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Magic in markets can mean danger or creation

Copplestone cartoon Mandos magic 8 Mar 19 230x150.jpg
By Jon Hay
07 Mar 2019

The root of arbitrage is the same thing being priced differently in two markets. As markets have got bigger and more sophisticated, arbitrage has become harder to find.

So when an elephant-sized arbitrage walks into the room it tends to cause a sensation. Vodafone’s £3.4bn ($4.45bn) of mandatorily convertible bonds is one of these rare events.

The perennially ambitious and daring UK telco is getting 100% equity credit (at least from accountants and probably from Moody’s) on two-year bonds that cost it roughly 25bp and 35bp over sterling swaps, plus some hedging charges. Telefonica, in the same industry and rated only a shade lower, paid 411bp over mid-swaps this week to issue hybrids with 50% equity credit.

Why? The two used different instruments, sold to different investors who think about the risks and rewards in completely different ways. There is no regulatory barrier between the two markets — just a schism of investment style and practice.

Can this be right? Is the system being gamed or is someone underpricing a risk? It is right for market participants, authorities and all interested parties to be vigilant and curious in such cases.

But there should not be a kneejerk assumption that something is wrong. Different financial players have different needs and strengths. Sometimes new ways can be found to combine them that produce results never seen before.

Regulatory arbitrage — which this partly is, relying on various parties’ attitudes to mandos, which are a promise to issue equity — can be a forerunner to abuse and disaster.

But sometimes an arbitrage is just the sign of something new. The arb may trickle away as it becomes better understood, or the new technique may become normal practice.

By Jon Hay
07 Mar 2019