What is the credit swap market? : Interview with Greg Foss ①

Greg Foss is a Canadian who spent 32 years trading credit both in Canada and the US. High yield credit (or Junk Bonds), which he focused on, trades mostly out of New York. He believes that credit markets are the most important markets in the world. Everyone focuses on equities, but the reality is credit markets are far bigger and more important.

Interview Date : 15th March 2021

What happens when credit markets get sick?

I’ve seen my share of credit calamities over time. Equity markets get destroyed when the credit markets get sick, which we have seen time and time again in various financial crises. You can see the warning signs come from the plumbing of the credit markets. Even if equity markets continue to flirt with new heights sometimes, the credit markets always provide preliminary warning signals.

What does the credit market compromise?

The credit market comprises everything from government borrowings to provincial or municipal and state borrowings all the way down to corporates, mortgage-backed securities, bank loans, etc. We typically start with government bond markets, and the US treasury typically is the base level borrower. They are called “the quintessential risk-free borrower” in the world on top of which all other rates are set.

How does the debt market grow?

Debt markets grow because there’s a demand for bonds from both pension funds and investors who want to place their investable assets into contractual obligations. There’s always supply and demand for credit that depends on the price typically set as the interest rate.

This interest rate is the contractual rate a borrower pays to the lender. The borrower could be the government, a corporation, etc., but the difference with the government is that they have a central bank behind them, thus government borrowing rates can be manipulated in the markets by the central bank. For example, the central bank can buy the bonds of the US treasury. This is a problem because it manipulates delays or it sets a false borrowing level for the risk-free rate of the US treasury. When that happens, it affects all sorts of different bond and equities markets, and even discount rates will be impacted on equities. It is central bank shenanigans.

What is the debt spiral?

A debt spiral happens when too much money is borrowed. There are three options that the government has in order to sustain the borrowing binge. First, they can raise taxes but that’s generally not a popular choice for the citizens. Second, they can reduce spending which is not a very popular choice amongst politicians, especially if they want to maintain their job for the next election term. And third, which is also always the easiest option, print money.

How have yields changed?

When I started my trading career in 1988, US treasury yields were 14%. At the time, the Chair of the Federal Reserve, Paul Volcker, was determined to stop inflation. The way that you stop inflation is by raising interest rates, so at one point, interest rates went as high as 18%. but when I started, it was down to 14%.

Over the next 30 years, from 1988 to 2020 interest rates for US treasuries went down to under 1%. They actually bottomed out at 60 basis points, which is 0.6%. That means the coupons on the bonds have decreased, yields that investors earn as an investor in the bond market have meaningfully decreased, and borrowers have absolutely benefited from lower interest rates. As a borrower, you like low-interest rates but not as the lender who’s the investor. If these lender retirees are counting on those savings accounts or on bond funds to produce an income, they’ve been hurt.

How do borrowers benefit when interest rates lower?

The person who invested at 14% would have had a 14% coupon. When the interest rates went down to 10%, the price of his bond increased because bond prices increase when interest rates decrease. Now, the value of that 14% coupon is much more attractive than the ones that are being issued at 10%. A bond is a contractual obligation of a future series of cash flows. There are a lot of people saying “I get capital gains in bonds” but that’s a misperception. You don’t actually get capital gains, rather when you cash your 14% coupons at a present value,  it’s above your 100 cents on the dollar that you initially bought the bond at. So, all you’re doing is pulling forward your cash flows.

If you have to reinvest that cash flow today, you don’t do it at 14% but at a lower rate. Thus, over the years people who have said “I got capital gains in bonds”, it’s just because rates were going down.

What if interest rates start going up?

We actually saw interest rates go up in 2021. The 30-year treasury in the US was borrowing at a 1.25% coupon. In 2020, that 30-year bond interest rate increased equivalent to 2.72%, meaning that the bond that was issued in 2020 is more than 100 basis points lower than the 2021 interest rate. The people who experienced that lost 25% of their value in only 1 year. For many, it is hard to imagine but there is not 0 chance that the US treasury will default.

Now, if you’ve lost 25 % of your principal, it will take you 18 years of coupons to make back that 25% loss. This is all bond math that can be very painful called duration and convexity; a is a contractual obligation of price changes because the interest rates (the coupons) do not change as coupons are fixed over the period of the bond.

Who changes the rates of these coupons?

The market changes interest rates. The US Treasury auctions 30-year bonds regularly, and the coupons are set by the prevailing interest rate in the market at that time. So, everyone would love to have higher coupons if you’re investing, but the treasury will not give you higher coupons because the market is only charging the treasury a certain amount. And, that is how they decide on an interest rate for a particular point in time.

Why do people want to be in bond markets?

