High Yield

US equity markets were the first to move yesterday on the news of the tapering which is a loosening and not a tightening move by the Fed. Overnight and today has seen stocks stabilize as the rest of the world wakes up to what this slowing of flow actually means... From EM FX to precious metals to colossal flattening in the US Treasury term structure, things are making major moves...

If yesterday's large tailing 5 Year paper sale exhibited some curious ESP ahead of the FOMC's tapering announcement, with a very ugly tail, and atrocious internals, then today's 7 Year was quite aware of what was coming. Which is why it was not surprising that the just concluded sale of $29 billion in belly-buster bonds, once again came with a flopping 2 bps tail, pricing at 2.385% or 2 bps wider of the 2.365% when issued, indicating the hiccups in the auction process continue.

Strategists were largely wrong about the yes taper in September, and then they were just as largely wrong about the no taper in December, and yet their opinion is just as largely gospel and people continue to listen to them (what else is there to be distracted by in a still very much centrally-planned market and economy). Which is why the below summary by Bloomberg of what global financial strategists and investors, also known as "they", are saying about how to trade assets in the post-taper world, should probably be taken, largely, with a grain of salt.

If Yesterday's 2 Year auction was strong to quite strong, with a soaring Bid to Cover and a yield stopping through the When Issued, today's 5 Year auction of $35 billion in 5 Year paper was ugly to very ugly. With a When Issued trading at 1.578% at 1 pm, there appears to have been an air pocket at the time of pricing, which concluded at a high yield of 1.600%, a rather massive 2.2 bps tail, and a surprising outcome for auctions on this side of the belly. Additionally, this yield was just shy of the 2013 auction highs which hit 1.624% at the peak of Taper Tantrum mania in August. Furthermore, while Bids to Cover in the short end of the spectrum have been steadily rising in recent months, today's auction saw a pronounced drop in the BTC from 2.61 to 2.42, the lowest since August, and well below the TTM average of 2.67. But the real story was in the internals, where Directs took down 11.8%, just shy of the 14.6% TTM average, but it was the Plunge in Indirects from 50% to half that number, or 25.8% that was the true surprise, as it was the lowest Indirect take down since December of 2008!

• BAD TRADE #1 For 2014: Ignoring Mean Reversion
• BAD TRADE #2 For 2014: Which-flation?
• BAD TRADE #3 For 2014: Forgetting Late Cycle Dynamics
• BAD TRADE #4 For 2014: Blind Faith In Policy
• BAD TRADE #5 For 2014: Reaching for Yield During Late Cycle

The 10 Year may so far be contained below its multi-year high of 3.00% hit in September just before Bernanke's "no taper" announcement, but the ultra long end, or the 30 Year, keeps dropping. Sure enough, moments ago the latest 30 Year reopening of 29 Year-11 Month CUSIP RD2 priced at a high yield of 3.900%. This may have been half a bp through the 3.905% When Issued, it still was the highest pricing yield on the 30 Year since July 2011, right before the US downgrade and the 20% S&P plunge resulting from the near debt ceiling breach. The Bid To Cover of 2.35 was modestly higher than last month's 2.16 but had a ways to go to catch up to the TTM average of 2.48. In terms of allotment, Indirects got the bulk of the auction, with 46% or the highest take down since April 2011. Directs were allotted 12.5%, or the lowest since June, which meant Dealers would have to "sell" back to the Fed 41.4% of the auction. So while not as immediately stirring as yesterday's very weak 10 Year, the sentiment toward the long end continues to deteriorate.

Tapering may not be tightening, as the Fed will keep repeating until someone actually believes it (the Fed may be right, however it's not what the Fed thinks or does, but the next most levered counterparty who is the risk factor, and whose potential selling is what is keeping everyone on their toes), but the just completed 3 Year auction just priced at a yield of 0.631%, precisely where it priced in August, the month before the last "consensus" taper announcement at the September FOMC, and above the 0.581% where the 3 Year was in June when the Taper Tantrum peaked. The short-end may not be panicking yet, but the enthusiasm for bonds is certainly not where it used to be, especially when one considers 3 Years priced in the mid-0.3% range from September 2011 until May 2013.

Technically, "High Yield" is no longer the appropriate name for the riskiest credit issuance since the average coupon has declined to where Investment Grade used to trade in the years before the New Normal. It is therefore only appropriate that as part and parcel of this record high yield bond issuance surge levering the riskiest companies to the gills with low interest debt, that there is also a scramble between underwriters to become as competitive as possible. And, sure enough, as Bloomberg Brief reports, "the underwriting fees disclosed to Bloomberg on U.S. junk bond deals average 1.276 percent for the year to date, the lowest since our records began. The prior low was set in 2008, when fees averaged 1.4 percent." 2008... that was when the last credit bubble burst on unprecedented demand for junk bonds: we are confident the bubble apologists will find some other metric with which to convince everyone that reality, and the Fed's Stein, have it all wrong.

