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Credit - Cheap Or Not?

Tyler Durden's picture




 

Via Peter Tchir of TF Market Advisors,

Last week P&G was able to issue a 10 year bond with a 2.3% coupon, priced to yield just a tad more than that with a spread of T+55.  Yesterday, McDonald’s issued 30 year bonds with a 3.7% coupon, priced to yield just over that with a spread of 80 bps versus the long bond.

The Fed is doing everything it can to push people out the risk curve, and in particular is encouraging the hunt for yield in credit products (see here for the must-readreaching for yield and getting clubbed like a baby seal”).

 

A lot of people are arguing that “credit” is cheap.  That spreads are high and offer a lot of value.  That may even be true, but the problem is that most retail investors don’t own bonds on a spread basis, they own them on a yield basis.

 

 

Here is 5 year P&G CDS.  It traded below 20 back in 2007.  It has traded in the 30’s in the past year.  At 50 bps it may be cheap.  There is some chance 5 year CDS tightens from here.  On the back of that, the 10 year bond could tighten from T+50, but that is a riskier bet. To lock in the 50 bps, you need to short treasuries. Is the relative lack of liquidity worth it? Can you rely on getting a good borrow on the treasury?  T+50 doesn’t strike me as particularly cheap, and think it offers less value than selling CDS at 50 bps, but it doesn’t strike me as expensive.  On the other hand 2.3% seems expensive and most investors will own this bond at 2.3%.  The ETF’s are all yield based.  The mutual funds are all yield based.  The argument might be that “corporate credit spreads” are cheap, but people aren’t investing in corporate credit spreads, they are investing in corporate credit yields, and that strikes me as very dangerous.

 

The yields are being held down by operation twist.  The treasury has anchored the short end and continues to shift money to the long end, keeping those yields low, for now.  What happens when that ends?  Without QE it seems incredibly hard to justify owning bonds like the P&G ones on an outright basis.  If yields moved to 3% for those bonds, the price drops 6 points, or almost 3 years of interest.  Same story for the new McDonalds bonds.  I have no worries about the credit, but think selling CDS offers better value, but owning the bonds on a yield basis is very risky and it is concerning that so many people are talking about cheap spreads but not executing a spread play.

 

Now that the banks have participated in the rally, LQD strikes me as good short.  Yields are not floored, but it is harder and harder for these bonds to trade at lower yields.  Spread tightening is mostly coming on the back of treasury yields increasing at a faster rate than corporate bond yields – good for corporate spreads, but bad for yields.

 

There is evidence that liquidity is at a premium.  Bonds that are owned by ETF’s are allegedly rich.  But across the board it looks like big liquid bonds are trading rich to less liquid.  This is most pronounced in high yield, but exists in investment grade as well.  It is more than just the ETF’s.  It is hedge funds who want to remain liquid.  It was only a few months ago that hedge funds couldn’t get a bid on some of the smaller issues, so they have stuck to the most liquid issues.  The next phase of the credit rally will have to include a move to grab some of these smaller, illiquid issues where there is more value.

 

I was looking at the Rogers Communications bonds as an example of this liquidity issue.  The 7.5% bonds of 2038 trade much richer than the 8.75% bonds of 2032.  The 2032 bonds were trading at T+250 and the 2038 bonds were at T+200.  Both were at a similar dollar price, so the spread differential can’t be explained by the high coupon bond trading at such a high relative dollar price.  The shape of the treasury curve has some impact, but what on the surface seems to be the difference is that the longer bond is a $350 million issue and is included in various benchmark indices, and the shorter bond is only $200 million so isn’t in the benchmark indices.  There is more to the story than that, I’m sure, but it certainly is worth looking at, and I would expect that if the rally continues, someone will give up their “liquidity discipline” and buy these, though with the way the market is working, the street will get long in advance of that, and then something will happen to the market to stop the “relentless grind tighter” and the market makers will once again own the worst bonds from a liquidity standpoint.  Maybe the Volcker rule isn’t so bad.

As I have written recently, the “Beta” trade in high yield is overCredit selection and specific bond selection is key here.  The ETF’s, which I am a fan of, are less interesting to me at these values because I don’t like a lot of the bonds.  Too many are the “safe” bonds with the greatest liquidity premiums.  Too many have horrible convexity.  Big coupon bonds trading to near term calls, with limited upside, and significant downside with any hint of renewed economic weakness.  That is the nature of the HY market as a whole.  So I would be looking for specific bonds and credits that offer value.

