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Capital Context Update: Credit Crumbling

Submitted by CapitalContext on 05/23/2011 17:27 -0400

Global growth proxies lost ground as 'stores of wealth' were stable after China, Germany, and France macro data.

Stocks underperformed credit today on a beta-adjusted basis for the second day in a row from a top-down perspective even as HY shifted above 450bps (its widest year-to-date). IG also weakened, led by financials, but CDS in the better quality names managed to outperform with crossover names clearly hurt harder in credit than other quality cohorts.

The message has been loud and clear from us for a while - that credit has been anticipating problems and the last few days has seen a re-emergence of the equity recognition of this as stocks pull back to more realistic relative valuations to credit. Secondary bond selling was significant today also - especially in financials as we suspect macro overlays have been lifted and underlying positions liquidated as fears are not abating.

Overnight saw further macro weakness with China PMI and Germany/France manufacturing which stalled the EUR and dragged our risk basket significantly lower. The interesting point from this is that oil and copper (think global growth proxies) lost notable ground today while gold/silver (think alternate safe assets and stores of wealth) were relatively unmoved (even as the USD strengthened quite significantly).

S&P futures opened low and just trod water for much of the day, staying closely synced (as opposed to last week's divergences) with the equity risk basket we have been tracking. Downgrades in European sovereigns and banks put more pressure on their spreads and that flopped over into US credit.

Credit outperformed stocks across all sectors, on our model-adjusted beta basis, except for financials which saw modest equity outperformance relative to credit. Utilities, Tech, and Energy were the best credit performers relative to equity today.

Up-in-Quality persists in credit and up-in-capital structure is clear.

As a slight change, low beta names in our capital structure context actually outperformed in stocks but underperformed in credit. High beta names were very modestly tighter on average while low beta names were wider. Vol was more balanced between high and low beta than in recent weeks -perhaps post OPEX is claming it down a little.

The bottom line is that our themes in credit are playing out as projected
- up-in-quality and up-in-capital structure. Dispersion is rising which we also suggested as a theme based on positioning short correlation (thanks to the tri-party Financials, Energy/Basic Materials, and Others dislocation and clustering we have seen). Top-down we still see equities as having notable (at least 10-20%) downside relative to credit (and obviously more if we see HY cointonue to deteriorate as it has been recently).

At sector levels, we are jumping the gun a little with this output but we see Financials and Basic Materials as having the most implied upside for stocks (we are using the S&P sector ETFs for our modeling here) and Healthcare, Staples, and Industrials as having the most implied downside in stocks. These are short-term trading signals based on credit, vol, and stock behaviors for each of the sector cohorts. (we know we owe readers a sector wrap with this detail but client commitments have put that on hold until later this week).

The HYG-LQD proxy for HY-IG decompression has slowly gone our way and conviction remains high.

Our HY-IG decompression trade is slowly moving our way (based on the
ETF trade
we put on a couple of weeks ago) as is seen in the chart above (where we use HYG and LQD weighted based on our deltas to proxy this in a more actionable way for individual investors than our typical CDS approach).

The trade we like for our institutional investors is
short IG insurer credit and long IG index credit
as a low cost long vol play on further HY decompression - the correlation between insurers and HY is extreme and largely thanks to their huge undertakings of issuance over the last few years.

It is worth remembering that we have been out of stocks since late April based on our credit-equity TAA (Tactical Asset Allocation model) and feel comfortable with that view both fundamentally and quantitatively still (we will release the white paper on this impressive modeling approach shortly).

So IG has widened back to its 50-day average, HY is well above its and has closed above 450bps for the first time since April 18th and the on-the-run is at its widest close since Dec 27th (so year-to-date). IG was 2bps wider than current levels and S&P was 1257 and VIX 17.7% at that date so it seems only the S&P is really out of line currently on a pure like-for-like basis.

If we use intrinsics (meaning we create indices of the fair-value going back for many years before the index was created based on the underlying components of the index) we can create longer-term more fungible histories to judge strength or weakness by. It turns out that both IG and HY are pretty close to unchanged now YTD. Hy is however dramatically wider than its mid-Feb tights and has decoupled from IG's performance (evident in the chart is the up-in-quality preference). We would not be at all surprised, given the forced preference for risky assets that QE2 post-Jackson Hole overlaid on the world, to see HY back to 525bps shortly and even with the up-in-quality preference and fund flows, IG to break back to 100bps as equity market participants begin to recognize the disconnect between a liquidity elevated asset price (USD numeraire - the US equity market and all commodities) and the DCF value of those assets as growth is lowered and discount rates rise.

HY and IG credit spreads are as good as unchanged YTD but HY is decompressing fast and in a way that signals cyclical change we have not seen since MAR09 lows.

