Is This The Biggest Threat To The Market?

Tyler Durden's picture

Authored by Jason Shoup of Citi Credit,

Looking for the ‘just right’ level for rates

Indeed, we’d argue that the Fed’s zero lower bound policies have dislodged credit risk as the primary concern for investors, only to replace it with a major technical headache: interest rate risk. Granted, rates could rise in an orderly fashion and drive spreads tighter from here - the ‘just right’ scenario that remains our base case. But there is the probability that Treasury yields do otherwise pose serious risks to the market, as we have started to observe in recent weeks. What’s more, the risks are in both directions.

Too low for too long …

If rates remain too low for too long, financial stability suffers as investors reach for yield, companies lever up, and lending standards decline. In early February, Federal Reserve Governor Jeremy Stein pointed out that many of these concerns are already visible in high yield where covenant-lite issuance has exploded, yields on triple-Cs are at all time lows, and CLOs have returned in force. Similarly, investment grade companies have been relevering at an alarming pace, banks are reportedly making ever dodgier C&I loans, and the mega-LBO is back.

What’s more, a look to Japan illustrates the dangers of allowing these imbalances to build. As JGB yields have started to rise after being depressed for so long, concerns have emerged about the health of the Japanese banks, which generally hold longer duration bonds in their security portfolios than their US peers—presumably a function of having to cope with low rates for so long. And a handful of major Japanese corporates have pulled new deals as rates have gapped higher as well, suggesting they too have become dependent on low rates. 

Still, the greatest of financial stability risks is probably the least discussed among those that matter at the Fed: the deterioration in trading volumes.To the credit of the Street, trading in corporate bonds hasn’t declined much in outright terms. But the corporate bond markets have grown so rapidly as a result of the Fed’s zero lower bound policy that the sell-side’s ability to transfer risk just hasn’t been able to keep pace, which could potentially spell disaster if investors all choose to sell at once. One can clearly see this in the steady decline in market turnover over the last few years (Figure 9).

Finally, a less diverse investor base, or conversely one in which everyone is in the same trade, can also be seen as a financial stability concern and a direct byproduct of rates staying low for an extended period of time. To our minds, little diversity among investors raises the risk of overshooting in both directions: first as yields compress to abnormally low levels, and then as all investors race for the exit all at once.

As such, we suspect that the longer low rates persist, the worse the unwind of QE may be. And it may, in fact, already be too late.

… or too high too quickly

As events in the past two weeks have shown, credit markets appear vulnerable to a rise in rates that occurs too quickly or in a chaotic fashion. What’s more, there’s an air of inevitability to it all, suggesting that even though market participants can see what’s coming, there’s little that can be done.

Part of the problem is that investment grade credit has increasingly become more sensitive to total returns during the past five years as the AUM of mutual funds dedicated to bonds have rapidly grown. Using Fed data, we reckon that the percentage of the corporate bond market that mutual funds now own is roughly 17%, up from about 12% in 2007. Likewise, cumulative inflows into high yield mutual funds have been similarly impressive in the period after the great financial recession.

Yet the reliability and stickiness of mutual fund flows going forward is definitely a wildcard, to our minds. At the very least, it’s hard to envision that bond funds will continue to attract the same level of inflows that they’ve enjoyed since 2008 when faced with expected future total returns that are likely to be exceptionally low, if not negative. Indeed, in such an environment, there’s a very real possibility that fixed income funds experience outflows when retail investors fully appreciate the upside limitations in bonds as the economy recovers. In fact, some major funds are already seeing redemptions on the back of May’s performance.

To get an idea of how significant the retail flow situation might become, we find it instructive to look at credit ETFs as a guide. Assets under management at LQD - an unhedged IG ETF - have dropped by nearly 15% since mid-December, forcing the fund to sell roughly $3.9bn of corporate bonds through the redemption process. By comparison, if mutual funds were to experience an outflow of the same magnitude, they’d need to sell upwards of $100bn of corporate bonds.

To our minds, that amount of selling could be exceptionally disruptive to valuations if (1) it occurred over a relatively short time period, (2) institutional investors were unwilling to take the other side, and (3) the Street was unwilling to increase their inventory of bonds.


Moreover, to the extent that issuers sense demand may be waning for bonds, there’s a distinct possibility the pace of supply increases precisely at the same time that demand decreases. In the high yield markets, for instance, companies have become far more proactive at taking callable bonds out with make wholes in order to issue low coupon longer-dated debt. Similarly, we expect that a number of high grade issuers debating doing a liability management exercise, an acquisition, or simply prefinancing 2014 maturities, may be persuaded to come to market sooner rather than later as rates show signs of permanently moving higher.

Invariably, it’s the sort of dynamic that ends in tears.

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LetThemEatRand's picture

"I misjudged in believing that CEO's would give a flying fuck about shareholders and not use free credit to enrich themselves and expose their companies to systemic risk requiring government bailouts."  -- Alan Greenspan.

Lets Buy The Dip's picture

if you do not know, alan greenspan is the biggest pile of dog shit zombie dickhead that ever walked the face of this earth. He helped create the credit bubble, and evil asshole at best. 

the market is strong, they will keep lying and pump this market full of money, even though they get everyone to panic that QE will end, it will not...comon, lets not fall for that. FOOL ME ONCE shame on me, FOOL me twice shame on me.