A world, in which former permabears David Rosenberg, Jeremy Grantham and now Hugh Hendry have thrown in the towel and gone bull retard, and where none other than the Chief Investment Officer of General Re-New England Asset Management - a company wholly-owned by Warren Buffett's Berkshire Hathaway, has issued one of the direst proclamations about the future to date and blasts the Fed's role in creating the biggest mess in financial history, is truly upside down...

"What keeps us up at night? Well I can’t speak for the others, having spoken too much already to please PIMCO’s marketing specialists, but I will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the creator of the “New Normal” characterization of our post-Lehman global economy, now focuses on the possibility of a” T junction” investment future where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world.  ... investors are all playing the same dangerous game that depends on a near perpetual policy of cheap financing and artificially low interest rates in a desperate gamble to promote growth. The Fed, the BOJ (certainly), the ECB and the BOE are setting the example for global markets, basically telling investors that they have no alternative than to invest in riskier assets or to lever high quality assets. “You have no other choice,” their policies insinuate....  Deep in the bowels of central banks research staffs must lay the unmodelable fear that zero-bound interest rates supporting Dow 16,000 stock prices will slowly lose momentum after the real economy fails to reach orbit, even with zero-bound yields and QE." - Bill Gross

In Feb 2007, Oaktree Capital's Howard Marks wrote 'The Race to the Bottom', providing a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008 as he worried about "carelessness-induced behavior." In the pre-crisis years, as described in his 2007 memo, the race to the bottom manifested itself in a number of ways, and as Marks notes, "now we’re seeing another upswing in risky behavior." Simply put, Marks warns, "when people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed," adding that "the riskiest thing in the investment world is the belief that there’s no risk."

If this week's 2 year auction was an indication of a rising Bid to Cover, and the 5 Year yesterday showed a modest decline, the just completed 7 Year auction was evidence that any rumors of a pick up in ultimate demand in the belly and the long-end of the curve are greatly exagerated. The initial indication of how weak the auction would be came moments before the 11:30 am announcement, when the When Issued was trading at 2.094%. When the formal announcement from the Treasury came that the bond had priced at a high yield of 2.106%, or tailing by a 1.2 bps, the bond complex promptly exhaled. Things only got uglier when looking at the internals: as noted above, the Bid to Cover came at 2.36: a sharp drop from the last auction's 2.66, well below the TTM average of 2.62, and the lowest going back all the way to the 2.26 in May 2009. The takedown was just as unimpressive, with Direct interest sliding to just 16.14% of the final allocation, Indirects likewise seeing their allotment tumble from 42.30% to 34.07%, the lowest since February, which left Dealers holding half of the auction, or the most since June 2012.

If yesterday's 2 Year Auction showed a substantial pick up in Bids to Cover in recent months, then today's 5 Year, while sold in terms of end demand with the high yield pricing at 1.340%, through the 1.344% when issued, did not confirm this trend for at least the next longer maturity. The sale of $35 billion in 5 Years came at a 2.61 Bid to Cover, below last month's 2.65, and below the TTM average of 2.69. More importantly as can be seen on the chart below, the trendline is lower if one sets aside such "one-time" spooking events as debt ceilings and government shutdowns. Indirect demand picked up notably, taking down precisely 50% of the auction, leaving 10.8% to Directs, and just 39.2% to Dealers: the lowest PD takedown since the 37.8% in July. Overall, nothing to write home about as total US debt, contrary to all fabulations about a plunging deficit, continues on its relentless ramp every higher, at last check printing over $17.2 trillion.

If one of the biggest concerns in early 2013 was the progressively declining Bids To Cover in US Treasury auctions, the past few months have seen a halt in this trend, while today's auction of $32 billion in 2 Year paper marked a substantial return to the high-flying  BTC day of yore when the just completed 2 Year auction not only priced strongly through the 0.303% high yield, pricing at 0.300, but more importantly, at a 3.54 Bid to Cover, a jump from October's 3.09, and the second highest since February excluding only April's 3.63. Curiously, the drop in the overall Bid To Cover (as can be sen on the chart below) correlates closely to the drop off in Direct take downs in the first half of the year. This too has reversed in recent months with Directs getting 27.28%, Indirects holding 22.47% and Dealers left holding just over half, or 50.25%. Over the next few days it will be revealed if the same rising BTC trend is sustained in the other near-term vintages, the 5 and 7 year auctions also due out later week.

It is hard to believe that the end of the year is fast approaching.  This weekend's list of things to ponder covers a range of issues that caught our attention this week. Will the economy continue to grow, are stocks under owned, what about Fed - rising credit risk (and collapsing credit risk premia) and the question of "when or if to taper?"  These are all important questions that all investors must answer as the new year rapidly approaches.