 

HY17 might even be a decent play.  The “fixed duration” is attractive to the extent the rally continues.  The big concern here is that it would be the “hedgers choice” on any weakness. It will underperform cash (or at least where cash is marked) on any weakness.  That is part of the reason it has lagged in this rally.

 

So the trade I like is go long HY17, short some IG17 against it (IG17 has outperformed HY17 so this is a “spread compression” trade, and IG17 will also attract hedgers on any weakness) and short a little HYG or JNK (the convexity and some very low yield bonds limits their upside on a rally).

 

And keep in mind that credit almost always grinds tighter and gaps wider with little to no warning.  When the shift from concern about not getting enough yield to concern about how much notional I can lose always seems to catch the market by surprise.

 

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Tue, 02/07/2012 - 13:51 | 2134426 bpom
bpom's picture

yield bitchez

Tue, 02/07/2012 - 18:51 | 2135962 Eireann go Brach
Eireann go Brach's picture

An old tried and trusted gauge on determining where we are at in terms of credit or how the economy is doing?..is to call your local hooker and ask how much it is for a blow job?

Tue, 02/07/2012 - 13:52 | 2134430 Hedgetard55
Hedgetard55's picture

"The yields are being held down by operation twist.  The treasury has anchored the short end and continues to shift money to the long end, keeping those yields low, for now.  What happens when that ends?"

 

     VAPORIZATION. Thus it can never end. Which spells doom for the dollar.

Tue, 02/07/2012 - 14:11 | 2134490 ozziindaus
ozziindaus's picture

Low yield spells bullish on the dollar by definition since the dollar represents a zero expiration coupon. In other words, you can hold the dollar now and yield 0% or throw it into a bond for 10 years and yield about 2%.

High yield on the other hand signifies expansion (inflation) which is detrimental to the dollar’s value.

 

 

Tue, 02/07/2012 - 14:14 | 2134501 Hedgetard55
Hedgetard55's picture

Printing trillions more dollars to try to keep interest rates low will destroy the dollar, not support it. Look at gold and silver for the past 3 years, they tell the story. Think REAL, not nominal.

Tue, 02/07/2012 - 14:19 | 2134519 ozziindaus
ozziindaus's picture

Where exactly are those trillions parked? Why is housing still depreciating? Gold and silver are not inflation hedges, they are hedges against uncertainty. They are emotion driven instruments.

WIth all QE's, the PM's spike because of the uncertainty, not because of the excess liquidity. It's all trapped and never hits the economy.

Tue, 02/07/2012 - 14:24 | 2134544 Flakmeister
Flakmeister's picture

The Ben and Mario print tag team are walking a fine line between the amount they "print" and the amount that has gone to the "debt heaven"...

They could pull it off but for this little problem...  The dollar derives its value from it's interchanability into oil, as the amount of oil that is on the market decreases, the relevance of the dollar fades... And if the House of Saud fails, it is game over....

In the mean time grab some popcorn, buy oil and gold on the dips and try not to sweat things too badly....

Tue, 02/07/2012 - 14:47 | 2134649 ozziindaus
ozziindaus's picture

So if we have excess oil production, it's natural that the price/barrel drops. Since dollars are interchangeable to oil as a form of exchange, then it's safe to assume that the value of the dollar has increased. This is contrary to your argument. I believe you base your argument on oils relevance rather than it's availability.

If the House of Saud fails, it's game over for Israel.

Tue, 02/07/2012 - 15:07 | 2134764 Flakmeister
Flakmeister's picture

Not quite.... the growth in the supply of dollars has dwarfed any increase in the supply of oil, esp. since 2005 when oil production flatlined...

Oil is extremely relevant, it is the alpha-asset. Irreplaceable.

Are you aware of the declining Net Oil Exports?? In 2005, ~45 mmbpd were available on a daily basis, 6 years later we are down to ~41 mmbpd.... And Chindia is taking a larger and larger fraction of it. 

Following current trends, Mexico becomes a net importer in about 6 years, Iran in about 12 and SA in about 15....

For shits and giggles, compute the amount of US treasuries held in foriegn hands and compute the average coupon, now convert that in barrels of oil and compare that to the total available... Let me know what you think happens as the interest on US treasuries approaches the value of oil on the market....

