Covid bondsOne theory of finance is that certain projects are beneficial for society, and if you come up with one of those projects then you can go to the capital markets and seek financing for those projects, and investors say "this project sounds beneficial for society so I will give you money," and you raise the money and do the project, and it benefits society, and so you get lots of money, because money is the way that we keep score of how much you have benefited society,[1] and you give some of the money to your investors to reward them for doing the socially beneficial job of financing your socially beneficial project. This theory is called "capitalism," and it is wildly popular in certain circles. Investors, for instance, love it, and there are hedge fund managers who will happily talk about how they improve the world by allocating capital to good projects. Investment bankers tend to love it even more; when you think about it, isn't structuring derivatives to hedge a biotech company's capital raise basically the same thing as curing cancer yourself?It is hardly necessary to add that this theory is wildly unpopular in certain other circles, or that lots of people think that actual financial markets profit from financing socially harmful activities, etc. There is another, odder, also very popular theory, which is that (1) mostly the capital markets fund socially neutral or harmful activities, but (2) there is some narrow slice of socially beneficial activities that get financing from a narrow slice of socially beneficial capital markets. Like, there are a few nice entrepreneurs doing nice projects funded by nice investors, and those projects are good for society, and if you care about doing good for society you can be one of the nice investors funding the nice projects, while the mainstream capital markets don't care about doing good for society and are pursuing some other, possibly nefarious goal. That other goal is money. If you are in the nice, socially responsible, capital markets, you are also pursuing money, but you are willing to accept slightly less of it in exchange for the satisfaction of making the world better.[2] One implication of this theory might be that there is only limited money to invest in nice projects, and if you want to benefit society with your investing you have to choose carefully. For instance you can't afford to care about the environment when there's a pandemic: A new coronavirus bond market has reached $65bn in just a few months and is set to keep growing, as companies and governments rush to issue debt to help ease the effects of the pandemic. The Covid-19 bond market — in which proceeds are earmarked to address impacts of the outbreak — could top $100bn by the end of 2020, according to analysis by Axa Investment Managers, which has invested roughly €230m in coronavirus bonds across its portfolios. Issuers range from the World Bank's International Bank for Reconstruction and Development, and the European Investment Bank, to the nation of Guatemala. Companies have also jumped in, including Bank of China, which sold the first Covid-related bond in February, and drugmaker Pfizer, which in late March issued $1.25bn in 10-year bonds designed in part to address the pandemic. … Analysts note that some of that growth appears to have come at the expense of so-called green bonds, which were much in vogue last year and had been expected to have another strong year in 2020. But as coronavirus bonds have taken hold, green bond issuance has taken "a back seat," said Mr Bond. Companies issued 40 per cent less high-grade green debt in April this year compared to the same month in 2019, according to Morgan Stanley. A combined $32bn of so-called "social" and "sustainability" bonds were issued this April, the bank calculates, most of which were designated for Covid-19 response initiatives. This marked the first time that social and sustainability bonds eclipsed the issuance of green bonds in a single calendar month.
Pfizer! Pfizer Inc. is a $200 billion for-profit drug company. The thing that it does for a living is develop drugs to cure diseases. You might naively think, well, if Pfizer is issuing a bond, it is probably going to invest that money in curing diseases, which is a good thing that investors might want to support, not only because they will be paid 2.625% interest for 10 years, but also because curing diseases is good for the world and financing a disease-curing company is a good thing to do. But in actually existing capitalism nobody, not even the investors, quite trusts that rationale, and so Pfizer's actual social bond promises to use its proceeds only to fund projects "that have environmental and/or social benefits," including "dedicating financial capital, know-how and expertise to meet global health challenges facing underserved patients in need of reliable access to quality medicines and vaccines at affordable prices." (Also energy-efficient buildings, why not.) On the naive view you might think that providing reliable access to quality medicines and vaccines at affordable prices would be the basic business of a drug company, but in fact it is a weird add-on marketed to a niche audience. This sounds like I am criticizing Pfizer, which I am not. I am happy to believe that Pfizer believes itself to be in the business of providing access to medicines, and that it thinks of all of its spending as being devoted to socially beneficial goals like curing disease. It would have happily raised $1.25 billion for general corporate purposes with no limits on how the money was spent, and then it would have happily spent that money on good disease-curing stuff, but it saw the market opportunity and realized that it could access low-cost funding from a particular investor niche by putting in the only-on-good-projects limitation. "If investors are willing to accept less money for financing beneficial projects, and if we do beneficial projects anyway, it costs us nothing, and we should hit that bid," Pfizer could reasonably have thought. The weird thing here is the market segmentation, the odd assumption that normal bonds fund evil projects and if you want to fund good projects you have to say that explicitly. Elsewhere in green bondsSometimes you agree to a green covenant and then have second thoughts: Eskom Holdings Ltd., South Africa's biggest air polluter, is seeking to have the terms of a $3.75 billion World Bank loan changed to avoid spending money to cut emissions from one of its largest power plants. The 2010 loan is being used to partly fund the construction of the 4,764 megawatt Medupi coal-fired power plant east of Johannesburg. It contains a "legal covenant" that Eskom must install so-called flue-gas desulfurization, or FGD, equipment at the plant by 2025 to curb emissions of sulfur dioxide, according to the World Bank. … Eskom, which is owned by the government and produces almost all of South Africa's power, is struggling to service 454 billion rand ($25 billion) of debt and says the equipment would cost 42 billion rand.
