See here for this letter of 29 June (but only just published) from Andrew Bailey, Governor of the Bank of England, to Mel Stride, chair of Treasury Committee, in reply to Stride’s letter of 10 June with questions following on from the Treasury Committee evidence session on 20 May.
It really is the most astonishing thing I have ever seen coming out of the Bank, and there is material for many posts. But I will start with the weirdest one.
Stride asked (question i) whether, if falls in asset prices were liquidity driven, “would it not be the case that an investor with a long time horizon would buy these assets in the anticipation of certain, or near certain future profits?”
The insinuation is that if the falls in asset price are certain to be reversed, then speculators could be 100% confident of making profits over the risk free rate, which is interesting because it contradicts efficient market theory, which maintains that there are no certain profits over the risk free rate. The Governor replies:
Through the MA, Solvency II recognises that UK life insurers will not be forced sellers of the assets used to back annuity liabilities and can therefore ride out short-term fluctuations in asset prices. UK life insurers also hold capital in the form of Own Funds to cover their SCR which protects them from the risk that what was thought to be liquidity-driven falls in asset prices turns out to be credit-driven. Other investors with a similarly long investment horizon, and with similar access to long-term secure funding, could follow a similar investment strategy. Such investors could, in some cases, expect to make increased returns by forgoing the ability to realise an asset’s value at short notice. (My emphasis.)
Congratulations to Governor Bailey for a major intellectual breakthrough. Some of the returns on assets in excess of the risk-free rate are themselves risk-free. The term ‘risk-free’ now takes on an entirely new meaning. Admittedly, you have to wait, because ‘in some cases’ investors can be certain of profits in excess of the risk free rate, although not ‘at short notice’. The point is that you can get rich, but not get rich quick.
But hang on a moment. It seems completely to have passed the Governor by that an issuer can have issued short term bonds as well as long term bonds, and that if the issuer is in trouble the price of both bonds will fall. See the chart above of for the price of the International Consolidated Airlines Group 0.625% bond maturing November 2022, currently struggling at 80. If the issuer – the owner of British Airways and a few other major airlines – does not default by then, it looks like it is one of those ‘cases’ where we can get rich by buying at 80 and getting 100 back soon afterwards. What could possibly go wrong for the owner of an airline in a crisis that led air travel almost to stop?
And November 2022 is nothing like a long time horizon. So Bailey has challenged the whole underpinning of efficient market theory: every time a bond falls in price, look for the bond with the shortest date issuance of the parent, buy it and you will be sure to make a fortune when it matures at 100. Not only can you get rich, you can get rich quick.
More to follow.