Capital Context Update: Lonely Leaps and Virtuous Cycles

From Capital Context

S&P futures closed with up today but gave back most of their gains as they reverted back to risk asset fair-value into the close.

HY and IG closed off their tights of the day but not as much as stocks did. However, credit did not benefit from the surreal need in S&P futures to buy 30-40k contracts at around 3pmET that was unable to break above and hold the 50DMA.

Our risk basket shows this lonely leap as S&P futures jumped notably away from every other asset class, only to settle back towards the close and while top-down equities outperformed stocks still, the momentum was not healthy at all. Top-down and bottom-up, today had hints of window-dressing as opposed to trend rotation.

There was very significant net selling in secondary bond markets today, more than we have seen in a while. The fact that pretty much every sector saw significant net selling (except Consumer Cyclical and Industrials which were pretty much perfectly balanced) is unusual and on a day of decent volume too but we suspect much of it was rotation into new issues.

The size of issuance once again was high and likely accounts for much of the rotation into the new issues - highlighted by the clear switch volumes in HPQ today (i.e. selling down existing securities to make room for new issues). They issued a shed-load of debt (a technical term) and as a highly rated firm they did well but still we indicate that concessions remain a little generous. The 5Y issue came around 10bps ($0.5) cheap to CDS-implied levels - though not astounding, it is plenty for basis traders to leverage at such low absolute spread levels (60-70bps) and plenty to entice managers to try and extend the self-fulfiling virtuous liquidity cycle we saw in 2009 (more below).

Bottom-up we see low beta names underperforming high beta in stocks and credit today (with low beta names actually net down in stocks on average). Both high and low beta names on average saw spreads widen but the mix was pretty balanced with 52% of CDS wider, 37% of stocks lower and 65% of vols higher in our capital structure universe.

Aggregated at the sector level, only Consumer Noncyclicals saw credit outperform equity on a beta-adjusted basis. Energy and Basic Materials topped the tree (or bottomed the roots?) as equity relatively outperformed credit on the day. Utilities and Transports were among the weakest credit sectors overall as Consumer Noncyclicals and Capital Goods were the best (their spreads compressed the most on average on the day - though still only modestly) as only Consumer Noncyclicals saw an average stock price drop in our universe.

On the day 49% of all equities were divergently positive relative to their credit spreads - somewhat unusual - making us wonder if combined with that odd surge in futures late in the afternoon if we didnt see some sizable window-dressing in equity land take place - pre-empting the pre-empters as it were. There was little theme to the relative outperformance of equity over credit across the quality spectrum and in general equity's relative outperformance appeared more systemic than idiosyncratic - again helping to persuade us that today was not so much a regime rotation back into stocks as a potential window-dressing pop.

After three days in a row of equity underperformance, equities managed to just edge credit spreads on the day but the marginal change was very minimal at best as actually HY and IG moved pretty much in sync with what we would expect from their rolling betas. What was notable (again) for me was the decompression in 3Y HY spreads once again - we had reached the upper level of the 3s5s channel and we think there is plenty of room for that to flatten from here. We also note that IG 3s5s flattened but the longer-end steepened.

Very briefly on a tangent, we remind readers of the reflexive chasing of tails
(the virtuous cycle of bond-CDS curve-new issue demand)
that was evident in 2009 may perhaps be playing out a little here (but we suspect with a lot less juice and fervor given where levels of risk premia are now). This simple circle of life as is evident from the chart above, that we grabbed from a DEC09 presentation we gave, indicates the need to risk manage curve steepeners and their roll-down.

The virtuous liquidity cycle of corporate credit.

The inevitable concern that we are seeing in front-end HY played out then and in a decision to manage the risk - the decision to add more risk by refinancing firm's debt was actively taken - this implicitly lowered refi risk, lowered short-term spreads, steepened the front-end term structure and helped the curve steepener profit (or loss) in turn. The supply of new issues was satiated by these curve steepening risk managers and also by basis traders who not only rode the momentum (as a steeper curve can help that trade) but also picked up valuable carry in an environment when spread/carry is becoming a more important part of total performance.

We will discuss this in more detail later in the week but for now we want to reiterate now, what we said then, would be the
likely stallers of the wall of liquidity
that this virtuous cycle seemed to provide. First a rise in vol thanks to
Fed exit strategy fears
/uncertainty (end of QE2, Reverse Repo chatter). Second,
compression in the spread/yield ratio
(if we see TSY yields rise post QE2 which many - not us - presume) will reduce the attractiveness of this strategy. Third, a
compression in the Cash-CDS basis
(which we are seeing everywhere) will reduce demand for this strategy since it removes some upside. Foruth, a
slowing in momentum
- which we are seeing as both IG and HY curves are extremely steep and have been starting to lag. Fifth and finally,
event risk
concerns which are clearly magnified in our view currently.

We hope this provided some color on what is going on in corporate credit land and what to watch for signals that this virtuous circle may ebb away.

At 9bps, the short Aussie banks vs long Aussie corporates trade seems attractive given the housing debacle unfolding downunder.

Late in the day, Australian loan delinquencies jumped to record levels and we remain strongly convicted of our Aussie Banks vs non-financials trade - which at 9bps seems like one of our low cost long vol trades. 30-day delinquencies rose to 1.79% according to Fitch and we suspect there is more to come here - confirmed by region after region of confirmation of burst bubbles in housing and the imitable Steve Keen's great writings.

On a much more somber note, our condolences go to Mark Haines family. We always enjoyed being interviewed by him and saw him as one of very few real truth-seekers in the financial media community.

Comments

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The risk basket was a bit of a cluster fuck in the last two hours, but at least correlations were high enough to keep the faith. We live to fight another day