“How have bonds transitioned from one of the most elementary investments to one of the most complex?”

By Tristan Baylor

On April 18th, 2017, Citigroup announced breakthrough first-quarter profit earnings; up 17% to $4.09 billion dollars. Most of this profit came from the fixed income department, which primarily buys, sells, and repackages bonds. Until the 1980s, bonds had been a safe, low return investment mostly managed by local banks. How did they become such a profitable, complex, and popular trading strategy for investment banks, hedge funds, and asset management firms?

 

What is a bond?

A bond is classified as a debt investment, which means that the investor loans money to an entity for a defined period of time. Large, well-run corporations or governments use bonds to bypass traditional means of raising capital and go directly to lenders and consumers, who often give more favorable terms than institutions like banks. Bonds, like stocks, are traded on markets. When a consumer purchases a bond from a corporation, unlike a stock, they do not own a part of the corporation. Instead, the bond acts as a contract that guarantees the corporation will pay you back a certain amount at a particular point in time. There exists a risk, referred to as default risk, that the issuer of the bond will default on the payment when the bond matures. Rating agencies like S&P and Moody’s rate the security of bonds on scale from AAA to D, AAA being the safest. If a bond has a rating below B-, the bond  is commonly referred to as a junk bond.  These junk bonds are the key to the bond trading boom that arrived in the 1980s. Since issuers of lower-rated bonds can’t compete on the security of the bond, they compete by offering a more favorable interest rate.

 

Junk Bond Trading and the Birth of CDOs

Junk bonds remained a fairly unpopular and unprofitable investment until Michael Milken revitalized the bond market in the 1980s. Many bonds with low ratings were not necessarily poorly rated at the time of issue; instead, these bonds had gone from investment grade to junk grade based on a reassessment of the issuing corporation or government. Milken realized that many of these junk bonds were underpriced, meaning that the security rating of the bond had fallen below the actual safety of the bond. As in any market, this mispricing allowed traders to profit off of junk bond speculation. The extreme, multi-million dollar profits came when junk bonds began to be packaged into a collateralized debt obligation, or CDO. A CDO is essentially a collection of bonds treated as a single financial investment. The earliest CDO’s were diversified, meaning they contained bonds from different sectors of the economy, and were in theory protected and insulated from a downturn in any particular sector. Packaging high-yield junk bonds together meant that while a fair amount of the bonds defaulted, the underpriced bonds in the CDO had such great returns that the CDO generated positive returns as a whole. Armed with this new financial instrument, Milken and his co-workers at Drexel Burnham Lambert made recording setting profits, even by Wall Street’s standards. CDO’s with poorly rated bonds could themselves be highly rated, and often returned 2 to 3 percent more than similarly rated corporate or government bonds.

 

CDOs and the 2008 financial crisis

Milken’s profitable invention caught on heavily in the early 2000s; sales of CDOs grew from $69 billion in 2000 to nearly $500 billion by 2006, and the total worth of CDOs issued between 2004 to 2007 was an eye-popping $1.4 trillion dollars. During this time, CDOs became less diversified, and greed led many banks to ignore high risk in search of massive rewards. The housing boom of the early 2000s presented a lucrative opportunity to package mortgages into CDOs, since housing prices had historically never seen a heavy downturn. The demand for more mortgages to create new CDOs pressured smaller banks to lower standards in their mortgage lending practice, and there existed a faulty assumption that packaging the sub-prime mortgages into a CDO would eliminate almost all of the risk associated with each individual mortgage. Leaving out other factors for the sake of simplicity, once people stopped being able to repay their mortgage, the underlying bonds of most CDOs defaulted, and the banks that held these CDOs experienced incredible losses. These losses were the catalyst for the worst financial recession in U.S. history.

 

Bond Trading Today

Naturally, in the immediate aftermath of the 2008 crash, the bond market was slow and trades were low-volume. Around 2010, as banks recovered from their losses, traders created a new financial instrument dubbed a bespoke portfolio or bespoke tranche opportunity. Bespoke portfolios are extremely complex, but they are closely tied to the performance of what are called synthetic CDOs. The easiest way to think about synthetic CDOs is considering them a bet on the performance of other bonds rather than a package of the bonds themselves. Synthetic CDOs are more easily created than regular CDOs, since they don’t require underlying assets like mortgages to make them up. These are what contributed to the unexpected earnings boom of Citigroup, Merrill Lynch, and J.P. Morgan this April.

 

Are synthetic CDOs  safe? Or are we headed down a path similar to 2008? Banks claim that the combination of new financial regulation and the mathematical sophistication of these new instruments means they are insulated from the huge losses seen during the financial crisis. Critics point out that the mathematical models that insisted CDOs were safe during the financial crisis were incorrect, and since the synthetic CDOs that link to bespoke portfolios aren’t value on a market, so there is no other way to value them.

 

When Michael Milken first began to package mortgages into CDOs, he probably couldn’t have imagined the boom of financial sophistication that would follow. In the 30 years since, markets have transitioned from something many could understand and participate in to something dominated by investments so complex only a handful of mathematicians can fully comprehend them. Will this be good in the long run? There is no definitive answer. We can only wait and see.

 

References

Carlozo, L. (n.d.). What is a Bespoke Tranche Opportunity. Retrieved from http://money.usnews.com/investing/articles/2016-05-23/what-is-a-bespoke-tranche-opportunity

Chappatta, B. (2016, June 30). Global Bond Market Surges Most Since 2008 as Growth Outlook Dims. Retrieved from https://www.bloomberg.com/news/articles/2016-06-30/global-bond-market-surges-most-since-2008-as-growth-outlook-dims

Cousseran, O., & Rahmouni, I. (2005). Synthetic CDO primer. New York, NY: Bond Market Association.

I. (2014, June 03). The Bond Market. Retrieved from http://www.investopedia.com/walkthrough/corporate-finance/3/bonds/market.aspx