Who Is Going To Buy It?

My post from last week on debt produced some discussion about leverage and the value of arbitrage-free prices. Basically I’m arguing that if leverage (a.k.a. I wanted to illustrate this in a bit more detail by giving a admittedly stylized example. When you are reading this, bear in mind that I’m merely explaining why some extent of leverage is required to produce efficient markets. This shouldn’t be taken as an endorsement of any particular level of leverage, simply as an argument that Wall Street leverage is actually good.

Let’s pretend we live in a global where there is a discrete amount of “real” money that is investable in the short-run. In other words that long-term investors have fully allocated their investments and any change in their demand for investments only occurs in the long-run. We can imagine this sort of like a world of dollar cost averagers who put some collection sum of money aside for investment at the end of each calendar year.

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However during the year, the amount of investable capital is constant. Now let’s assume we’re at equilibrium and the marketplace is perfectly efficient. Suddenly a new bond issue involves market. Who’s going to buy it? Given that investors haven’t any uninvested assets, the only way an trader could buy this new asset is if they sell other property. This can’t work, of course, because if one buyer sells another investor must buy. There’s no available net capital in the machine. Now many readers are thinking to themselves that is a dumb example, since obviously my preliminary assumption doesn’t keep.

We see capital flowing backwards and forwards on a regular basis. Investable assets certainly aren’t set. Consider who accocunts for real money traders. They might involve some property seated in their bank checking account which could in theory be invested, but its obviously limited. They have bills to pay using their liquid money.

Similar to individuals. Mutual funds? Day On any given, they only have what they have. Maybe we can not say that investable assets are literally fixed, but I argue that in the brief run its damn close. Furthermore, real money isn’t heading to respond to relatively small arbitrage opportunities. Let`s say the produce curve is lifeless level at 5%. Let’s further suppose that ABC Corp has bonds exceptional due in 2018 currently trading with a 6% produce. Now ABC desires to sell new bonds which will have a maturity in 2019. What should the produce be?

With a set yield curve, the yield should be extremely near to the 2018 bonds. But if real money has limited excess capital, there will be a supply/demand imbalance here. Real cash shall need to be enticed to generate new capital, and therefore the complete produce should be large enough to do the enticing. Relative yield doesn’t apply. Put yourself in this situation.

You wake up one morning comfortable with your investments when some poor connection salesman calls you up and asks about these new ABC Corp bonds. You admit that some money is had by you in your bank checking account, but are you going to connect up your liquidity for a 6% produce? Depends on your own situation.

Now let’s expose the possibility of fast money. They also have limited capital, but we’ll presume there is also usage of leverage. So back again to ABC Corp. They look to sell new bonds. Real cash is strapped and wouldn’t be enticed unless the yield is 8%. But fast money are able to look new bonds vs long.

2018 bonds with a produce differential that is a lot smaller. If fast money can get 10/1 leverage, a 1% differential earns them a 10% IRR. Or even better, fast money can speculate that once ABC Corp has sold their large relationship concern, the supply/demand picture shall improve. 1 billion in bonds, real money can’t take it down. 1 billion bonds in smaller chunks at a tighter pass on. Fast money would therefore take the bonds at 6 Maybe.25% and sell them off at 6%. That would be about a 2% price gain. At 10/1 leverage, that is clearly a 20% IRR.