Thursday, April 24, 2014

What is happening here???

Central banks are keeping interest rates really low.  So investors go into riskier investments in the search for yield.  Consider Europe:



 Europe is seeing a boom in so-called CoCo, or contingent convertible,
bonds issued by banks to shore up capital. Investors in these securities
are wiped out or forced to convert the bonds to stock, if the issuer's
capital falls under a certain threshold, or if regulators consider the
bank ripe for a bailout...The only way to hedge the risk is to buy put options on the issuing
banks' stock or short it, creating the potential for a "death spiral"
should things go wrong. Credit default swaps on CoCos will only become
available in September.Another booming asset class is catastrophe bonds, sold by insurance companies to pass on all sorts of natural disaster risks. These catastrophe bonds bet against damage from named storms in the US....Low interest rates are great for European governments happily increasing their already oppressive
debt burdens. They are also nice for creating the impression that
European economies are growing – at rates scarcely discernible from
zero. Yet glorified bets on U.S. weather patterns and the capital levels
of European banks are inherently shaky investments. And blockbuster
junk bond issues such as Numericable's are downright scary...[Numericable is a European company]. 
 



Hunt for Exotic Yields Is Dangerous - Bloomberg View



The problem is that the artificially low nominal interest rates mask the amount of risk involved in all of these activities.  What happened to the idea that lower interest rates create incentives for more real investment?  

3 comments:

  1. this all just sounds like recipe for disaster...

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  2. I fully endorse private firms right to "manufacture" and sell exotic bonds and financial instruments. With a caveat of course: central governments need to stop keeping interest rates so artificially low, and banks shouldn't expect bail-outs when their exotic bonds blow up in their face.

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  3. This discussion reminds me of when the IT bubble collapsed, during which Greenspan dropped interest rates to the floor, and investors started to buy more riskier bonds because the return on the average bond was so low. People should just buy stocks instead of these exotic bonds.

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