High Yield

We have previously eschewed the constant refrain of any and every talking head who pounds the table on adding to equity risk on the basis of 'low' interest rates - why wouldn't you earn the higher dividend? or how much lower can rates go? However, aside from the drawdown-risk and empirical failure of the stocks-bonds arguments, there are three very pressing reasons currently for reconsidering the status quo of bonds against equities. Volatility in equity markets has been considerably higher than bonds and even at elevated earnings yields, it is no surprise that risk-savvy investors prefer a 'safer' lower-vol yield. Furthermore, when compared to a long-run modeling of business cycle shifts in stocks and high yield credit markets, stocks remain notably expensive to the credit cycle. Simply put, corporate bonds are at best offering better value than stocks if your macro position is bullish (and are forced to put money to work) and at worst suggest being beta-hedged is the best idea (or market-neutral) or in Treasuries.

UPDATE: Denials of the rumor (confirming our earlier note) of a mass refi program has BAC dropping (-3% AH) and ES down around 5pts so far (red on the day).

Late in the day as news broke of Iran nuclear talks, Oil lost some of it sheen and Gold overtook it year-to-date. Gold is now up 3.6% YTD against stocks up 1.9% (and the USD up 0.75%) as we saw stocks on their own today compared to credit markets and broad risk assets. Instead of following yesterday's stability post-Europe, FX (from a USD perspective) continued its uptrend as equities (led by financials - led by BofA on refi rumors) surged into the green as high yield credit, investment grade credit, and high-yield bond ETFs all lost ground on the day. Treasuries did sell-off (directionally correct at least) with stocks rallying but did not move as much as expected on a beta-adjusted basis (even though 30Y is now 16bps wider this year). EURUSD closed at its lows of the day (under 1.28) and Oil under $101.5 at its lows.

The S&P 500 closed practically unchanged today - recovering from decent selloff to a late-Europe-session low - amid volume that was over 30% lower than at the same time last year. Investment grade credit, the high-yield bond ETF HYG, and broad risk assets in general kept pace with ES (the e-mini S&P 500 futures contract) but high yield credit (tracked by the HY17 credit derivative index) outperformed considerably - moving to its best levels since late October. This disconnect appeared as much driven by technicals from HY-XOver (Long US credit vs Short EU credit) and HYG vs HY17 (a high premium-to-NAV bond ETF vs relatively cheap high yield spread index) trades as it was a pure risk-on trade. Elsewhere, the USD retraced only marginally the earlier gains of the day (with EUR hanging under 1.2950 by the close) as Treasury yields jumped 5-7bps more (30Y +14bps on the week now) as we can't help but notice the correlation between TSY weakness and EUR strength for a few hours this afternoon (repatriation to pay up for tomorrow's French auction?). Commodities were very mixed with Copper sliding notably (decoupling from its new friend Gold which rose and stabilized this afternoon over $1610) as Oil pushed higher all day (over $103) on Iran news and Silver leaked back this afternoon (under $29.5).

The issue of Germany and its approach to ameliorating the overleveraged balance sheets of its southern neighbors will dictate the direction of sovereign spreads in 2012. The direction of sovereign spreads will also determine the direction of risk premium spreads in the leveraged finance markets— both bonds and loans. Defaults in the leveraged finance market will and should be an afterthought to the systemic risk factors inherent in sovereign and next-of-kin bank credit spreads. Therefore, forecasting default rates should take a backseat to a better understanding of German Kultur and thought that will shape the euro-zone sovereign finance structure in 2012 and beyond. The most recent European Union summit highlighted that we are left with some of the same issues that confronted the great empires prior to World War I—the battle between “English liberalism with its emphasis on individual freedom and self-determination and Prussian socialism with its emphasis on order and authority.”