In general, if you are a company and you decide that you can't or don't want to comply with the covenants in your debt, you approach your lenders and ask them to amend or waive the covenants. They ask "what's in it for me," and you make them an offer. Sometimes the offer is more of a threat, like, "if you don't amend the covenant, we will default, and then there will be a huge mess and you won't like it." Other times the offer is like "we'll pay you a one-point amendment fee and add some collateral." It is generally an economic offer: More money, or a greater likelihood of getting paid back, or some combination. If you decide that you can't or don't want to comply with the green covenants in your green debt, though, it's a little weirder. "We'll pay you an extra 25 basis points to let us pollute" is … sort of a strange offer to make to a green investor? Or to the World Bank? They're gonna look bad if they accept that deal. Instead Eskom is offering a sort of environmental amendment package: Eskom argues that in addition to being expensive, the equipment would increase water consumption, necessitate the use of large quantities of limestone and produce additional carbon dioxide, a greenhouse gas. Some of the money saved could be used to adapt some older, coal-fired plants to use other fuel, it said. "Installing FGD at Medupi may reduce the impact on health by a small margin, but it will result in other negative environmental impacts," Eskom said.
I have no idea if that's right, and obviously Eskom has some self-interested reasons to say it, but I guess that is how you have to negotiate environmental covenant amendments. Elsewhere in Covid projectsOne pet theory that I have is that investors in drug companies should be rooting for those companies to quickly develop an effective cure or vaccine for Covid-19 and then roll that cure out widely and at low cost. This will not be particularly profitable for those drug companies, but their investors should be happy anyway, because those investors also own lots of other companies, and those other companies' revenues have all been smushed by the pandemic, and if there's a vaccine then everything can go back to normal. If 10% of your portfolio is in drug companies and 90% is in everything else, curing the pandemic will be so good for 90% of your portfolio that you just won't care if the drug companies lose money. This is a rather non-standard theory, but there is some empirical support for it, as big institutional investors have urged drug companies to work together on a cure and not worry too much about profits or competition or patents. But I cannot deny that a lot of investors take a more traditional view of the desirability of profits. For instance: Larry Robbins, who runs health-care hedge fund Glenview Capital Management, is avoiding bets on possible coronavirus treatments, partly because he expects researchers to find a vaccine, limiting the need for even the most effective treatments. "We are all cheering for a treatment on a humanitarian level, but as an investor, you have to believe a treatment works, and that sales last long enough for it to have a material impact on a company," he says.
To be fair if you are a health-care hedge-fund manager you don't have the same motivations as a broadly diversified institutional investor; he really does have to pick the health-care winners rather than maximize the value of public companies as a whole. Fortunately there are a lot of broadly diversified investors out there, and they tend to be near the top of many companies' shareholder lists. Still, here's this: Gilead is among the stocks that has investors thinking twice. The company expects to manufacture more than one million treatment courses of remdesivir by the end of this year, and the drug could have billions of dollars in new annual sales, investors say. If Gilead can develop an inhaled version of the drug or other alternatives to receiving it intravenously, its popularity could increase, bullish investors argue. But Gilead has promised to donate 1.5 million doses of Covid-19 treatments to hospitals free of charge, and the price it would charge thereafter is unclear, raising questions about eventual profits.
