High Yield

"They are going to be toast. It will be one of our first levels of shorting the moment we start to see cracks, because it’s ripe with retail, emotional investors."

How the intersection of Fed policy, the post-crisis regulatory regime, and illiquid markets turned ETFs into the new financial weapons of mass destruction.

On Wednesday, Carl Icahn and Larry Fink engaged in an epic debate about the role ETFs play in perpetuating systemic risk. Icahn, taking a page from the Tyler Durden playbook, talks phantom liquidity before calling BlackRock "a dangerous company", and opining that Fink and Janet Yellen are "pushing the damn thing off a cliff."

If yesterday's 10 Year auction priced stronger than expected during yesterday's NYSE-trading vacuum, today's 30 Year was the mirror image, with the Treasury selling $13 billion in 30 Year paper far weaker than the When Issued market had expected, resulting in a 3.084% high yield, a tail of 1.6 bps to the When Issued.

While Carl Icahn's latest ramblings have brought attention to the 'bubble' in high-yield debt, we would note that the HY market has already dramatically diverged from the ongoing bubble in US equities and as we have been discussing for the past year, this is exactly the pattern we saw in 2008. However there is another aspect of the HY market that is flashing red, High yield debt downgrades are the highest since Lehman and the upgrade / downgrade ratio has tumbled to its lowest since the crisis...  The last time this happened, Bernanke unleashed QE3 - are we about to see the same in a massive surprise to markets?

That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances.

Capital should always be allocated to the “marginal cost of capital”. The stock market in its most simple form is really an input–output black box: In goes the “cost of capital” – out comes “profit”. No one can disagree that, over the long- and medium-term, it’s the profit which both explains and drives stocks best. The most profitable companies get the best stock returns... which brings us to the “dilemma” of today’s market: The marginal cost of capital is significantly higher.

“Any of these events would likely trigger asset price volatility [and] attempts by institutional investors to redeem illiquid corporate bonds in crisis circumstances would amplify volatility.”

One recurring pattern that we had noticed months ago, and which had a nearly 100% predictive hit record, was that on auction days when there is a major lack of collateral as evidenced by a negative repo rate, Tsy auctions were stellar. Today, was just such a day, with the 5 Year repo printing well special at -0.85% this morning as ICAP reported. All else equal this would have meant a big scramble to cover shorts into the auction and a high yield well tighter than the When Issued. Only not today. Because for all those who expected the yield to price through the when issued, the result was a surprising 1 basis point tail to the 1.700% W.I., with the auction of $35 billion in 5 Year bonds pricing at 1.710%.

2/2 If more respected investors had warned about the market in ’07, we might have avoided the crisis in ’08.

— Carl Icahn (@Carl_C_Icahn) June 24, 2015

As we move toward the second half of 2015, signs of financial turmoil are appearing all over the globe. Slowly but surely, we are starting to see the smart money head for the exits. As one Swedish fund manager put it recently, everyone wants “to avoid being caught on the wrong side of markets once the herd realizes stocks are over-valued“.

The Fed’s balance sheet grew eight times more rapidly than the economy during the last fourteen years. That’s just the inverse of the relationship that occurred back in the Golden Era. if you need any proof at all of this massive intrusion into the financial system isn’t working; the huge amount of money printing and balance sheet expansion; the unremitting financial repression and pegging of interest rates; look at that fundamental comparison. The only thing it’s really doing is simply inflating the serial bubble that ultimately reach unsustainable peaks and collapse. Hopefully on the third strike, the people who gave us these bubbles will be out.

If I'm a fund manager, the idea that ETFs provide liquidity rests on the assumption that when I experience outflows, someone else will be experiencing inflows and thus I can sell ETFs and avoid offloading my bonds into an illiquid corporate credit market. Put another way: I am depending on new money coming into the market to fund redemptions from previous investors who are exiting the market, all so that I can avoid liquidating assets that are declining in value and that I believe will be difficult to sell. There's a term for that kind of business. It's called a ponzi scheme.