Because they can’t be 100% in equity markets. Typically, investment advisers have a 60-40 model portfolio where 60% is in equities and 40% is in bonds. Those 40% bonds could be government bonds, provincial bonds, state bonds, corporate bonds, and high yield bonds. Even “high yield bonds” only yield 4% today- it is ridiculous! In my history of treating high yield, that’s not high yield. You are almost guaranteed to lose money after defaults because high yield credits have a higher rate of default as they are riskier.

Can governments default?

Governments can default as well, and this leads to collateral damage. The myth that governments never default because they print money is not true. Historically we have seen governments like Venezuela and Argentina default. When I started in the bond market, Brazil and Mexico defaulted. I had to work on a project because treasury secretary, Nicholas Brady, designed a plan to restructure the debts which banks loaned to third-world countries, like Brazil and Mexico.

It’s really fun to borrow money when people are giving it to you because you can do projects, create jobs, create a federal stimulus, etc., but when you can’t pay that money back, it’s a hardship. When a country defaults, education and health care will be on the line for the citizens. Government defaults are rarely seen in G7 nations, but there are so many other countries where a government default is a regular occurrence.

What is the credit swap market?

The credit default swap market is default insurance on any reference asset. It is like an insurance policy that you purchase to protect yourself if the reference asset defaults. Purchasing the insurance costs you a certain premium each year, much like an insurance premium for house insurance, fire insurance, etc. There’s default insurance where you pay a certain premium that is set by the market and by the riskiness of the borrower. For example, Canada is a sovereign borrower and the insurance market for Canada is charging 37 basis points per year over a 5-year term to ensure Canada against default. This means the purchaser has to pay $37000 a year to ensure about $10 million worth of debt. The seller of the insurance collects the premium; however, they are on the hook for any payout in the event of default.

Now, that doesn’t sound like a big price tag for a country, but Canada is supposed to be a very high-rated credit, yet the market is signaling the opposite because the purchaser of insurance in Canada still has to pay $37000 a year. Imagine that the seller of the insurance is a big hedge fund or some counterparty that uses, let’s say, 5 times leverage. They can turn that 37 basis points into almost a 2% yield or return if they use 5 times leverage. Sounds like free money to some people, but the reality is in 2006, Lehman’s brother’s credit default protection was trading at 9 basis points, so  $9000 to insure $10 million of Lehman brothers debt. 3 years later that $9000 premium was worth $6 million because Lehman defaulted. Rates of insurance continued to increase, and it was like a spread that perceived credit quality of the reference asset changes. This meant that as it got riskier, the insurance market would charge more and more.

How are foreign investors at risk?

Let’s say you’re a foreign lender to Canada, and you own a ton of dollar debt (Canadian counterparty debt). When you realize that you own too much of that debt in Canadian dollars, you would want to purchase protection to reduce your exposure. In the market, you can purchase default protection from a seller of protection; it could be a big global investment bank, like Goldman Sachs, etc., which are all huge players in the market. This is how markets develop and calibrate risk premiums.

Such situations are created due to questioning confidence and trust in the borrower. Trust is a tough word – it’s not about trust but about managing risk. The average citizens may think politicians want well for their citizens, so they’re just borrowing as much money as they can. But as a lender, it increases my risk to that country. If they just want to turn on the tap and keep borrowing, implicitly that means they become a riskier credit.

What is a credit spread?

A credit spread is a function of the risk of reference asset failure, so the market charges you a higher premium. If you think of the US treasuries being the quintessential risk-free borrower over terms of T-bills to 5-year notes, 5-year bonds, 10-year bonds to 30-year bonds, etc., setting what’s called the risk-free rate will make everything else stack up on top of that.

Let’s look at a state or municipality within the United States, such as that state of Illinois is in big trouble. Their finances are horrible, so their premium that they have to pay over the US treasury is meaningful because there is a much higher level of risk of default in their case.

What is the defective too-big-too-fail concept of banks?

I started my career by working at the largest financial institution in Canada, and the reality was Royal Bank of Canada was insolvent in 1988. If you had taken its debts that they had lent to third world countries like Brazil, Mexico, Vietnam, Thailand, etc., cumulative losses the Royal Bank of Canada would have to absorb by writing down these loans would have exceeded the value with its book value of equity. Now, it was a scary thing because that is Canada’s largest financial institution. At the same time, it was no different from the money center banks in New York City. That is why treasury secretary Nicholas Brady had to come up with the Brady Plan.

You quickly realize that there is a de facto too-big-to-fail concept amongst global banks. Investors in the banks, including depositors that have deposit insurance provided by the country, think banks are too big to fail because it has an implied backstop. That implied backstop is the government providing protection through printing money. This whole fiat situation is suspect and it has been for a very long time.

Interviewer , Editor : Lina Kamada


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