The reason we spent time on this chart and created the hostory is because we hear so much about how low high yield 'yields' are and how that is apparently a positive. The only reason to buy a high yield bond is to capture a higher yield (or capital appreciation should you believe that is possible) and therefore it is the spread over risk free rates that is critical NOT the yield in risk comprehension (something we fear many individual investors fail to recognize). If TSY yields drop further, we will see rates on HY debt drop but spreads will likely widen - both on an empirically sensitive negative correlation to sticky bond prices as well as lower growth fundamentals.

Deflation is the absolute enemy of HY bonds - odd to say that given one always thinks of inflation as the enemy of fixed income - but the fact that assets and liabilities are much closer in a high yield firm means a deflating value of the assets with fixed liabilities will have a larger and larger negative impact on firm credit risk and that decompression in spreads will outweigh any lower growth-expectation that drops TSY yields.
HY credit is clearly signaling worrisome times ahead
as we have been saying for a while and the fact that dispersion is rising also means this is more than simple macro overlays protecting portfolios, this is beginning to be a very discriminatory shift by the investor class away from this good performer.

The fact that today and Friday saw increasing amounts of net selling in secondary bond markets should also raise flags as typically CDS overlays are put in place and then unwound. The overlay has happened (as HY underperformed above) and now the actual underlyings are being unwound (as opposed to the overlay removed as fears die down). Long-dated corporates were especially net sold today (from the buy side to the dealers) and today specifically saw very significant selling in financials overall in bond land (dominated by our majors and USD denominated Europeans also).

European markets underperformed US markets
today with sovereign woes (thanks to the late friday downgrade and overnight;s weak macro data). We are happy to report that SovX and its intrinsic value has resynced at 202bps (having been more than 10bps aprt a week or so ago) - we say happy as we suggested this was what much of the spread compression in individual names was being driven by - index arb and basis trades.

Cash (bonds) and synthetics (CDS) traded side by side today suggesting little uncertainty in general that any restructuring or reprofiling will trigger CDS and keep their relative values in line. Portugal remains very notably cheap in bonds relative to CDS - despite the inverted curve - and offers the most upside for basis traders.

Financials were hammered as a number of greek banks got downgrades with FINSEN (senior financial debt) trading 11bps wider at 156bps and even non-Financials traded 2bps wider at 91bps. This handsome divergence once again helped our triangle trade as with SovX so wide we would expect financials to trade still notably wider than non-financials - even as austerity appears to be setting in and impacting more than just the peripherals themselves.

CEEMEA
sovereigns were all wider today with the exception of Latvia as oil producing states underperformed.

Asia
Ex-Japan (AXJ) underperformed considerably relative to Japan (compressing that spread and helping our normalization trade) as AXJ broke 110bps once again. Australia also followed AXJ and widened 4.5bps on the day - one of its largest single day moves and now trades wide of AXJ as banks underperformed led by Maquaria and ANZ - once again playing to our theme trade of Aussie financials underperforming Aussie corporates in general. Bank of China was also a decent loser overnight in credit space as was Sony on its loss.

Index/Intrinsics Changes

CDX16 IG
+1.88bps to 91.88 ($-0.06 to $100.3) (FV +1.14bps to 89.5) (89 wider - 12 tighter <> 65 steeper - 54 flatter) - No Trend.

CDX16 HVOL
+1.9bps to 149.3 (FV +2.54bps to 149.76) (24 wider - 2 tighter <> 17 steeper - 12 flatter) - No Trend.

CDX16 ExHVOL
+1.87bps to 73.75 (FV +0.79bps to 71.25) (66 wider - 30 tighter <> 47 steeper - 49 flatter).

CDX16 HY
(30% recovery) Px $-0.37 to $101.94 / +9bps to 452.4 (FV +8.33bps to 438.6) (95 wider - 0 tighter <> 32 steeper - 65 flatter) - Trend Wider.

LCDX16
(70% recovery) Px $-0.12 to $101.375 / +3.06bps to 253.06 - No Trend.

MCDX16
+6.75bps to 129bps. - Trend Wider.

ITRX15 Main
+3.81bps to 103.75bps (FV+3.28bps to 105.72bps).

ITRX15 HiVol
+4bps to 140bps (FV+4.19bps to 140.88bps).

ITRX15 Xover
+11bps to 375bps (FV+11.63bps to 362.96bps).

ITRX15 FINLs
+10.75bps to 156bps (FV+7.72bps to 150.13bps).

DXY
strengthened 0.93% to 76.14.

Oil
fell $2.03 to $97.46.

Gold
rose $4.93 to $1517.23.