Gilead Sciences Inc.'s biggest investors are Capital Group Cos., Vanguard Group, BlackRock Inc. and State Street Corp., gigantic institutions that own huge swaths of stocks. They'd better all be calling up Gilead and saying "we have absolutely no questions about eventual profits, just find a cure and give it to everyone." People are worried about bond market liquidityHere is one worry about bond exchange-traded funds that was very popular for a long time. Bond ETFs are liquid instruments (you can trade them instantly, electronically, on a stock exchange), but they are made up of underlying bonds that are less liquid (they trade over the phone, with banks, less reliably). In ordinary times you can easily buy or sell ETF shares, and they are closely linked to the price of underlying bonds through an arbitrage mechanism: If a lot of people buy the ETF shares, arbitrageurs will buy the underlying bonds, deliver them to the ETF sponsor, get back ETF shares, and sell those shares to the investors who want to buy them. When liquidity in the underlying bonds is good, this trade is easy, the ETF is a good substitute for bonds, and everything is good. But, the worry goes, in bad times, everyone will want to get out of their bond ETFs. They will all sell at once. The arbitrage will work in reverse, and the arbitrageurs will have to sell a bunch of bonds. (They're the ones buying the ETF shares from investors, and if there are no buyers for the ETF shares they will deliver them to the ETF sponsor, get back the bonds, and sell them.) In bad times liquidity in the underlying bonds will be bad and it will be hard to sell the bonds. So the arbitrageurs will have to sell the bonds at fire-sale prices, pushing down the prices of bonds and also of the ETF, leading to more redemptions and spreading contagion throughout the bond market and the financial system. Because ETF investors are too used to liquidity—the "liquidity illusion"—they will, in bad times, create too much selling pressure in the bond market, leading to huge losses. That was the worry. In broad strokes it sounds a little like "if people want to sell bonds the price of bonds will go down," so I was never that impressed by it, but you can see the idea. If you pile a lot of flighty investors into a crowded trade, and then they can't get out when things go wrong, that can be a problem. Bloomberg's Claire Ballentine and Katherine Greifeld had a story yesterday titled "Bond ETFs Survived Their First Big Crisis," which is the best overview I've seen of how bond ETFs performed during the volatile trading of the past few months. As the headline implies, and as we've discussed several times before, they generally performed fine. But here I want to highlight one thing, which is that that popular worry about fire sales was totally wrong in a particular, simple way. The fire sales of bonds that everyone worried about never happened, because the arbitrage mechanism didn't work in reverse. People wanted to sell their ETFs, and instead of arbitrageurs stepping in to buy the ETF shares and sell the underlying bonds in a crashing illiquid market, the arbitrageurs instead … did not do that: In the underlying markets that the ETFs track, trading essentially froze in many debt securities. That spooked the specialized traders—known as authorized participants—who normally keep a fund's price aligned with its net asset value. Typically, those market makers will buy shares of a falling ETF to redeem in return for the underlying bonds, which they then can sell. That process reduces the number of shares outstanding and keeps the ETF in lockstep with its holdings. But in March appetite for that arbitrage trade soured as those traders became wary of getting stuck with hard-to-unload bonds. "They're not doing this out of the goodness of their hearts," David Perlman, an ETF strategist at UBS Global Wealth Management, says about the authorized participants. "They don't jump in until they think they can execute the redemption and make a profit from doing so."
If you invest in a regular bond mutual fund, and you want to sell your shares, what you do is you sell your shares back to the mutual fund. The mutual fund can't easily say no; if you're selling, they have to buy, at the net asset value of the fund. They don't have tons of cash lying around, so if you redeem your shares they have to sell bonds to raise the cash. If enough people do that, fire sale, etc. But if you invest in a bond ETF, and you want to sell your shares, you cannot generally sell them to the fund. You sell them in the market, on the stock exchange, to some anonymous buyer. The arbitrage/authorized-participant mechanism connects your sales to the fund: If there are more sellers than buyers, some arbitrageurs will step in to buy, and will then redeem their shares by handing them to the fund, getting back the underlying bonds, and selling them. But the arbitrageurs don't have to do that. They could just not do that. Instead of buying your shares and handing them in to the fund and getting back bonds and selling them in an illiquid market, they could turn off their computers and go home. That's what they did. This had two effects. One, it caused ETF prices to be low—lower than they'd be if arbitrageurs were buying lots of shares, and lower than the indicative net asset value of the ETFs. If an ETF had bonds worth $90 per share, and arbitrageurs did not want to do the arbitrage (buy ETF shares for $90, hand them in, get bonds worth $90, sell the bonds for … $80? … in a falling illiquid market), then there would be fewer buyers to support the price, and the ETF would trade at $85 or whatever: The record volatility that plagued U.S. bond markets in March led to share prices of bond ETFs trading at deep discounts to the value of their underlying assets. … Some of the hardest-hit were the Vanguard Total Bond Market ETF, or BND, and iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD. In one notable example, on March 12, Vanguard's BND was down 3.8% year-to-date, while its mutual fund counterpart—the Vanguard Total Bond Market Index Fund—was up 2.7%. The prices have since reunited, with both funds up about 3.7% so far this year as of May 11.
