With UniCredit, PIMCO Steps Out of the Bill Gross Shadow
December 1, 2018
PIMCO stepped up and bought the whole $3 billion, 5Y megillah from UniCredit. For a coupon of 7.83%. Yes, a 7.83% shearing, 420 basis points over euro swap. It is exactly the kind of horsetrader deal that Bill Gross would have done. Ironically, the deal finally puts the Bill Gross years behind them. He could do it, and PIMCO can do it without him.
The debtor leg: Unicredit aparently needed capital at essentially any price. For regulatory reasons, they had to build a capital buffer. They also had to consider the impact of a downgrade of Italian debt on their ability to raise funds in the future.
The creditor leg: A 5Y global bank domiciled in Italy needs decent compensatory yield, and PIMCO demanded their view of what that was.
When two parties get together like this, it is common to do a deal post-mortem, if only to understand the rerating implications.
PIMCO got an amazing deal for two reasons. The first reason is that Italian banks have become the fulcrum point for macro tail risk on planet earth. When a risk morphs into a “tail risk” it is invariably mispriced. When a risk morphs into a “black swan”, well, you are looking at bonanza-style upside with limited downside. Italian banks are in the tail risk bucket. Then is simply a feature of markets. Expectations—implied optionality—tends to underreact in the absence of information, then overreact to newsflow.
Proposition 1. Focus on what everyone else believes, not on making accurate predictions.
Proposition 2. Exploit mispriced optionality implied by expectations.
The second reason relates to the source of this risk mispricing: UniCredit holdings of Italian sovereign debt. The UniCredit deal isn’t priced for a slow-down, or a recession. It is priced for a sovereign default. Despite the jaw-boning of Italian politicians, this is unlikely.
Let’s have a look at the data.
Exhibit 1. Sovereign yields of Germany, Italy, Slovakia, Latvia, and Lithuania, average weighted maturity roughly equivalent: Germany 7.8 yrs, Italy 7.8 yrs, Slovakia 8.4 yrs, Latvia 11.5, and Lithuania 11.5 yrs. Italy is wide-- by far.
This is astonishing. German bond yields still don’t generate positive yield, apparently priced for an 8-year depression. Yet since this summer Italian yields are wide to all them and as volatile as all get-out.
Are Italian spreads acting this way because of redenomination risk? Probably. But Latvia and Lithuanian are a couple of Russian armored divisions away from redenominating to the ruble.
Are Italian spreads reflective of weaker growth prospects? Probably. But it should still trade tighter to Slovakia in the event of a global recession.
Proposition 3. Tail risks: they are always there, seldom discounted. When discounting is applied, they tend to overshoot the actual risk.
Note that something interesting occurred which should (and likely does) concern PIMCO: Italian inflation.
Exhibit 2. Italian nominal-linker breakevens imply inflation exceeding 1% for the first time in five years.
This inflation breakout is less a sign of recovery and growth as much as an expectation that the Italian government is going to pay lip service to EU GDP targets but act to deliver fiscal stimulus regardless of deficit spending.
There really is no other sustainable option in a democracy. No one would call the country-in-receivership model imposed on Greece a success.
But inflation is something that UniCredit can well manage. Recall that PIMCO bought the debt of a private company with a profit motive and means to handle inflation. They didn’t buy the government.
Corollary 1. A bank is a call option on its assets.
While nothing is certain in this world, it is very likely that five years from now, somebody at PIMCO will be getting a lot of high-fives for that win.