And so the inevitable has happened: the European currency finally fell below that strange attrractor level of 1.3000 following an Italian 5 year auction that despite the "technical" clarification that it would be of Off The Run bonds, still ended up being the highest rate ever paid for a 5 Year piece of Italian paper. As Reuters explains, the euro slipped versus the dollar on Wednesday after Italy paid a euro era record yield of 6.47 percent to sell five-year debt, adding to concerns that an EU summit last week had made little progress in tackling the region's debt crisis. More: "Italy paid a euro era record yield of 6.47 percent to sell five-year paper at its first auction of longer-term debt after the EU moved towards greater fiscal integration at last week's summit, but failed to convince markets it can solve the debt crisis. The average yield at Wednesday's sale compares with an auction rate of 6.29 percent Italy paid a month ago, which was also a euro lifetime record high. Rome sold 3 billion euros of the Sept. 2016 BTP bond, the top of an unusually small range of 2 billion to 3 billion euros for the sale. Italy has trimmed the size of its auctions in reaction to market pressure but it will have to step up issuance in coming months if it is to meet a gross funding goal of around 440 billion euros next year." And result: EURUSD < 1.3000 which means bad things for the record high correlated stock market... and the Christmas Rally.

UPDATE: HYG's premium to Net Asset Value (NAV) is its highest since May09!!

We often discuss how credit markets have provided useful insights (and potential pre-emptive indications) with regard to risk appetite and whether ES should rip and today's incredible rally in HYG (the high yield credit bond ETF) is one to be aware (beware) of. The rumble of liquidity-driven hedging being unwound was very loud indeed and as spreads reach significant levels on a medium-term basis and HYG recovers its major drop in price, we wonder if the market is now less prepared to handle any downside shock especially as risk-appetite is clearly dragging even in high-concession primary issue land. Much of today's action in the high yield credit market seemed as much about catch up to each segment's relative-value as any real aggressive buying as hedges were clearly unwound. We would warn traders who use index aggregates to judge relative asset allocations between credit and equity to be very careful with this shift, as bottom-up, it does not exist yet.

This week's trifecta of key financial developments, that go far deeper than superficial headlines, namely China, Morgan Stanley (and European bank exposure in general) and the equity-credit disconnect, just got another major push. CNBC just interviewed Tim Backshall (of Capital Context) to discuss the dramatic moves in MS credit risk (which we mentioned earlier) and in an undeniably convincing accent (British, Aussie, South African?), he managed to bring many of our broader concerns into focus including global financial contagion, bank funding, Chinese growth, and high yield credit. We also learned that ZeroHedge is a blog.

We wish we had some good news to report this morning.... But we don't.

More flashing red recessionary indicators are coming courtesy of the largely ignored High Yield market, which following a 5.3% decline is, as Bank of America (itself ironically contributing substantially to the blow out) says, is shaping up to be "among the worst months in the HY market's 25 year history, in a bad company of post-Lehman, post-WorldCom, post-9/11, and post-Russia sell-offs. The difference of course is that we did not have the largest bankruptcy in history taking place (LEH or WCOM shared that title at a time), no terror attack, and no outright sovereign default (Russia in Aug ’98). What we did have however, is a global risk-off trade, sparked by concerns that this fragile environment could slip into a double-dip recession as consumer and business confidence fails to sustain repeated beating from sovereign and financial systemic risk issues." What we also did have is the near end of the modern ponzi economic model, whose viability was once again extended courtesy of a variety of sticky objects thrown at the wall with hopes one sticks. For now the obliteration has been halted, although one thing is undeniable - central planner intervention buys increasingly less and less time. We are confident that August is just the beggining of pain for not only HY, but all other asset classes. And some more ammo for those who like comparing 2011 to 2008: "Parallels are being drawn between today’s environment and that of 2008, given the degree of equity destruction that has taken place across the financial space. Financial CDS – the epitome of ’08 systemic risk – are trading at an average of 190bp in the US, within reach of Oct ’08 levels, and 240bp in Europe, well north of their ’08 wides." What do spreads imply? Nothing short of recession: "The HY index, in the meantime, has widened to 739bp as of close on Thursday, its widest level since Nov 2009. With the spread normally peaking at 1,000bps in full recessionary periods2 (1991 and 2001-02) and bottoming at 250bp in times of strong economic growth, the current level is pricing in an 80% probability of a fullblown contraction in GDP, and a 100% chance of a mild recession."

