Submitted by Peter Tchir of TF Market Advisors
Two Clear Warning Signs in the Credit Markets
Credit markets have been performing well all year. The returns, while not outstanding have been incredibly consistent. There has been an eerie calm to the market. Most people are bullish on corporate credit - even those who don't like the overall yields argue that the spreads are attractive. That may be true, but two leading indicators of potential trouble in the credit market have popped onto my radar screen.
The performance of recently issued bonds is a good lead indicator for the credit market. These bonds are not performing well any longer and the trading volume is getting very thin. This signal occurs fairly infrequently and is a very good indicator of future credit moves. The CDS indices are trading cheap to fair value and that cheapness is persisting longer than it has recently. This signal sends more false positives than watching recent new issues, but it is still useful when analyzing the downside potential of the credit market. I'm not yet concerned about flows, but there are a couple of small signs showing that flows are slowing if not reversing.
It's getting to the point that it makes sense to sell cash rather than buying CDS as the next leg down should see them move equally; whereas on a rally, the CDS indices in particular will outperform cash as the weak hedges are taken out of the market. In ETF land selling HYG and JNK makes sense or selling LQD vs buying TLH. LQD vs TLH is a reasonable attempt at putting on an investment grade credit spread trade. Going outright short LQD without a rate hedge is more costly and potentially more dangerous - though with treasury yields next to nothing it might not be that dangerous.
Recent New Issues Underperforming
The recent new issue market is performing poorly. I focus on bonds issued in May prior to May 23rd. I don't include bonds more recent than that because they still have too much noise from the underwriters using their net short position on the break to support the bonds. They are also recent enough that underwriters are more reluctant to down bid them. Bonds issued 3 to 5 weeks ago should still be doing fine. They came at a concession to the market and were well oversubscribed at the time. Yet, of the 60 bonds I looked at 42 were trading wider than their issue price and the average spread is 9 bps wider than the 254 spread they came out. These are bonds that were priced at a concession, were oversubscribed, mostly traded tighter on the break, and the underwriter likely started net short. The volumes are declining too. Recent new issues becoming illiquid so quickly and seeing their spreads widen is a great warning signal for the market as a whole. In my sample I only included bonds in the 5 - 10 year maturity range, corporate issuers, and deals of at least $500 million, to eliminate the quirks of the short and long dated end of the credit market, and the potential that small issues were held by only a couple of buyers.
The GOOG 3 5/8's of 2021 are a good example of the performance of these recent new issues. It came on May 16th at T+58. The bonds broke marginally tighter and closed the first day at T+55. These bonds are now trading at T+78 according to TRACE. The volumes have also dropped and talking to T+bond investors it is getting harder to get dealers to make a firm bid for this sort of paper. Traders are complaining that the bulk of the selling interest is coming from these recent new issues and that the client bid side has disappeared.
Why this is a particularly strong warning sign
This is a particularly strong danger signal for several reasons. The most obvious is that these bonds had everything going for them. They were cheap to the market, oversubscribed, the underwriter was short them and had a chance to allocate them as they felt best. When the bonds with so many advantages cannot perform well you have to wonder about the state of the market.
It is also a bad sign because it indicates some potentially weak hands holding too much corporate debt. Some of these bonds went to hedge funds. The funds are often looking to flip out of these for a quick profit, but greed gets the better of them. They have been trained over the past year that the longer they hold onto a new issue, the better the price they will receive. To the extent hedge funds own these because they got caught being too cute while playing the flip, are now watching 'easy' money becoming a loss. They are still ahead of the game YTD on this flip strategy, but they will be the first to get nervous and the first to 'freak out' when they realize how little depth there is to the bond market at any sign of weakness.
The other weak holders are mutual funds who may be receiving redemptions. So far that hasn't started by the looks of the AMG flows, though HY did see a moderate outflow. On the other hand, LQD which has seen a steady increase in shares outstanding saw a sharp reversal the other day. The mutual funds are generally buy and hold and strong hands, but if they face redemptions they will be forced sellers. They will own a decent amount of these new issues because they were receiving inflows and this was one of the easy ways to buy up blocks of bonds quickly.
Why aren't the dealers more willing to take these down? Dealers don't want to bid on any more bonds because they probably provided liquidity one time too many already. Until recently buying these bonds was good for dealers as they could sell them into a client or maybe to the underwriter via the inter dealer market. But once the underwriter was full and clients had moved onto the newest new issues (last week's) they had nowhere to go with these bonds and now hold them in inventory, hoping for a bounce so they can sell them. In the meantime they may have shorted the CDX index to hedge their inventory, which feeds into the other warning sign.
