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What’s a saver to do, given that government policy is designed to punish him?

As I cycled to my office this morning I passed a billboard advertisement for Halifax ISAs, offering tax-free savings accounts. For non-UK readers, ISAs are a form of savings account into which you can deposit up to £3600 in each tax year and earn interest tax-free. Normally, higher-rate taxpayers pay 40% on any savings interest, while those in the basic-rate band pay tax at 20%.

Unfortunately for savers, the interest rates on offer from Halifax (and from the other banks involved in the ISA business) are pitiful. Their basic variable rate ISA pays an annual interest rate of 0.5%, while, according to the company’s website, the limited offer ISA direct reward account (which is subject to a minimum balance and allows only four withdrawals a year) offers “a great tax-free interest rate of 2.6%”. Great, I suppose, compared to the standard 0.5%, but not on any other grounds.

Whichever way you look at it, you’re losing money as a saver. The latest retail price index release showed a year-on-year increase of 3.7%, so you’re not keeping up with inflation, even if you are able to reclaim that portion of your interest that you normally lose to tax. 

Can switching into other currencies help to protect the value of your savings? Yes, to some extent. While, surprisingly, sterling has actually appreciated against the U.S. dollar over the last year (by 9.2%), it’s down by 3.6% against the euro, by 2% against the Swiss franc and by 11.5% against gold.

The advent of exchange-traded currencies, ETFs offering exposure to money market rates in other currencies (i.e. giving both currency and local interest rate exposure) and, of course, precious metals ETCs, has been of great help for those seeking to protect their assets from the counterfeiters in charge of our central banks and governments, whose sole objective appears to be to inflate their way out of the previous mess caused by uncontrolled, debt-fuelled expansion.

The other options available to savers seeking to avoid negative real (inflation-adjusted) interest rates – to pick up equities offering higher yields, to buy longer-maturity bonds with higher yields or to buy corporate fixed income bonds – are all fraught with danger.

The credit strategists at Société Générale sent an email yesterday in which they highlighted that the iBoxx corporate bond index yield spread is now within 1% of pre-crisis highs. It’s almost as if the credit crunch never happened. Meanwhile, chasing yield in other asset classes has a record of leading to disaster. Wasn’t it a combination of low U.S. interest rates, loose underwriting standards and poor credit evaluation by investors that led to the sub-prime crisis in the first place?

In short, this seems a particularly risky time for investors seeking to protect themselves from those sub-inflation interest rates on offer at UK banks. Perhaps gold still seems the safest bet. While it’s trading near all-time highs in sterling terms, when measured in terms of share prices it has been treading water for the last year, as shown by the Dow/Gold chart from Fred’s Intelligent Bear site.

This chart, when combined with central banks’ stated policy of keeping rates low for the foreseeable future, suggest to me that gold’s bull market is still far from its peak. For the under-fire saver, precious metals are still the place to be.

Who owes what to whom and who’s posted what in return?

An intriguing article on Bloomberg, published yesterday, throws light on the arcane world of collateral management.

Since the financial crisis there’s been a trend towards the greater collateralisation of financial market exposures. Fewer lenders are prepared to advance money on an unsecured basis, having seen how loans disappeared into the black hole of Lehman’s balance sheet.

However, Bloomberg reports that there’s a surprising difference between what banks post to their counterparties as collateral and what the counterparties post to banks in return. This is of great importance for the over-the-counter derivatives market, whose gross notional exposure dwarfs world GDP by a factor of around 10:1.  In this enormous market 84% of collateral agreements are bilateral - in other words, they are negotiated on a case-by-case basis, rather than being set by any industry standard or government regulation.

Bloomberg gives the example of Goldman Sachs, apparently the best negotiator, which had received collateral worth 57% of notional exposure on its OTC derivatives contracts at the end of December 2009, while only posting 16% itself to its counterparties. That’s a difference worth US$110 billion, on which the bank can earn interest – a nice revenue stream if you can get it. For JP Morgan, collateral received also totalled 57% of notional exposures, while collateral posted represented 45%, a much smaller gap, while for Citigroup, the net balance was in the other direction by a margin of some US$11 billion.

Moving OTC derivatives onto exchanges would eliminate these balances, since banks’ exposures would no longer be to each other but to the exchange. Margin would be posted to the exchange as required by the overall mark-to-market value of each bank’s total positions. This would be a much safer system, since one of the major problems with the current setup is that funds posted as collateral to a dealer are not segregated, meaning that if a dealer fails, its counterparties will end up as unsecured creditors and face a likely loss of most of their assets. The likelihood of a chain reaction of failures is very high under such a scenario.