VIX
increased 0.84pts to 18.27%.

10Y US Treasury yields
fell 1.7bps to 3.13%.

S&P500 Futures
lost 0.98% to 1314.8.

Spreads were broadly wider in the US as all the indices deteriorated. IG trades 0.3bps tight (rich) to its 50d moving average, which is a Z-Score of -0.1s.d.. At 91.88bps, IG has closed tighter on 86 days in the last 615 trading days (JAN09). The last five days have seen IG flat to its 50d moving average. HY trades 8.2bps wide (cheap) to its 50d moving average, which is a Z-Score of 2s.d. and at 452.38bps, HY has closed tighter on 102 days in the last 615 trading days (JAN09). Indices typically underperformed single-names with skews widening in general.

Comparing the relative HY and IG moves to their 50-day rolling beta, we see that HY underperformed by around 4.4bps (or 50% of today's move). Interestingly, based on short-run empirical betas between IG, HY, and the S&P, stocks underperformed HY by an equivalent 8.5bps, and stocks underperformed IG by an equivalent 1.8bps - (implying IG outperformed HY (on an equity-adjusted basis)).

Among the IG names in the US, the worst performing names (on a DV01-adjusted basis) were Toll Brothers, Inc. (+8bps) [+0.06bps], MDC Holdings Inc (+6.5bps) [+0.05bps], and Metlife, Inc. (+6bps) [+0.05bps], and the best performing names were Reynolds American Inc. (-1.5bps) [-0.01bps], Hewlett-Packard Company (-1bps) [-0.01bps], and Marriott International Inc. (-1bps) [-0.01bps] // (absolute spread chg) [HY index impact].

Among the HY names in the US, the worst performing names (on a DV01-adjusted basis) were K Hovnanian Enterprises, Inc. (+51.12bps) [+0.36bps], PMI Group Inc/The (+39.39bps) [+0.29bps], and McClatchy Co./The (+26.7bps) [+0.22bps], and the best performing names were Boyd Gaming Corporation (0bps) [+0bps], Owens-Illinois Inc. (0bps) [+0bps], and Tesoro Corporation (0bps) [+0bps] // (absolute spread chg) [HY index impact].

Among the European IG names, the worst performing names (on a DV01-adjusted basis) were Banca Monte dei Paschi di Siena SpA (+15.5bps) [+0.12bps], Banco Bilbao Vizcaya Argentaria SA (+14.75bps) [+0.11bps], and Banco Popolare SC (+14bps) [+0.11bps], and the best performing names were Rentokil Initial Plc (-7.5bps) [-0.06bps], Suedzucker AG (-0.5bps) [-0bps], and Pearson Plc (-0.25bps) [-0bps] // (absolute spread chg) [HY index impact].

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Tue, 05/24/2011 - 06:17 | 1304405 AUD

Excellent HY & IG graph CC. Are the axes some measure of spread over government debt?

Also, any chance of providing us a graph that goes back long term, as in a few years at least, before the '07-'08 debacle?

Tue, 05/24/2011 - 01:22 | 1304240 Slim

This was a really solid and comprehensive piece. Thank you for positing it and please continue to contribute to the site. THANKS!

Mon, 05/23/2011 - 23:36 | 1304118 sasebo

Does any of this shit produce anything edible? How about toilet paper?

Mon, 05/23/2011 - 21:22 | 1303786 hack3434

Great stuff...Thanks!

Mon, 05/23/2011 - 20:17 | 1303589 Lmo Mutton

Thanks for the explanations.

It is good to see somebody knows what is going on.

Just don't get a hold of both keys and push the red button.

Mon, 05/23/2011 - 20:08 | 1303552 Dolemite

Mon, 05/23/2011 - 20:06 | 1303550 Dolemite

http://deadcatbouncing.blogspot.com/
Equities at a very important crossroads

Mon, 05/23/2011 - 19:39 | 1303451 exportbank

I love how language changes salt to sugar. A big lump of that HY will soon reprofile,

Mon, 05/23/2011 - 18:41 | 1303275 skepticCarl

You explain it so clearly....it's so simple!

But I have just one question....

Should I BTFD?

Mon, 05/23/2011 - 19:27 | 1303395 treasurefish

My bet at The Bernanke Casino is to STFT (Short the Fucking Top).

Mon, 05/23/2011 - 18:48 | 1303296 CapitalContext

Do not BTFD at these levels. LOL.

I hope this post was a little clearer and more useful for you. Please let us know of any specifics where we remain jargon-bound.

