As the old-time option traders used to say, "Strip, strap, straddle and spread".
Now we talk Iron Condors and Inverse Skip Strike Butterflies.
Sometimes I think I should have been born in those simpler times.
No human can realistically be expected to understand or focus on the constant stream of Eurozone gyrations and in fact humans increasingly don’t, with the half-life of blather-driven euphoria declining rapidly. The latest gyration seems to be that Germany is contemplating letting the Eurozone collective rescue funds think about maybe one day putting up for discussion the possibility of considering buying bonds of distressed countries directly to try to drive down funding costs for those countries.Emphasis mine.
This seems to have helped Spanish yields more than did the announcement earlier this month that those funds might consider giving Spain €100bn in special senior debt to get its banks sorted, for sort of obvious reasons. If the EFSFSMCBFFFFF is buying hundreds of billions worth of Spanish bonds right alongside whatever brave dopes are buying them already, that buying pressure should push up prices and push down Spanish borrowing costs and improve Spanish sustainability in a virtuous circle etc. etc. If the EFSFSMCBFFFFF is instead putting in its money at a more senior level than those bondholders, then those bondholders are subordinated and, empirically, sad about it.
One weird thing though is that there is little assurance that “EFSFSMCBFFFFF buying the same bonds that everyone else is buying” is actually the same thing as “EFSFSMCBFFFFF ending up with the same bonds that everyone else is buying.” The (not yet ratified!) ESM treaty maybe requires the ESM to be senior to market creditors (maybe!), but also maybe allows it to buy market bonds, which generally are not senior to themselves. Seniority is ordinarily a matter of contract: if you buy one of a series of totally fungible publicly traded bonds, you generally expect to be treated pari passu with the rest of those publicly traded bonds.
Ordinarily! Of course the European public sector has a record of owning publicly traded bonds and getting treated better than regular holders: in Greece, ECB-held bonds were not haircut the way that privately held bonds were, even though they were contractually the same bonds. Greece just negotiated a prior exchange with the ECB, turning them into not the same bonds at the last moment.
But of course before that moment the ECB was buying Greek bonds in the same market and at the same prices as everyone else – if you wanted Greek bonds, you were competing with the ECB, and so theoretically that would push down rates. (Not enough but whatever.)
David Murphy has this wonderful round-up of capital arbitrage strategies that is worth reading if you plan to arbitrage your capital, or arbitrage anything really, and it got me thinking about the leveling effect of this trade. Eurodudes buy contractually senior debt = panic junior debtholders. Eurodudes buy contractually pari passu debt = support debt markets. If the result that you intend is “get money into Spanish banks,” then perhaps you don’t care about that choice; if it is “help Spain keep access to debt markets” then buying pari debt is theoretically and empirically much better. If as a practical matter you end up in the same place in terms of getting your money back – as you did with Greece – even better. You’ve managed a strange structural arbitrage, investing at a senior level and protecting your principal, while convincing more junior creditors that you’re right there with them. In effect you buy regular bonds and magically transmute them into quantum-possibly-more-senior bonds without anyone being entirely sure if that’s what you’ve done....MORE