However, deciding what derivatives contracts are standardised enough to be exchange-traded is proving much harder than anticipated. Clearly, there are also vested interests that would lose out from a move to exchange trading.

What’s the relevance of this to exchange-traded products? While the collateralisation of exposures in ETFs is much more standardised under the UCITS regulatory framework (which almost all European ETFs follow) than in the over-the-counter derivatives market, how collateral is managed and the extent to which it is segregated, if at all, is crucial. Plus, with last year’s decline in credit risk we have seen the re-emergence of uncollateralised exchange-traded products. Bloomberg highlighting such large-scale collateral imbalances is a reminder of financial systemic risk –notwithstanding government backstops – that cannot be overlooked, something that should give investors pause for thought before incurring unsecured exposures.

Nothing illustrates the manic-depressive character of the equity market better than the property sector.

In early 2009, investors were clamouring to get out of commercial property funds, in many cases finding themselves locked in. Now, it seems, they can’t get enough of real estate.

In March last year, exchange-traded funds tracking real estate investment trusts (REITs) were at the bottom of the pile for their performance since the start of the credit crunch, with many having lost four-fifths of their value since 2007. Since then these ETFs have been amongst the best performers in the market.

The chart below shows the performance over the last year of four iShares property ETFs: the iShares FTSE EPRA/NAREIT UK property fund (IUKP), the iShares FTSE EPRA European Property Index Fund (IPRP), the iShares FTSE EPRA/NAREIT US Property Yield Fund (IUSP) and the iShares FTSE EPRA/NAREIT Asia Property Yield Fund (IASP). The performance measure is based on the total return NAV (i.e., with the reinvestment of dividends) and NAVs have been rebased to 100 on 9 March 2009, which marked the low point in prices for three of the four funds.

Their performance over the last year means that REIT portfolios are nowhere near as attractive to yield-hungry investors as they were in March 2009 – see the change in distribution yield on the four iShares ETFs over the same period in the table below.

Distribution yield is imperfect since it’s a backward-looking measure, calculated as a trailing sum of payouts divided by the current share price. In fact, the dramatic yield declines shown in the table are partly due to the REIT ETFs’ share price rises over the last year and partly due to the fall in absolute dividends paid out.

Taking IUSP, for example, the fall in the distribution yield to a quarter of the level seen this time last year is a result of both the 129% share price rise and a fall in the cumulative dividend payout (the sum of the four prior quarterly payouts) from US$0.91 on 9 March 2009 to US$0.48 on 9 March 2010.

In fact, to justify the current valuations of these REITs, which on a yield basis now offer quite a bit less than long-term government bonds, you’d have to expect dividends to start growing pretty quickly.

Is this realistic? A chart that recently featured in a Congressional Oversight Panel report on the US commercial real estate sector shows vacancy rates rising for all four commercial real estate subsectors. 

It’s hard to see rents embarking on a steep rise in the face of this supply overhang. Indeed, they may continue to fall – as the report’s authors note, vacancy rates are being buffered by the existence of long-term leases. As these expire, and as the additional space accruing from boom-year projects comes onstream, there’s a good chance that rents may carry on downwards.

If one reads the sobering conclusion of the congressional report’s authors, which states that “there is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public,” then looks at the valuation of real estate investment trusts, it’s hard to avoid drawing the conclusion that one group – either Congress’s analysts or equity investors – has got it badly wrong.

Bipolar disorder, in other words. Are we about to embark on the next phase in the cycle?

Matt, you assume that markets trade smoothly from one point to the next and that investors can take their place in an orderly queue to get out of positions if things start to go wrong.

Unfortunately, they don’t, and traders struggle with “gap risk” and “jump to default risk” (in the credit markets) on a daily basis. One day an entity is solvent, the next day it’s not, and there may be little or no advance warning that things are about to shift from one state to the next.

That’s the key difference between textbooks on finance (which assume that things do trade in an orderly, continuous fashion) and real life, where things are messy and chaotic. Mathematician Benoit Mandelbrot started pointing this out 50 years ago, as we covered in a recent interview on the site, but mainstream finance theory continues to largely ignore what he says.

