Do What Feels Wrong, Citi's Credit Strategy For 2012

Tyler Durden's picture

As strange as it may seem, the current market environment of highly correlated risk assets and surge/plunge movements in prices does indeed lend itself to the contrarian view that Citigroup's credit research group has to 'do what feels wrong' in 2012. This has proved very profitable in the last few months and they warn that the consensus view that 'its okay to miss the first leg of the rally, I'll catch the second' may be a losing proposition as the current chase we are seeing in the last few days (and saw on 11/30 for example) exemplifies the rapid one-way shifts in credit, equity, and in fact every asset class at the merest hint of solution (or problem). Citi lays out five scenarios for 2012's credit market (and the concomitant equity markets) basing their opinion on market (VIX and rate level and vol movements) as well as fundamental (the economic surprise index we have been extensively discussing), and technical (issuance and trading volumes) and see spread compensation for default as negligible and mostly prone to systemic risk which should disappear in the low probability 'very bullish' scenario. The highest probability scenario is continued sovereign stress (or a decade of deleveraging), which we agree with, and a very range-bound trading market as systemic risk remains high (though not cataclysmic) with the floor on secular spreads notably higher than pre-crisis levels. We do wonder though when we see spreads 'switch' regimes from reflective of systemic risk to reflective of fundamental (recessionary slowdown) cyclical risk.


5 Scenarios for Spreads in 2012

Our base case for corporate spreads must be cognizant of both the likelihood that Europe is slowly resolved, at best, and that the equilibrium level of spreads going forward is likely to be higher than during past credit cycles in order to reflect greater vulnerability and a secular deterioration in liquidity. As such, we envision spreads trading within a relatively wide range of 160 to 220bp throughout much of 2012, provided the Eurozone remains intact – a big qualification.


At 240bp, Citi’s US Broad Investment Grade Index (US BIG), looks cheap under the base case scenario. In fact, we see a high probability of generating excess returns of at least 380bp (240bp of carry, 20bp of spread tightening) and the potential for 840bp should spreads end the year at the tight end our range – which seems unlikely given the volatility fourth quarter elections may create.


Our basic approach to spread forecasting involves dividing the index spread into two categories: the compensation for default risk and the compensation for non-default risk. To do so, we appeal to macroeconomic default forecasts. In particular, Moody’s has been providing a one year forecast for each rating’s category every month for the last five years. We apply that forecast iteratively to generate default probabilities for each ratings category and then use those probabilities to determine the worth to investors in basis points (Figure 12). The compensation for non-default risk is then calculated by subtracting the spread compensation for default from the current spread of the high grade index.




Focusing just on the non-default spread compensation in high grade can be very instructive. We find that this series of spreads can be easily modeled using five variables: the VIX, the level of 10-yr swaps, the volatility of 1-yr swaps, high grade trading volumes, and Citi’s economic surprise index (Figure 13). The first three of these variables are the biggest drivers (in addition to being the most statistically significant) and their values tend to capture changes in systemic risk.



When forecasting then, having a view on volatility and rates can go some way to determining where high grade credit should trade when assets prices are so highly correlated – as they are now. Moreover, since the spread compensation needed to protect against default is so low (we figure just 5bp), nearly all the spread one sees in the market is compensation for systemic risk, not fundamentals. This conclusion shouldn’t come as a surprise to investors, as it is equivalent to saying a resolution to Europe’s ills could be worth 80bp.


More formally, we outline five scenarios for spreads in 2012 (Figure 14) along with some indication of how probable we think each is.





Consensus among investors seems to be “it’s okay to miss the first leg of the rally, I’ll catch the second”. Ultimately, this strategy could prove ill judged. It is our contention that the current risk on/risk off trading environment will make it difficult to capture any potential relief rally, and that spreads will ultimately plateau at a much higher equilibrium level than before. In other words: There may not be a second leg to the rally - at least not in 2012.


For some time now, the best strategy for taking advantage of spread volatility has been to do what feels wrong. We continue to think abiding by this rule will prove profitable. Our range of 160bp-220bp argues for buying high grade bonds when the index is trading wide of 220bp – as it is now – and gradually selling as the index tightens toward 160bp.


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DonBadajoz's picture

Finally, First Bitchez

Moe Howard's picture

You are officially "First Bitchez"

Yen Cross's picture

 How about Sovereign Debt? Better yet ( Euro ~ Fund) , packages?

Yen Cross's picture

 Hey ? Check out those inverted ( reborn) , yield curves. I need a haircut for " X-MAS"!

Michael's picture


Dr Ron Paul started the national discussion on the Federal Reserve last campaign. Now he has started a discussion on US Foreign Policy that more and more people are starting to discuss.

Here's a good example;

Ron Paul vs. Israel (The Truth) 

Yen Cross's picture

 SNB was inferring a 1.30 purchasing power (vs( euro on the DE-PEG, last week. I call that bullshit! The SNB was basing that call on (USD). Exports!

  Now SNB has a better position, slightly. That 120 peg is being tested.

