Capital Context Update: Bond Breadth Bad

From Capital Context

IG, HY, and S&P futures may look comfortably in sync intraday but on a beta-adjusted basis, credit is in a far weaker context.

While stock indices handily outperformed credit (and risk assets in general) today on a close-to-close basis (for the second day-in-a-row), the tension in the credit markets is rising as weakness in low beta credits, gaps in high-yield credits, bond's performance relative to CDS, and credit performance relative to stocks all confirm fears are growing.

The chart above shows that equity and spread markets tended to move generally in sync today - which is relatively normal by the way, it is the goings-on among the index components and the context that is very different as HY ended the day marginally wider (though as we discuss below, major changes in internals intrday), IG very marginally tighter, even though stocks managed an almost 1% gain - admittedly on one of the lowest volume days of the year (and on the day when stock futures roll).

Longer-term trends are weak overall for bond trading volumes but the last month has seen a dramatic divergence as HY was shunned.

IG outperformed HY and demand for investment grade bonds was impressive (evidently enough to not warrant trying for the 30Y auction today with its ugly tail) and short- and medium-term breadth and volume differentials between high-yield bonds (very weak) and investment-grade bonds (positive) are increasing (this is bad from a risk appetite sentiment perspective).

It is worth digging into the internals a little in secondary bond land as they are notably supportive of many of our theses with regard to risk appetite and the credit cycle (and inevitably the business cycle) - more on this below.

LQD eked out a small outperformance of TLT on the day while HYG outperformed overall though saw a dramatic derisking late on.

But first a slight sidetrack - we get many questions from our individual and professional investor clients with regard our discussions of implementing strategies in and out of OTC (CDS/vol markets) and as you know we have designed several ETF-based alternatives that function as decent proxies for debt-equity arbs and credit spread directional views. The reason we bring it up specifically is that
today saw a fascinating shift across the most liquid equity and bond ETFs
.

Hopefully, it is self-evident from the chart that LQD's performance is in a huge part due to interest rate performance overall (TLT in this case for example) while HYG's performance is much higher beta to SPY's performance. This is not news but should be borne in mind by those who look to 'bonds' for safety.

This is the cornerstone of many of our (and the industry's) capital structure models -
the comprehension of the change in relative exposure to interest rates and asset values (think equities for simplicity) as firms become more or less risky
. This is why we discuss credit spreads most frequently rather than yields since the rate-component of the yield is a very different beast than the risk premium (the spread) which is really the main decision investors should make when considering buying different styles of bonds (huge oversimplification but I think the point is clear).

This understanding is as important now as it has ever been as the relative size of the spread component of the yield from bonds is large since interest rates are so low (we would chart this for you but this is already going to be a chart-heavy post so for now - believe it). The reason to bring this up is that
buying or selling HYG and LQD is very much a slightly levered bet on either rates/safety or risk/equities unless you manage the 'other' risk away
- i.e. trade LQD against IEF or TLT, trade HYG against LQD, trade HYG/LQD/TLT against SPY instead of more naked exposure.

However, we do believe currently that a short HYG position has an acceptable risk-reward (since its beta to equities is so high and duration sensitivity to rates will drop as spreads widen
- a much longer discussion that we have had before - and are happy to discuss with institutional clients). We commented recently that based on the relative vol in HY and equity markets, we would
expect realized vol to ramp up much more significantly in HY (than stocks) in the short-term
and this (as much as every fundamental, internal, relative-value, and flow factor we have given you for the last few weeks) provides some comfort for this view.
We still prefer our HYG-LQD trade
(which was down modestly today but remains comfortably positive since inception (note this is +1.2x LQD vs -1xHYG) but for those who are even more directionally negative we
prefer short HYG over short SPY
.

The Advance-Decline line for HY bonds has been trending down for much of the last year while IG bonds have seen relative demand all of 2011.

Having mentioned bond market internals earlier and indicated how volumes are diverging, we wanted to take a step back and look at
longer-term internals from an advance-decline perspective for secondary corporate bond trading
. The time-series is noisy, as you can imagine, but if we look at trends over rolling month-long periods, we think it becomes very clear what the general perspective is - risk appetite is waning!

There are many more IG bonds than HY bonds (especially at the end of this cycle as we are now), but it should be apparent from the chart above that medium-term trends in
the Advance-Decline line for IG and HY bonds has been very different for much of 2011
. If you squint
the two 'smoothed' series have tended to have a relatively high correlation (at least from an up/down perspective if not size-wise) but what we want you to pay attention to is the last month or so.

It is very clear that the two series have diverged - the green HY line - is dropping fast as slowly but surely an overly-stuffed buyside (and dealer inventories we would guess) try to cover; while the blue IG line has seen demand picking up as safety trumps return and investors start to value capital preservation (remember how little movement one needs in a stock to wipe out that so-called protective dividend we are told is so important).

So summarizing
, we have seen very notable spread widening in HY bonds and credit derivatives (more so the latter for now but more on this below), widening in IG bonds (but some stability in price/yields as rates hav dropped protecting them for now), considerable trends lower and lower in bond trading volumes (the amount of new issuance and the
virtuous cycle
we have been so vociferous about may also be a factor), and major shifts in bond market internals as advance-decline lines show a significant change in risk appetites.

