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The Center can Hold. Forget the Barbell Trade

Financial markets have accepted market inefficiency. This is another way of saying that the martingale property in markets is satisfied only as an approximation and there is no real justification for believing it. But money-ballers has really just traded one flavor of Kool-aid for another. The current flavor is the barbell.

Simply put, consider three investments. The first is most safe and in the event of a default will get most if not all of the recovery value. The second is the riskiest and offers unlimited upside in exchange for complete loss in the event of a default. The thirds sits in the middle of the other two, offering less but some recovery value in the event of default and higher yield. Splitting your money across investments 1 and 2 is the barbell. Buying the third is the belly. Just like some people like to look out the window, and some like to site with on leg in the aisle, everybody avoids the middle seat.

The barbell puts more weight on extreme events. It exploits OTM optionality. In credit, the barbell argument work like this: the belly of the capital structure has a poor performance record compared to the wings. In good times, equity investors make all the money. In bad times, senior investors keep all the recovery value. Sub investors make feeble returns in the good times and lose everything when the value of the portfolio collapses.

That’s not how it happened last time. Banks didn’t BK. Banks didn’t sell assets. Instead, banks bought their sub debt back. In a perfect storm, the belly was the place to be.

Picture this: a precarious situation. A bank is levered 5 x (Debt/EBITDA), has capital expenditures 30% of EBITDA, and other cash outflows at 20% of EBITDA. If a given interest rate is 6.5%, then interest cost out of EBITDA is 32.5%. Cash interest cover is 50% of EBITDA. It can pay 17.5% of EBITDA to debt principal. If rates rise to 10% at the same leverage, the interest costs out of EBITDA is 49.73%, nearly exceeding the needed cash cover for 50% of EBITDA: these names can scarcely make the interest payments.

When a firm cannot pay both interest and principal, EBITDA doesn’t really matter much and it is not meaningful to characterize speculative and “Ponzi” borrowers in terms of EBITDA. What matters is solvency: whether the combined net present value of future cash-flows and book value of the firm exceeds its debt. This explains why banks need rising book asset prices to remain solvent.

Banks also have to clean up their balance sheets. The most straightforward tactical solution is to look to unwind trades. This means selling assets for cash and releasing provision reserves. This means assets up for sale at a discount. Until the banks balk at the idea of selling cheap to outfits with names like Tiger Shark Capital, Raptor Investments, or some other carnivorous name pulled from juvenile persecution. No bank will ever willingly sell a distressed firm that walks around in a t-shirt saying “we just bought from stupid”. So they think of alternatives to giving up performing assets for not much.

The deleveraging alternative is to raise capital. They do this by buying back their own sub debt. Basel and other rules designate many types of conventional subordinated bonds as “non loss-absorbing”, so their impact on regulatory capital ratios is reduced. By buying back these bonds a banks will improve the efficiency of their capital structure. When the bonds are bought back discounted to par, the discount is realized as core equity, boosting the bank’s capital ratio.

So in summary, banks sell assets. This impairs future earnings and hammers stocks. They finance the purchase of sub debt by issuing senior debt, depressing senior debt performance. Who wins? The belly. Why? Because of some inadvertent consequence of regulation.

It’s not just regulators that support trading the belly. Unintended consequences happen all over the place. Consider that the ECB offered money market rates at capital market maturities to support the liability side of bank balance sheets. Central banks try to put a nice bid underwriting asset prices in times of crisis—but they just can’t control where all that liquidity goes. The asset inflation policy isn’t enough to turn the ship, because inflating asset prices don’t get banks to releverage when their loan book is cratered with write-offs. They use the cash to provision and recapitalize instead. All unintended consequences.

There is a time and place for trading unintended consequences. Don’t split money into the tail via the barbell, don’t buy the belly. Buy all three. The trick is knowing the season for it, and God’s not telling.

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