Tue, 02/07/2012 - 14:49 | 2134663 francis_sawyer
francis_sawyer's picture

& take some 'spinning' classes so that your legs will be in shape to ride your bike...

Tue, 02/07/2012 - 14:43 | 2134635 Hedgetard55
Hedgetard55's picture

oz,

 

     Of course it hits the economy, the debt being bought by the FED allows the Fed .gov to spend that much more than otherwise they would be able to. That is inflationary. With your logic, the FED could buy 100 trillion worth of debt from the fed gov and it would have no effect on the dollar because it ws all being held on the FED's books.

Tue, 02/07/2012 - 14:53 | 2134684 ozziindaus
ozziindaus's picture

I'm glad you understood my logic. Remember that the Public debt is only a quarter of the Private debt. Public debt (National Debt) can rise through entitlement spending, war, GSE's etc as long as the collective public allows it to but Private debt is capped by the individual. Can't force or entice lending even at these ridiculously low rates.

Tue, 02/07/2012 - 15:09 | 2134776 Hedgetard55
Hedgetard55's picture

oz,

 

     "Can't force or entice lending even at these ridiculously low rates. "

 

    That is why housing hasn't recovered but continues to deflate.

Tue, 02/07/2012 - 18:44 | 2134439 ilion
ilion's picture

This stuff is getting funnier by the day.

Tue, 02/07/2012 - 14:08 | 2134443 hedgeless_horseman
hedgeless_horseman's picture

 

 

...most retail investors don’t own bonds on a spread basis, they own them on a yield basis.

If they are lucky, they own the bonds on a yield basis, and not a bond fund.

"Bond funds are a very safe investment," Mrs. Schwartz.  "Some of the bonds are backed by the United States government."

"Will I still get my coupons?"

"No, Ma'am, investing in a bond fund is far more convenient than owning actual bonds, receiving quarterly interest payments, and having to reinvest them at maturity." 

Tue, 02/07/2012 - 14:10 | 2134486 Flakmeister
Flakmeister's picture

Very good point...

Check out the management fees on some corporate bond funds....

Tue, 02/07/2012 - 14:23 | 2134533 hedgeless_horseman
hedgeless_horseman's picture

 

 

That's nothing.  Check out the NAVs as they plummet when rates rise. 

"How could I lose so much money investing in AAA bonds?  My broker told me these were safe!"

Tue, 02/07/2012 - 14:28 | 2134553 Flakmeister
Flakmeister's picture

I'll quibble... rates will not rise, when the jig is up (see my comment above), the bonds will become worthless almost overnight...

In this regards, Japan has been very instructive to date...

Tue, 02/07/2012 - 13:59 | 2134452 misterc
misterc's picture

FT's new word for Greece exiting the EMU: "GREXIT"

Tue, 02/07/2012 - 14:03 | 2134468 jimmy9200
jimmy9200's picture

my neighbor's mother makes $81 an hour on? the internet. She has been unemployed for 5 months but last month her paycheck was $8504 just working on the internet for a few hours. Read more on this site... http:// LazyCash9.com

Tue, 02/07/2012 - 14:11 | 2134488 Sandmann
Sandmann's picture

Yes but she still had not saved enough to buy some clothes so she had to appear naked beforev the camera every time

Tue, 02/07/2012 - 14:31 | 2134572 Flakmeister
Flakmeister's picture

And her genitalia resembles an Arbys Roast Beef sandwich....

Tue, 02/07/2012 - 14:58 | 2134707 therearetoomany...
therearetoomanyidiots's picture

Yes, but prostitution is illegal, isn't it?

Tue, 02/07/2012 - 17:24 | 2135463 Pool Shark
Pool Shark's picture

Not in Washington, D.C.

 

Tue, 02/07/2012 - 14:04 | 2134473 ozziindaus
ozziindaus's picture

I would trade yield for security, and apparently, so would the rest of the world.

Tue, 02/07/2012 - 14:15 | 2134475 Mercury
Mercury's picture

The Fed is doing everything it can to push people out the risk curve, and in particular is encouraging the hunt for yield in credit products...

It's plenty risky on the "safe" end of the curve.