Instead of selling to an arbitrageur who kept the ETF price close to its net asset value, you'd sell to someone else. A deep-value investor trying to buy the ETF at a discount, or a market maker willing to buy it at a very wide bid-ask spread, or whatever. There'd still be a buyer—just like in the market for regular stocks, trading never vanishes, prices just drop—but the price would be lower than the net asset value you see on the screen. The other effect, though, is it caused the bonds not to be sold: Instead of ETF sales leading to arbitrageurs dumping bonds in fire sales in an illiquid bond market, some ETF sales simply had no effect on the underlying bond market.[3] People who didn't like bond prices sold their ETF shares, people who did like them bought them, and no one traded the underlying bonds. The trading was focused on the liquid easy electronic market, not the bad illiquid fire-saley market. In fact it's even better than that: As we've discussed before, the ETF market was so much more appealing than the bond market during the chaos of March that there were inflows to some bond ETFs. As ordinary investors were dumping their ETF shares to flee from bonds, the arbitrageurs were actually creating new ETF shares, buying the underlying bonds to deliver to the ETF sponsors to get more ETF shares. This was even though the ETFs were trading at a discount to the underlying bond prices: You'd have to buy $90 worth of bonds to get $85 worth of ETF shares. Why was this happening? The simplest answer seems to be that the ETFs were easier to trade than the bonds. If you happened to have $90 worth of bonds that mirrored an ETF portfolio, rather than selling them in a falling illiquid market and getting $80, you might want to pop them into an ETF, get back ETF shares, and sell those for $85. This all strikes me as very good. There are tradeoffs. The main tradeoff is that the arbitrage mechanism is imperfect, ETF prices do not always track net asset value, and sometimes if you want to sell shares of your ETF you will get back less than the NAV. I think there is a good case that this is because the ETF's market price is right and the NAV is wrong: In my stylized example, where the stated NAV is $90 but you'd only get $80 if you had to sell the underlying bonds, it is a little silly to say that the value is actually $90. We have discussed a Bank for International Settlements paper along those lines, and here are Ballentine and Greifeld: "ETFs were actually showing the true value of where fixed income was priced real time," says Will McGough, chief investment officer of retirement strategies at Stadion Money Management in Watkinsville, Ga. "Because the bonds don't price themselves—they only price when they trade—they [ETFs] were effectively the supermarket for pricing bonds for a week or two."
But the "value" of a thing in an opaque and illiquid market is a little subjective, and if you want to complain that bond ETFs traded below their real value in March, you should feel free. But the good news is that ETFs are not papering over the true illiquidity in underlying bonds; they are replacing the underlying bond illiquidity with a new, liquid, market. One way to think about it is that ETFs are kind of like companies. A company owns assets, factories and offices and inventory and stuff. Its stock trades on the stock exchange. If a bunch of people sell the stock, the price of the stock goes down. But the company doesn't have to go liquidate its factories and inventories. The stock price is related to the value of the underlying assets, but not in a strict mechanical way; no one expects the stock price to exactly track the asset value, and a bad day in the stock market doesn't lead to a fire sale of the company's real assets. An ETF isn't really like that; the arbitrage and creation/redemption mechanisms link the ETF's price to its underlying assets much more closely, and if everyone wants to sell the ETF then that can cause a fire-sale liquidation of its assets. But that's less automatic and mechanical than you might think—certainly less automatic than in a regular mutual fund—and, where a fire-sale liquidation would be especially destructive, it sometimes just doesn't happen. The ETF trades on its own, unmoored from the bonds, unable to hurt them. Things happenNew York Stock Exchange to Reopen Trading Floor. How bank hedging jolted investors into talk of negative rates. Firms That Left U.S. for Tax Reasons Could Qualify for Fed's Aid. 'Stealth Bailout' Shovels Millions of Dollars to Oil Companies. PNC says fears for US economy prompted sale of BlackRock stake. Insurance Firms Plan to Fight Federal Pandemic Liability Proposal. SPAC IPOs are hot. Ghost quarantine. Restaurant using blow-up dolls to enforce social distancing. Coronation St actor Philip Middlemiss wanted over sale of military planes to Ghana. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] I love J.W. Mason's formulation of this point: "People get very excited about China's social credit system, a sort of generalization of the 'permanent record' we use to intimidate schoolchildren. And ok, it does sound kind of dystopian. If your rating is too low, you aren't allowed to fly on a plane. Think about that — a number assigned to every person, adjusted based on somebody's judgement of your pro-social or anti-social behavior. If your number is too low, you can't on a plane. If it's really low, you can't even get on a bus. Could you imagine a system like that in the US? Except, of course, that we have exactly this system already. The number is called a bank account. The difference is simply that we have so naturalized the system that 'how much money you have' seems like simply a fact about you, rather than a judgement imposed by society." [2] Again, on the standard capitalism theory, this is incoherent—on that theory, money is how you measure how much you have made the world better—but that is just one competing theory. [3] I am exaggerating here for effect. I don't mean to say that *no* arbitrage occurred, that no one ever redeemed ETF shares or sold bonds or whatever. I am saying that there was marginally less of it in a way that had an impact on prices, etc. | 
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