The Pricing of Risk
The Pricing of Risk
The most important thing we do everyday at Vertex One
The importance of pricing risk is under-appreciated and often misunderstood. In all endeavors that involve some level of risk, there is an evaluation performed, whether it is a conscious or unconscious decision. The person pictured on the tightrope has evaluated his risk for walking on a wire suspended between two tall buildings. If his evaluation is wrong, chances are it won’t end well for him.
Thankfully, in most situations measuring risk isn’t a life or death scenario, but it’s still important. In the world of finance, careers can be made or lost based on a measurement of risk. History is littered with examples of people that have incorrectly or correctly measured risk.
- MF Global’s Jon Corzine got it wrong betting the firm on European bonds
- George Soros got it right shorting the UK pound
What does a winner have that a loser doesn’t? Is it luck? Was it that they could better measure risk? Banks have made a living measuring risk and anyone who has ever worked for a bank understands that measuring risk is the engine that drives a bank. Mortgage and loan rates are calculated from risk-based models; a blended measure of the risk of default, personal risk, market risk and macro risk.
Unfortunately, many times underlying risk is not fully understood when investment decisions are made. When a Canadian investor buys a US bond, for example, there is exposure to currency risk, interest rate risk and macro risk. For 30 years in Canada, at the end of the last century (1970-2000), portfolio managers thought they were geniuses when they bought US securities and made money year-after-year as the Canadian dollar relentlessly headed towards $1.60 per US dollar.
However, in 2003 when the Canadian Dollar started to reverse trend, many portfolio managers were at a loss as to why they were losing money and what to do about it.
In the world of lending, evaluating risk is perhaps one of the most important tools an investor can have. How do you value capital invested or lent to a start-up company? How would a loan to a friend’s company be priced? Any type of loan should use risk-based pricing to come up with a rate of return. Concordantly, the high-yield bond market does this every day and these rates (yields) fluctuate based on market rates and are usually, much like mortgages, priced off the Government bond market.
Typically, when pricing a high-yield bond a banker will pitch a rate of return to a client and then have to go out to canvas some influential investors. The investors will let the banker know where they would be interested in buying and/or their size of interest at various price points. When the banker thinks he has consensus to the point of being able to build a book, the rate of return gets set. With all the new high-yield issuance this year, our team has been busy looking at a plethora of new deals and attempting to analyze each deal based on its risk/reward. We determine where we think each should be priced based on its associated risk.
Recently, we purchased HD Supply bonds in the Vertex Enhanced Income Fund after management diligently increased sales, restructured debt at a lower interest rate and spoke about an IPO to further right-size their capital structure. This activity led us to re-assess the investment risk and conclude a favorable risk/reward outcome.
With start-up companies it can be more of an art than a science, but statistical logic can still be applied. 25% of companies fail in their first year and 50% fail in their first four years. If you are considering lending money to a new company, you need to factor in the probability of recovery. Failed companies typically don’t have the cash to pay off all their debts. Of course, there is no real tonic as each business is unique in terms of hard assets and cash usage. If the business is asset rich, there might be some recovery for creditors to benefit from and if it is asset poor, there might not be much to recover at all.
Walter Wriston, a former Chairman of Citicorp once remarked “capital goes where it’s welcome and stays where it’s well treated” and there is a lot of truth to that statement. The risk of putting cash in a European bank went up after Cypress put currency controls on their banks and every account over 100,000 Euros was given a crew cut. Since the 2008 crisis, Greeks had been moving their savings to Cypriot banks thinking they were safer than Greek banks. Obviously, they had incorrectly measured risk. At first they were earning 5% per year and thought “this is great”. Through 2012, they continued to make 5% and breathed a sigh of relief, comforted by their savvy investment decision. 2013 arrives and their returns are basically wiped out. Where will the cash go now that European banks aren’t safe – North American banks? Only if investors view the risk as containable and they can effectively measure the downside risk as minuscule.
What occurred in Cyprus happens fairly regularly. Passive investors are lulled into complacency, risk is mis-priced and the market fails to understand the complexities of the risks surrounding an investment. The same could be said of Canadian investors in Asset Backed Paper in 2008. To achieve an extra 30 bps, investors took on additional risk, more than they realized. When liquidity in the market went sour, the ABS paper didn’t pay investors back. Again, the prospects looked great but the risk was poorly assessed.
Pricing risk is especially important in merger arbitrage investing (a core strategy of the Vertex Fund), where small spreads get annualized to produce decent returns, however, if a deal ends up going bad the losses can be substantial. In these situations, the measurement of risk is real-time and its fluid. Every market tick, every piece of news factors into the measurement and requires analysis. In 2012, Nexen went through a soap opera of ups and downs before the deal eventually closed. The Vertex Fund team had to analyze each piece of news and re-price the risk with every new circumstance. An especially tricky task when there was thought that the Government of Canada might not allow the deal to move ahead.
The study of risk can be like the game of golf, something that is never perfect and must always be practiced in the pursuit of perfection. Measuring, pricing and re-pricing risk is the most important thing we do every day on the investment team at Vertex One and we don’t take it lightly. In this game, there’s more than a little sand to deal with when you land in the bunker…
For information on this update or the funds we offer, please contact a regional VP of sales:
(GTA & Western Ontario, Maritime Canada)
(GTA & Eastern Ontario)
(Nationwide Inside Sales)
866.681.5787 x122 or 604.408.5663
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