We will examine CREDIT risk contagion in the next installment.  All owners of sovereign debt need to be aware that credit (mark-to-market) losses can be very meaningful.  A 100bps widening will knock 20% off the price of long bonds, as detailed in section 2.6.  The Chinese PBOC owns US$1T in US Treasury debt.  All pension funds, life insurance companies, mutual funds, and individual investors need to understand the realities of credit exposure versus “manipulated” interest rate exposure.

We will also calculate a “Fulcrum Index”, essentially a dynamic calculation of the price of credit insurance multiplied by the funded and unfunded liabilities of a basket of sovereign credits. The Fulcrum Index can also be thought of as a proxy for the value of the hardest money/asset ever created. BITCOIN. 

Study math people.  Or end up playing stupid games and winning stupid prizes.

In part three we will discuss:

3.1 - 2008/2009 GFC – My experience and Fears, TARP

3.2 - True leverage in Banks.

3.3 - Administered Rates, Inflation, Government bonds – The NEW paradigm

3.4 - What is Fiat and the problems with a Fiat contract

3.5 - Bitcoin is default Insurance on a basket of Sovereigns/Fiats, The Fulcrum Index

3.6 - Other Bitcoin Valuation Methodologies

3.7 - Investing in bitcoin. Probability analysis, expected value, Future outliers


In our final part four, we will discuss

4.1 - Energy Priced in Bitcoin

4.2 - Bitcoin Miners, the Banks of the Future?  Strategic plans for the energy patch and Nations

4.3 - Indigenous Communities embracing Bitcoin

4.4 - Bringing ASIC chip manufacturing back to North America

Stay Tuned! 

Greg Foss

Reach me on Twitter at @fossgregfoss – concerned but Optimistic Canadian





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