This market is super strong check out CRUDE CHART HERE <-- That will skid up higher soon I think. 

jbvtme's picture

why would anyone take a face like greenspan's seriously?

PiltdownMan's picture

Zirp and government combined is a toxic combo. In the USA, the USDA insures 100% LTV mortgages on Martha's Vineyard since Vilsack declared it as rural land! Seriously. Zero down for the elites. Very ChiComn of them.

CHX's picture

high crude will give the global economy the coup de grace. can't let it rise above 100 for long IMHO, else complete and utter economic contraction and the depression is "official". that's why they hammer commodities relentlessly down, against the main trend (up). something will break badly, to be seen in the not too distant future.

fonzannoon's picture

" Assets under management at LQD - an unhedged IG ETF - have dropped by nearly 15% since mid-December, forcing the fund to sell roughly $3.9bn of corporate bonds through the redemption process."

They are just selling the paper to buy the physical?

Is it so hard to envision that CNBC is just there to pump stawks so everyone finally sells their bonds and buys stawks, sending interest rates up to...I don't know...4% on the ten which point some big fuckin thing happens and CNBC tells the muppets to sell their stocks...which proceed to take a massive hit, and buy 2% on the new 2% 10yr level? The squid buy the stocks back cheaper and sell the bonds after a 50% gain.

Rinse, repeat.

disabledvet's picture

dividends have been rising so a sudden spike in yields (like what we've just had) shouldn't be the end of the world (like what we also had.) this only means "don't panic" however Mr. Fonzerelli. doesn't mean "don't sell" and DEFINITELY is NOT a greenlight to buy by the Girl with the Pretty Smile. I think being long equities right here right now is a fools errand but we'll see. We're talking humans here and when the market moves very suddenly a lot of mistakes can be made that make the situation even worse not better. This is especially true since "complexity" and "ETF's" probably don't mix very well. these are bidless markets folks...there is ZERO information to glean from them because there is no money in there. You don't have this problem in least in large caps you don't. we know trading volumes suck on the upside...i say bail and "wait for better weather to play."

Spitzer's picture

Treasury bonds and JGB's are the worlds bank. There will eventually be a classic bank run on treasuries and then its all over.

Bank run, capital flight, call it what you want, it amounts to the same thing. And when the run happens, Bernanke will raise interest rates to try and attract money back. This was tried during the Asian financial crisis and it didn't work.


"To prevent currency values collapsing, these countries' governments raised domestic interest rates to exceedingly high levels (to help diminish flight of capital by making lending more attractive to investors) and to intervene in the exchange market, buying up any excess domestic currency at the fixed exchange rate with foreign reserves. (Indonesia had foreign exchange reserves of more than $20 billion)

Neither of these policy responses could be sustained for long. Very high interest rates, which can be extremely damaging to an economy that is healthy, wreaked further havoc on economies in an already fragile state, while the central banks were hemorrhaging foreign reserves, of which they had finite amounts. When it became clear that the tide of capital fleeing these countries was not to be stopped, the authorities ceased defending their fixed exchange rates and allowed their currencies to float. The resulting depreciated value of those currencies meant that foreign currency-denominated liabilities grew substantially in domestic currency terms, causing more bankruptcies and further deepening the crisis."

WTFUD's picture

A tad technical for me but i believe i have a handle on this:-
How to remove semen from your face without spoiling your make-up!

buzzsaw99's picture

Citi knows damn well this is just another fed fueled pump and dump. There are no markets, there is only the bernank.

Westcoastliberal's picture

This along with the war on terror/Iraq, is the costliest experiment in the history of the world.  It didn't work.  Problem is, the same bunch (neo-cons) are still in power and so won't admit they blew it. We're moving at near lightspeed straight into a granite mountain (much worse than the proverbial brick wall).

And why the fuck can't we have a full-length, Itchy and Scratchy show, marathon?

q99x2's picture

"in the period after the great financial recession"

Awh can't I get anything right. Did I miss that too?

PiltdownMan's picture

Low rates, the Fed keeps adding to their balance sheet. Fannie and Freddie keep adding loans to THEIR balance sheet, despite orders to unwind. Now they are all at the mercy of ... The Fed.

suz's picture

How shall they finesse a default for this foundering vessel?

Me's thinks they shall raise the ire of the rates, and bring back confidence to investors, and then default. put simply. 

disabledvet's picture

Good article. The Fed certainly is not telegraphing a rise in rates so it's a little odd that the media is lying about such a thing so vociferously. Obviously the Fed hasn't denied it either so maybe something is going on after all...i find nothing unworthy in putting some free market into this capitalism. having said that this was mere teeth bearing compared to what the Fed COULD be doing. I think the real scare is Japan and the fact that "time may have run out." you can tank the dollar vis a vis the yen...but only so far before even that doesn't work anymore and JGB's collapse, the yen follows closely behind and you get the hyperinflation. we'll see very quickly "who's next" after that happens. i will stay long treasuries unless and until there is more clarity on the geo political front(s).

Gringo Viejo's picture

The biggest threat to FREE markets is the federal reserve.
Ever closer to that "pitchfork" moment.

CHX's picture

There already are NO FREE MARKETS anymore. NADA, ZILTCH.