Mon, 05/23/2011 - 19:22 | 1303393 malusDiaz

I would like a decoder ring... I can take a guess at what acronyms mean what... but they would just be guesses:

HVOL

ExHVOL

-Perhaps also a 'For the intermediate gambler investor guide." Something about how the spread is more important then the price (if it is). Something that allows the use of this information that I know is valuable that I can't seem to make work in my brain!

I only know is... I BTFD (in silver!).

Mon, 05/23/2011 - 19:45 | 1303483 CapitalContext

Thank MalusDiaz.

HVOL - This is a credit index that tracks the highest vol/spread names from within the IG (investment grade index) - so it is a more volatile IG index and was very active a few years back. Not so much anymore.

HY - High Yield credit (in general I discuss only spreads and not yields). I often use the term HY interchangeably between the liquid index that trades in credit land and the HY market in general.

IG - Investment Grade credit (spreads once again). Again general IG or the index in credit land.

ExHVOL - The lower volatility names left in the IG index when the HVOL (see above) names are removed. This was/is a simple portfolio to trade and is one of the cheapest ways to get basic macro credit protection without cherry-picking aportfolio and facing liquidity issues.

As far as spread is concerned - it is a risk premia. Using price masks that - maybe worth thinking about that when you look at stocks also with their USD numeraire. We create frameworks to compare credit risk premia, equity risk premia, and volatility (and its risk premia) in the hope of finding insights that are not obvious.

If you see spreads increasing/widening then that tends to be BAD - just as we have been discussing for HY credit recently. We recently saw volatilities (options) rising for many investment grade names while their spreads remained flat - this opened up some great 'arbitrage' opportunities to bring them back into line.

Credit and equity cycle together but at times diverge (such as now with management perhaps overconfidently releveraging (adding more debt and raising credit risk) in order to compensate hungry shareholders) but these cycles will ebb and flow and we look to identify turning points to both trading and tactical asset allocation. For now, we are out of stocks as of late April (based on our TAA model).

As far as Silver goes - scares me mate - up or down.

Mon, 05/23/2011 - 18:34 | 1303258 disabledvet

Is your sense "there will be no supply issues vis a vis debt" going forward especially since "interest rates are at historic lows"?

Mon, 05/23/2011 - 19:38 | 1303433 CapitalContext

Given macro risks, bond fund flows will continue, there will be demand - especially in IG in my view. That demand will beget supply as firms continue to use low all-in yields to reduce interest expense and juice EPS (especially as we are seeing FCF and EPS diverging in terms of growth recently). My sense is the concessions are still quite high for anything but the best/safest credit and this will support basis traders and flippers in the new issue market for crossover names. Distressed guys, if there any left, will probably have holes to fill too. My view is that post QE2, banks will step back in to buy TSYs and instigate carry/curve flatteners and this is (as well as growth slowdowns) what we are seeing in the TSY curve as fwd rates are reduced.

The demand in corporates is very evident in front-end financials (extremely steep curves) and HY (same thing) and we have talked in the past about how IG indices in general have seen average durations extend during this extended compression period in spreads BUT HY has been unable to extend its durations meaningfully (in fact it was at record lows until Jackson Hole at just above 3Y!). HY still feels very nervous to us and the ebbing of TSY yields won't do much to encourage real money investors unless we see HY spreads widen notably more (i.e. the reach from TSY to HY bond is better compensated) as we note that while historically the 75% of all-in yields that are currently credit spread is very attractive, it is the sensitivity to de/disinflation (in our view) that is keeping HY players away and making this a more complicated picture - i.e. rates down => spreads up normally BUT when rates ->0/very low then spreads reflexively widen on growth/deflation concerns especially in HY names.

For us to really get a sense for supply-demand imbalance in corporate new issuance, watch concessions (or more simply CDS-implied valuations relative new issues - use VCDS in Bloomberg or your own model) - once that starts to compress then we will see if real money buyers are willing, and also watch HY average durations which we suspect will lose their fizz as investors shift back to TSYs after being crowded out by the Fed for 6 months. Of course this is all moot should we see some exogenous liquidity sucking event such as greek PIKs.

Bottom line - projecting demand/supply here is a guess at best and while we see fundamentals in favor of up-in-quality supportive of IG supply (balancing lower demand post QE2 as rotation back to TSYs might occur), the ongoing reinvestment, demographics, and fund flows seem to support demand here for all fixed income. With HY 3s5s at is steepest in months (and at the top of the channel) we suspect there will be some rebalancing either into longer-dated IG or out completely until some risk premia comes back at the front-end. Looking at TRACE data shows that HY has seen very notable net selling over the last week (in secondary bonds) with the bulk of it in 7-12Y and 3-7Y buckets so clearly the shift is not to extend duration in HY to reach for yield.

Capital Context Update: Credit Crumbling

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