Add to this
the fact that cash levels are low in bond mutual funds (underperformance and the herd mentality is a scary thing), retail exposure to the big bond ETFs (we suspect we will see major 'outflows' from HYG for example which today's action hinted at), growing chatter among our broker clients that 'selling' is picking up (remember its hard/expensive to short corporate bonds - hence CDS) and liquidity is low, and
today's dramatic moves intraday in indices relative to their intrinsic values (we'll explain below) makes us very nervous
.

We have discussed the skew in credit indices for a few weeks now and how it has stayed high and higher for a more extended period than normal. The
skew measures the difference between where the index trades and where the underlying components of the index say it 'should' trade
. In equity-land, this seemingly obvious arbitrage is taken care of my a trillion algos; however, in credit land, where liquidity is less, bid-offers wider, and nuances between single-name and index structures can be important, this does not happen quite as automagically.

However, it should not trade wide (i.e. the index should not trade too far away from its 'fair-value') for long since the arbitrage is very possible (especially among the larger hedge funds). We track the skew very actively both day-to-day and intraday (with real-time CDS) as an indication of where flows are occurring, if demand is macro/liquidity or micro/hedge, and so on. The point of this background is that
understanding index moves in the context of their fair-value is very important and today's move intraday was a clear signal from our perspective.

As the HY index tracked stocks higher (as seen in the chart above) dragged their by many a dealer desk simply re-racking on the back of S&P futures moves - it seems professionals took advantage of this to finally start to 'protect' their individual positions as opposed to a blanket overlay. Typically when 'stress' occurs, managers will reach for the closest (and most liquid) thing they can find, to hedge - even if the basis (noise/uncertainty) is high - better some than none where hedging is concerned. Again typically this 'stress' will unfold and de-stress and the hedge can be lifted leaving their pristine long bond portfolio safe and unharmed.

The HY skew compressed dramatically today as single-name protection was aggressively bid while the index tracked stock indices.

However, the blanket demand for index (macro/overlay) protection as a hedge has lasted a while (skews have remmained elevated for longer) this time and given all the concerns we outlined above in terms of underlying liquidity, underperformance, and breadth (which is not unnoticed among some), managers have/will grow increasingly concerned that the MtM on their bonds (or long credit positions) is not 'true' and while the hedge may be working the exit costs of their individual positions may well be much more than they expected.

We think today was the beginning of that realization - (that perhaps selling/hedging individual exposures as opposed to managing the basis in a macro hedge is a better trade). The chart above was created in the middle of the day when the skew massively compressed in HY land. At one point the index was 13bps tighter while the fair-value of the index was 8bps tighter (close-to-close) and the skew therefore had almost closed. The proximity of the CDS roll (June 20th) certainly encourages some index arb but given the behavior in secondary bond markets also today (HY net buying was very marginal) and breadth in single-name CDS,
we believe there was more than just a large arb as professionals sold into the strength today
. By the close, the HY index had sold back off into the close (first chart above), HYG also sold off very hard (compared to stocks in the third chart above) which actually provides some reflexive comfort to our view of what happened intraday as traders started to sense the derisking.

Among the other minutiae of the day
we saw 3s5s flattening (the steep front end of the curve starting to reprice as risk seems back), CMBX tranche prices inched higher but the relative performance of junior vs senior was again more of a systemic concern, ABX tranche prices were lower as older vintages and more senior underperformed (again more indicative of systemic concerns in real estate), PIIGS CDS blew wider still (Greece 5Y > 1500bps) and SovX broke back above 200bps, USA risk rose 2bps (above 50bps) perhaps in sympathy with the ugly 30Y tail, European financials SUBs (+25bps in last 2 days) majorly underperformed SENs getting above 275bps, European financials (2bps wider) underperformed non-financials (which were 0.5bps tighter), US financials underperformed non-financials (and insurers are now at 2011 wides and +25% from their Feb tights), credit curves flattened in REITs and homebuilders, and mortgage-sensitive HY names (insurers and monolines) underperformed notably (not helping off-the-run indices at all today).

All-in-all, not a lot to cheer about (as
every credit sector was wider on average
) - even if headlines will crow of the break in trend of down-days in stocks as Transports, Financials, and Energy sectors saw credit underperform stocks by the largest degree (beta-adjusted) and Utilities staying relatively in sync - even as low beta underperformed high beta in credit (that low cost protection basket and single-name cover seeming too good to turn down - even with the roll coming).

Comments

[Paul Thomason]

This is wrong.  Technical analysis 101 says bonds are in a bullish technical trend and until otherwise advised the trend is up.  Good luck shorting bonds if you choose to listen to this 'advice'.

[bond trader]

My take away is that he is not addressing the overall direction of bond prices , but the direction of the spread product prices versus treasuries. I agree with his analysis even though some of it is over my head. 

[teotwawki]

long bond yield at 42 think that was the low.................................

[teotwawki]

Nice exhaustion gap a few days ago, maybe gross will finally feel vindicated.

[teotwawki]

I think tlt has topped for now along with all the other shit bond funds.