That’s why your redemption mechanism in an ETN, however good it sounds on paper, is not perfect and if the issuing institution gets into trouble, you may not be able to get out in time. Instead, you’ll end up as a creditor in the bankruptcy court along with everyone else, possibly facing a recovery of a few cents on the dollar.

For a real-life example of how quickly things can go sour, take a look at the performance of ETF Securities’ Agriculture ETC (LSE:AIGA) around the time of the Lehman bankruptcy and the near-collapse of AIG, which at that time was the firm guaranteeing payment of the ETC’s underlying index performance.

AIGA Price Data (Source: Bloomberg)

If you had held this ETC then you would probably have ended the week of Friday 12 September unaware that all hell was about to break loose. Lehman Brothers’ bankruptcy was announced early on Monday 15 September and markets immediately began to speculate that AIG would be the next domino to fall.

Although decent trading volumes were recorded in AIGA on the Monday, market makers stopped quoting two-way prices at some point that afternoon, as a press release from ETF Securities made clear at the time. According to one market maker, many clearing firms and prime brokers cut their credit lines to AIG that day, creating a discount in all AIG-backed debt products and drastically reducing liquidity.

In effect, if you didn’t get out on that Monday morning you would have been stuck with your position.

Some trading was reported the following day, albeit in very limited volumes and at a 20%-plus discount to the previous closing price. And remember, Bloomberg data record information provided by exchanges; anecdotally, in the over-the-counter market some trades in AIG-backed ETF Securities ETCs were conducted at a 90% discount at the peak of the panic.

Fortunately for investors, a Fed-sponsored bailout of AIG was announced on the evening of Tuesday 16 September and, although it took a few days for ETC trading to get back up and running, AIG default risk had largely disappeared when the market reopened on Friday 19 September, by which time ETF Securities had also announced the introduction of a collateral mechanism to back up the ETCs.

One can quibble about the details here. There was no formal daily redemption mechanism (such as that which ETNs offer) for investors in ETCs, other than by trading with market intermediaries, for example. Equally, it wasn’t only certain ETNs and ETCs that got into trouble in late 2008 – many ETFs investing in corporate bonds also faced problems. And it wasn’t even just an ETF/ETC/ETN issue – the whole of the debt market was in turmoil at the time.

But there’s a central point to make about market liquidity, which, as one investor famously said, is there when you don’t need it but not when you do. The assumption that you can get out before the crowd if things go wrong is a dangerous one to make.

I don’t think exchange-traded notes are for everyone, Paul, but the credit risk is surely overstated.

I actually liked the way you laid out the arguments for and against ETNs in your recent blog. On the plus side, ETNs offer zero tracking error. On the negative side, they come with credit risk.

But while I agree that investors should assign some cost to an ETN’s credit risk, I think you seriously overstate the size of that cost by proxying it off of credit default swaps. The risks that CDS contracts protect against and the risk associated with ETNs are vastly different.

When you buy a CDS contract, you are covering yourself against a bond’s default for five years. When you buy an ETN, your credit exposure is limited to a single day, because you can always redeem the ETN back to the issuer.

You acknowledge this in your blog, but then dismiss its value, noting:

“[S]ceptics point out [that] the option is worth somewhat less for being granted by the same entity as the one issuing the bond, since it will be of limited or no use if the issuer gets into trouble.”

But remember: ETN aren’t like most bonds. The credit risk is entirely binary. An ETN is either worth 100% of its net asset value, or it is worth zero. That is a critical difference.

Bonds vs. ETNs

To illustrate, let’s suppose that you went out and bought two things in your brokerage account: a 10-year bond of Barclays debt and an iPath ETN underwritten by Barclays. The next morning, you woke up and read in the paper that Barclays had cooked its books and actually had half the cash it previously claimed.

What would happen?

The bond would certainly fall in value. By the market’s assessment, the risk that Barclays will default on its debt will have increased, so the bond’s price must drop.

But the ETN should continue to trade normally at net asset value. While the risk of default may have risen by 10 or 20 percent, it’s still relatively small. In the meantime, investors can still redeem their ETNs at full value, which means the notes will still trade at full value. In fact, Lehman processed redemptions on its ETNs right up to its eventual bankruptcy.

For investors who are paying attention, the risk that a bank like Barclays will go bankrupt overnight without you noticing is very small. It’s not zero, and CDS rates are absolutely the right mechanism for comparing the relative risk of competing banks issuing ETNs. But it’s not fair to assign the full cost of a CDS contract to an ETN’s expense ratio. That overstates the risk and the costs substantially.