Today's front page Journal article about the dire straits the money market fund business (and the SEC's plans to "fix" things) doesn't even mention ZIRP - or the fact that it is already the case (as of last spring) that shareholders can be prevented from withdrawing their funds in a crisis situation (that was the last SEC "fix").

http://online.wsj.com/article/SB10001424052970204136404577207601101417664.html?mod=WSJ_WSJ_US_News_3

MMFs are a disaster waiting to happen.

Tue, 02/07/2012 - 22:48 | 2136615 SAT 800
SAT 800's picture

I believe this is true. I also believe that an IRA is potentially unsafe. If the Feds. become more desperate, I'll say if because really it is difficult to foresee the future no matter how certain it seems, they may change the rules dramatically for these things; many other governments in modern history have sandbagged their citzens when their chickens came home to roost, and I think a lot of us have got beyond the point where we just say, well that can never happen here.

Tue, 02/07/2012 - 14:05 | 2134476 Newsboy
Newsboy's picture

The days of widespread payment of interest, depended upon steadily growing economy, depended on limitless/growing supply of cheap oil. That paradigm is over. Don't count on interest. Look for what will sustain you as your savings contract. The old paradigm, "where moth and rust do corrupt, and thieves break through and steal".

Tue, 02/07/2012 - 14:12 | 2134494 Sandmann
Sandmann's picture

The only safe Bond Fund is where Goldman Sachs Partners are invested...but you need to check hourly to see they still are

Tue, 02/07/2012 - 14:22 | 2134538 Aunty Christ
Aunty Christ's picture

who needs bank loans when you can borrow at negative real interest rates??? No wonder banks are having a hard time finding a home for all the Fed induced liquidity...

Tue, 02/07/2012 - 18:31 | 2135863 HungrySeagull
HungrySeagull's picture

There was a day long ago you could park your money for 15% yield. However briefly. Minimum balance 25,000 dollars.

..... SIGH....

25K back then was so high. Now it's but a stumble across the annual monthly bills total.

Tue, 02/07/2012 - 14:24 | 2134543 Rip van Wrinkle
Rip van Wrinkle's picture

'What happens when that ends?'

 

It can't and it won't. 'Cos if it does it's the end game.

 

 

Tue, 02/07/2012 - 14:37 | 2134616 I should be working
I should be working's picture

Buy the gap wide sell the grind tight.  

I wonder if you could put that to rap music?

Tue, 02/07/2012 - 14:59 | 2134711 tony bonn
tony bonn's picture

and if you believe that the economy is actually shrinking then even 0% is expensive....

Tue, 02/07/2012 - 15:03 | 2134740 Apocalicious
Apocalicious's picture

Spread duration is a better bet than interest rate duration right now. But credit is cheap on a relative basis moreso at the front end of the curve. Why would I want to take on 20 year risk for 8% when I can get 6.5% for leveraged loans, at a floating rate no less? Maybe 50 bps more spread to risk free, and maybe there's more spread compression at the back end, but when HY hits 800 over, it ALWAYS goes to 1,000 over at some point...

Tue, 02/07/2012 - 15:34 | 2134950 Bartanist
Bartanist's picture

Just to make a point of disagreement. Corporate credit yields are an investment. Corporate credit spreads are a casino bet.

Tue, 02/07/2012 - 22:52 | 2136626 SAT 800
SAT 800's picture

All "investments" are casino bets. Chasing interest rates is one of the cardinal sins of finance; it's caused a lot of gnashing and grinding of teeth over the years.

Wed, 02/08/2012 - 04:16 | 2137100 Olympia
Olympia's picture

Loan sharks knew that if they took the dollars printing machines under their control they could suffocate the world ...they could initially suffocate USA and after taking the USA from the Americans, they could move and suffocate the whole world and take the countries from their people.

FED printed cheap money and loansharking multiplied this money in an unnatural way within the American economy boarders and they discarded them abroad so that they did not threaten USA. USA became the first state in the world with artificial “breathing”...

It cannot be possible but just in the USA for only the last year, more than one million houses were seized. It cannot be impossible but the New World has returned to tents and shelters ..has returned to the ages of Columbus. It cannot be possible that we allow to a few loan sharks looting the toils and the assets of people...

http://eamb-ydrohoos.blogspot.com/2012/01/global-debt-crisis.html

------------------------

Global Debt Crisis

Authored by PANAGIOTIS TRAIANOU

Sun, 05/13/2012 - 23:29 | 2422689 qiongqiong
qiongqiong's picture

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