It is not that often that we see this scenario where recent new issues underperform the market on declining volume, and it usually ends up with the market as a whole selling off further.
The CDX Indices trading cheap to fair value is another warning sign
Whenever the credit indices start trading this cheap to intrinsic value there is opportunity. Over time the index and its components should trade in line. There is an index arbitrage community that puts these trades on. My experience is that in a reasonably healthy market, the 'cheapness' collapses fairly quickly, largely with the index outperforming as a short squeeze pushes it tighter and bondholders across the board breathe a sigh of relief that the sell off wasn't real. That tends to happen fairly quickly.
In weaker markets the cheapness exists for longer. The arbs come in and buy the single name CDS from dealers and sell them the index. This should collapse the cheapness just like it does in healthier markets, but it doesn't. Traders are so concerned about idiosyncratic risk that they rush to replace their single name protection. This pushes out CDS, which drives down bond prices, putting more pressure on the index as bond investors and bond market makers both try to buy some protection against their weakening position. In some ways this doesn't make sense, but once you've lived through it a few hundred times you just accept that is how it works.
Right now this cheapness could reverse itself but it feels like we are at the cusp of starting that self reinforcing trade wider. Hedge funds and market makers have been putting on shorts in the index to protect their inventory. Right now the trade is working as the indices are doing worse than their bond or CDS portfolio. They are feeling smart, but they also know that their mark to market on the bonds is dangerous. They can tell how thin the bid for bonds is and they are trying to avoid triggering a cascade of selling. On any bounce in stocks the market makers are screaming at their salespeople to find buyers of bonds. The salespeople are trying to find out what happened to all the clients who swore up and down they would buy any dip or that they were keeping powder dry for just such a moment.
Right now there are few corporate bond buyers, but there are not many sellers so we can stay in this limbo of a liquid but weak CDX index market and an illiquid but seemingly firm cash bond market. In my opinion we are at the cusp of seeing sellers of bonds and that these sellers would spark that cycle of sell bonds, bond spreads widen, buy CDS, CDS widens, CDS is wider so people get scared and sell bonds, making bond spreads wider, causing them to buy CDS, etc..
What could cause a wave of bond selling that acts as a catalyst for spread widening?
Hedge funds are one potential source of selling pressure. As much as hedge funds do have money they could put to work, they are subject to the most frequent mark to market scrutiny and valuation. They are only as good as their last month or quarter. With high yield bonds yielding less than 8%, a 2 point drop in bond prices wipes out 3 months of carry. No matter how much they planned to add bonds during any dip, it is hard for them to resist the urge to protect this month's return. Time and again they will revert from being net buyers to net sellers before any market maker figured it out.
This is particularly true when they are not up a lot, and my understanding is this has only been a marginal year for credit focused hedge funds. They aren't playing with house money like they were in 2009 and 2010 when early gains gave them a lot of extra confidence.
On the more daring side, someone may decide to push the market. They will have received enough calls from dealers trying to move inventory that they decide the market is ripe for a sell off. They will hit a few down bids on some large TRACE bonds. Getting the TRACE print will ensure that everyone has to mark there. They will pick bonds with big outstanding amounts held by weak hands to create the maximum pain possible (many of these are the recent new issues because street and hedge funds are long them). This is more aggressive of a strategy than we are likely to see but highlights how TRACE can actually accelerate the fall in bonds. A bond can TRACE once all day, but that print will drive everyone's closing price and ironically a print that seems too low is more likely to bring out additional sellers rather than buyers in the weird world of corporate bond trading.
Another potential seller is mutual funds. They are at the mercy of their flows. Most are running relatively small cash positions, largely because the return on cash is such a big drag on their portfolio. AMG numbers remain strong for IG funds, but did show a moderate outflow in HY. The shares outstanding for the JNK, HYG, and LQD have been flat to up slightly and stable. I'm not sure exactly what happened in LQD but it had a sharp spike up on the 1st and a big reduction on the 2nd. I wouldn't normally be concerned about small changes in the fund flows or ETF shares outstanding, but every indicator is that the street is caught long bonds and has little appetite to digest more risk.
Be wary of the CMBX and ABX space?
In the 'you never see it coming' category, it makes sense to watch what is going on in CMBX and ABX as I wrote about yesterday. Both of those markets have been under pressure and are at their yearly lows. Although, in many ways they have nothing to do with corporate bonds, you find out they actually do. Once you can no longer sell your CMBX BB's at any price, or you can't stomach locking in any more losses on a AA tranche of something, you look around and short some other market that you feel is correlated but hasn't moved as much. It doesn't usually work, but people can't help themselves and it does tend to drag that 'correlated' market down as it cannot absorb the additional shorts.