Yelling 'Fundamentals' In A Crowded 'Corporate Bond Market'

Tyler Durden's picture

Thanks in large part to the supply-constructing yield-compressing repression of a few 'apparently well meaning' bad men running the central banks of the world, the divergence between fundamental weakness and credit spread 'strength' is at record levels. The overwhelming 'technical' flow of funds from investors combined with an 'end of equity' cult and belief that tail-risks have been removed (OMT) juxtaposes with earnings crumbling, ratings downgrades, and the exogenous fact that a complex system means a systemic crisis is inevitable (especially after such ongoing volatility suppression). As Citi's Matt King notes, while "it is almost impossible to predict exactly when they start," the desperation for yield has led to highly unstable equilibria - as what investors can't earn they will lever; via lower-quality 'levered' assets (PIKs and BB/CCCs for example) or 'levered' vehicles (CLOs and structured credit). Sure enough, margins (street repo haircuts are low and NYSE margin accounts high) look very 2007-like. While yelling 'fire' in a crowded theater will typically get the people moving, it seems the movie that is playing in corporate credit is simply too engrossing for many to listen.

 

Central-Bank repression and investors' demand for some safety has crushed the yields of the most liquid sovereign bond markets...

 

and constrained supply of even the safest of non-safe securities...

 

And given the size of the 'credit' markets in general, there is fewer and fewer yield opportunities to go around...

 

as investors faced with little choice but to 'opt for the risky upside'... no matter how concentrated that risk is...

 

Which led to the second best year ever for corporate credit!!

 

However, this technical flow and overwhelming drive for yield is completely ignorant of the fundamental shifts occurring under the surface as yet more markets become dislocated from any signaling ability...

 

but fundamentals are not keeping up - especially now the new normal is to borrow cheap and dividend out...

 

which of course will eventually be capped by an unacceptable rise in leverage...

 

and while ratings agencies get that credit cycles 'cycle' and have actioned ratings downgrades on a large scale, the actual defaults remain limited thanks to the ability to roll debt (due to the self-sustaining liquidity pump)...

 

Which, due to at least modest risk-management in the highest quality credit, has led to a drop further and further down the credit quality spectrum - that appears to be nearing its limit to some extent..

 

 

and so managers demand more leverage (and dealers are willing to provide it given their unlimited backstop)...

 

and its not just credit - equity managers are almost as levered at they were at the peak in 2007...

 

and while forecasts for 2013 appear positive in general (with perhaps some first half volatility), the modal 'numbers' being offered hide the massively distorted distribution of possibilities awaiting those over-levered and over-exposed to corporate credit...

 

As Citi's Matt King summarizes the firm's recent credit conference:

As much as we can feel that the market wants to rally hard, and probably will if the fiscal cliff can be surmounted, we remain just as concerned that it will reverse that rally immediately thereafter – at least until the central banks up their injection of liquidity once more and the whole cycle begins again. The tension between market exuberance and deteriorating fundamentals is simply too great. When 1100 investors have a craving, it’s hard not to think they’re going to do whatever it takes to satisfy it. But equally, when you’re in a crowd of that size, it’s probably worth keeping an eye out for the nearest exit - and long before any fire actually starts.

The thundering herd remains.. for now.

 

Charts: Citi and Goldman Sachs