I am back to being bearish the high yield market. I am not yet short it, but would certainly recommend being underweight right now. A couple of things have pushed me back to being bearish. The main one is weakness in other credit markets. Once again CMBX is heading lower and back at or near its recent lows. It has not been able to sustain a big rally which is particularly surprising because it is relatively illiquid and is a 'hedge' trade so is usually very exposed to a violent short squeeze. Irish and Portuguese 10 year bond hit new record yields according to Bloomberg - 11.47% and 10.99% respectively at the time of the writing, though Portugal broke 11% earlier in the day...The combination of weakness in other credit markets, coupled by the HYG NAV confirming that liquidity is at an extreme low in the high yield bond market I think it is prudent to cut high yield risk. With European credit closing quite weakly, I may shift to an outright short.

Utilizing The Applied Finance Group’s backtest system, we ran a strategy of investing only in companies with a market capitalization of greater than US$ 1 Billion and a dividend yield above 3%. The strategy has worked fairly well with the annualized returns over the last 12 years beating the overall universe. While the dividend paying strategy worked well, a strategy based on AFG’s valuation metric performed better.

Just out per Lipper, High Yield recorded its largest weekly outflow ever with a negative $2.8 billion this week. Presumably this is due to the risk off mood in the markets carried over from last week, or maybe just more funds converting out of fixed income and pumping into equities in advance of what even the futures just seem to realize is an inevitability (go ahead, check out the ES chart AH, we dare you). That said, per ICI there was a 3rd consecutive outflow from domestic equity, so perhaps this was simply derisking. Continuing on the Lipper news, the 4 week average dropped from $181 million of inflows to $641 million in outflows, pushing the year to date down by half to just $2.9 billion in inflows. On the other hand, loan funds continues being John Holmes with $9.5 billion in YTD inflows, although just $57 million (down from $686 million) in the last week.

The shift in risk perception is on. While stock are not quite feeling it yet (they will), today's fulcrum security appears to be high yield debt, as tracked by the JNK ETF. A quick look at the most active options classes page shows something surprising: as of 2:30pm Eastern roughly 4250 puts had trade, compared to.... 4 calls. Yet while investors have certainly turned sour on junk very rapidly, they should be far more bearish on stocks. Not only have stocks outperformaed bonds far more during the QE2 rally (as expected), but a simple correlation model accounting for empirical beta confirms that the SPY is almost 12% rich to fair value as implied by the JNK. Which means that if investors are really bearish on high yield to the tune of 4250 to 4, they should be far more bearish on the stock market.

With today's $35 billion 5 year auction pricing at 1.41%, we continue to see confirmation that the recent strength in the belly of the curve is quickly turning into pronounced weakness. The Bid To Cover was 2.65, the lowest since June or 2.58, but most notably those mysterious Directs came and took down a record 15.6% of the auction: the largest in history. Offsetting this was the complete collapse in Indirect interest, as foreign institutions took only 31.5% of the auction, the lowest Indirect take down since April 2009. The result was that Primary Dealers got stuck with saving the auction as usual, taking down more than half, or 52.9% to be precise, the highest since June. That foreign interest in the bond was so low is not surprising to us: as we highlighted yesterday, the Fed is now the largest holder of US Treasury debt. At this point the divergence will accelerate, as PDs and the Fed end up owning ever more of each and every auction (and subsequent monetization), while China et al is increasingly relegated to stand by status.

I missed a big part of the high yield run-up.  I even said there was an implosion eminent in Q2 2010.  Boy was I wrong.

• I underestimated the capacity for debt restructuring.
• I didn’t appreciate the power of extreme monetary policy.  I didn’t research economists with useful first-hand knowledge.
• I missed some implications of market-maker change.  OTC derivatives are not evil.  They function mostly to control market makers’ huge aggregate risk in an increasingly illiquid secondary market. 

To begin: credit has some nice features.  The price-to-hopefulness ratio is never a part of valuation.  Few have trouble parting with a bond when the price is right.  There is a fuzzy but ever-present upside limit.  There is a downside bounded by the recovery rate.  There are simple opening lines: acquiring higher yield implies taking more risk by 1) lengthening term risk, 2) taking more credit risk, 3) moving down the capital structure or 4) some combination.  In the large, I avoided 2).