Tag Archives: risks

The Specter Of Risk In The Derivatives Of Bond Mutual Funds

By Fabio Cortes, Economist in the IMF’s Monetary and Capital Markets Department Current regulations only require U.S. and European bond mutual funds to disclose a limited amount of information about the risks they have taken using financial instruments called derivatives. This leaves investors and policymakers in the dark on a key issue for financial stability. Our new research in the October 2015 Global Financial Stability Report looks at just how much is at stake. A number of large bond mutual funds use derivatives-contracts that permit investors to bet on the future direction of interest rates. However, unlike bonds, most derivatives only require a small deposit to make the investment, which amplifies their potential gains through leverage, or borrowed money. For this reason, leveraged investments are potentially more profitable, as the gains on invested capital can be larger. For the same reason, losses can be much larger. Derivatives offer mutual fund managers a flexible and less capital intensive alternative to bonds when managing their portfolios. When used to insure against potential changes in interest rates, they are a useful tool. When used to speculate, they can be bad news given the potential for big losses when bets go wrong. Strong growth in the assets of bond mutual funds active in derivatives The assets of large bond mutual funds that use derivatives have increased significantly since the global financial crisis. As you can see below in Chart 1, we now estimate they amount to more than $900 billion, or about 13 percent of the world’s bond mutual fund sector. While existing regulations in the United States and the European Union on mutual funds impose clear limits on cash borrowing levels, the amount of leverage that can be achieved through derivatives exposure is potentially large, often multiples of the market value of their portfolios. This may explain why mutual funds accounting for about 2/3 of the assets in our sample disclose derivatives leverage ranging from 100 percent to 1000 percent of net asset value in their annual reports. This range may be also conservative as these are the notional exposures of derivatives adjusted for hedging and netting at the fund manager’s discretion. What makes them sensitive to higher rates and volatile financial markets Although these leveraged bond mutual funds have not performed differently to benchmarks over the past three years, their relative performance has occurred in a period of both low interest rates and low volatility, which may mask the risks of leverage. This is because the market value of a number of speculative derivatives positions could have been unaffected by the relatively small changes in the price of fixed income assets. In addition, limited investor withdrawals from leveraged bond mutual funds may have also masked the risks of fund managers having to sell-off illiquid derivatives to pay for investor redemptions. In our analysis we find that a portion of leveraged bond mutual funds exhibit both relatively high leverage and sensitivity to the returns of U.S. fixed-income benchmarks, depicted in Chart 2 below. This combination raises a risk that losses from highly leveraged derivatives could accelerate in a scenario where market volatility and U.S. bond yields suddenly rise. Investors in leveraged bond mutual funds, when faced with a rapid deterioration in the value of their investments, may rush to cash in, particularly if this results in greater than expected losses relative to benchmarks (and the historical performance of their investments). This could then reinforce a vicious cycle of fire sales by mutual fund managers, further investor losses and redemptions, and more volatility. Improve disclosure: regulators need to act Making a comprehensive assessment of these risks is problematic due to insufficient data; lack of oversight by regulators compounds the risks. The latest proposals by the U.S. Securities and Exchange Commission to enhance regulations and improve disclosure on the derivatives of mutual funds is a welcome step. There is currently no requirement for disclosing leverage data in the United States (and only on a selected basis in some European Union countries). Implementing detailed and globally consistent reporting standards across the asset management industry would give regulators the data necessary to locate and measure the extent of leverage risks. Reporting standards should include enough leverage information (level of cash, assets, and derivatives) to show mutual funds’ sensitivity to large market moves-for example, bond funds should report their sensitivity to rate and credit market moves-and to facilitate meaningful analysis of risks across the financial sector.

Brave Investors: Long Engie And Short Electricite De France

The French state is looking to broker a deal for EDF to buy Areva’s entire nuclear reactor business. There is risk that EDF pays a high price in many ways. There is a possibility of a deal with Engie for just the installed reactor maintenance business. A deal involving Engie would be better received by the markets and see upside on all names. Anything else means downside on all companies involved – except Engie. A purchase of the bulk of Areva’s ( OTCPK:ARVCF ) nuclear reactor and engineering business by Electricite de France, or EDF ( OTC:ECIFF ), is currently favoured by the state. But a purchase of the maintenance business by Engie ( OTCPK:GDFZY ), would be a more favourable outcome for all parties involved, investors included. On the issues concerning EDF, also see my previous SA article, “Electricite de France SA And A Potential Areva Deal – Nuclear Champion Or Explosion?” The French state is reported to be pushing for Electricite de France to acquire Areva’s nuclear reactor and engineering businesses . The broad outline has been known for a while. Now, EDF is said to be finalizing an offer. Press reports suggest Area is looking for Eur 1bn (USD 11bn) or just the engineering business. A Eur 300m (USD 337m), EDF’s valuation is considerably lower. That compares to market valuations floating between in a Eur 1.5-3bn (USD 1.7-3.4bn) Range for the reactor business. I estimate an implied EV/Sales range of 1.1-2.1x on that basis. But, on those revenues come the risks and liabilities which are highly uncertain. Engie might emerge as a strong competitive bidder. The CFO recently confirmed potential interest. Engie seems to be interested in the reactor maintenance business, which it could be valuing at around Eur 3bn (USD 3.4bn). That would imply just short of 2x sales, which is reasonable for a high margin and stable cash flow business. In my view, a deal with Engie would be in the interest of all parties involved. Even the state could find reassurance, given its holding in Engie. It would be much better received by markets, too. EDF would benefit from vertical integration, a potentially more streamlined and efficient new build operation, and all in all lower future costs of its nuclear fleet. Conversely, the reactor build business its outside of its core business and expertise. Lastly, a deal would not be helpful for EDF’s cash flow as it is already capex strained. An EDF deal might not provide enough funding to Areva. The government might look for a more complex solution with Chinese investors. Engie has existing expertise in large utility engineering through Tractebel and its energy engineering and services business. The nuclear maintenance business could tie in well with that. There would be much less of an issue with providing the service to competitors than in the case of EDF. Engie’s business does that already. The company would also derive synergies with its own large fleet of operational nuclear reactors. Investors are prepared for M&A from Engie, following recent management comments. I gage a deal would, contrary to EDF, be perceived as coming from sound management rationale, and given all indications, free from political pressures. Brave investors might consider a long Engie/short EDF trade as the downside on Engie, irrespective of the outcome, is limited. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.