Dick Darlington's picture

Bonds Stop Flowing as Collateral Gets Stuck at ECB


Dec. 21 (Bloomberg) -- The chains of loaned securities
being pledged and re-pledged in the so-called wholesale money
markets are growing shorter, as collateral piles up at central
banks where it can’t generate additional borrowing.
     Rehypothecation is the financial alchemy that transmutes
$2.45 trillion of assets into $5.8 trillion of collateral
at the 14 largest securities dealers, down from a peak
of $10 trillion in 2007, according to Manmohan Singh, senior
financial economist at the International Monetary Fund in
Washington. Once collateral is parked at the central bank, it
can’t be recycled, and may become hard to find in times of need.
     At the end of last year, banks turned each dollar of
securities into $2.40 of collateral, Singh says. As banks
grow wary of lending to each other, those assets are being
pledged instead to the European Central Bank in one-time
transactions that mean the securities can’t be recommitted.
     “The system is collapsing onto the balance sheet of the
most-solid member of the system, which is the central bank,”
said Perry Mehrling, professor of economics at Barnard College,
Colombia University in New York. “The central bank is on one
side of the market only. The bonds are flowing in and they’re
not flowing out again.”
     The disappearance of the unsecured credit markets as the
sovereign debt crisis deepens has underlined the importance of
secured borrowing through repurchase agreements.

                     Shortage of Collateral

     “There is an enormous shortage of collateral,” said Simon
Gleeson, a financial-services lawyer at Clifford Chance LLP in
London. “That’s because the European banks can no longer raise
unsecured funds. There’s never been enough quality collateral so
the only way to do it was to re-use the securities.”
     European banks are opting to park money on deposit at the
central bank rather than lend it to one another. They kept an
average of 272 billion euros ($356 billion) at the Frankfurt-
based institution during the past 20 days, within 6 billion
euros of the most since July 2010, according to ECB data.
     The importance of secured lending in the interbank market
has grown largely unnoticed in recent years, said Matt King,
global head of credit strategy at Citigroup Inc. in London. Its
size may make it a source of risk, since borrowers may struggle
to find enough acceptable securities should lenders demand more
security, he said.
     “Risk has become channeled here in an increasing way in
recent years, and we just don’t focus on it,” King said.
“Everyone is just doing what is efficient under the rules but
it’s built up to become a source of systemic risk.” There is
“scope for runs on banks due to collateral suddenly becoming
very scarce, as in Europe at present,” he said.

                          Systemic Risk

     Repo trading volumes in Europe are sliding, according to
ICAP Plc, the largest interdealer broker and the owner of
BrokerTec, the biggest platform for repo trading, where
securities such as government bonds are loaned for a fee.
     “We’ve seen quite a significant fallback in the past two
to three months, and most of that’s driven by Germany,” said
Don Smith, an ICAP economist, who puts the decline at as much as
20 percent. “The German repo market has been getting very, very
tight,” forcing borrowers to use larger amounts of lower-
quality collateral and pushing up borrowing costs, he said.
     “There is a lack of position-taking going on which is
consistent with elevated levels of risk aversion, the sense that
people just want to buy and hold German government collateral,”
Smith said.

                          Risk Aversion

     Secured lending was viewed as having two big advantages,
said Barbara Ridpath, the chief executive of the International
Centre for Financial Regulation in London, who was head of
Standard & Poor’s ratings activities in Europe until 2008.
     “Bankers realized that if they took collateral, two good
things happened,” she said. “One, they could stop looking at
the credit of a counterparty. And two, they could get ahead of
other creditors in a bankruptcy because they had security.”
     Rehypothecation, where a bank takes an asset pledged to it
and recycles it to another institution, makes it hard for
creditors to keep track of ownership, as was shown in the 2008
collapse of New York-based Lehman Brothers Holdings Inc. in the
biggest bankruptcy to date.
     In a paper dated 10 days before the collapse, King at
Citigroup pointed out how assets pledged to Lehman had declined
54 percent since November 2007, compared with declines of no
more than 3 percent among its peers. Those still using Lehman as
a counterparty when it crashed found the securities they had
pledged as collateral had been recycled through London and they
were now in line for payment with other creditors.

                         ‘Credit Claim’

     “Once you engage in a repo with me, you no longer have the
assets, you have a credit claim against me,” said Gleeson at
Clifford Chance. “A wise counterparty doesn’t do repo with
someone in a deep hole.”
     As secured transactions increase, unsecured creditors get
pushed further back in the queue for payment in a default. This,
combined with reforms in countries such as the U.K. to make
insured depositors whole before unsecured bondholders, mean it’s
more costly for banks to issue unsecured debt, said Simon
Adamson, a bank analyst at CreditSights Inc. in London.
     “I suspect regulators will become increasingly concerned
about asset encumbrance and levels of collateralized
borrowing,” he said. “Senior unsecured will remain an option
for banks, at least if and when the sovereign debt crisis is
fixed. However, it will be a smaller market, partly because of
bail-in legislation, lower-rated, and more costly.”

                          Debt Crisis

     Faced with a situation in which the lack of collateral is
starving the financial system of the instruments it needs to do
business, the ECB said Dec. 8 that it will offer unlimited
three-year funding against collateral in two auctions.
     The central bank also said it would accept lower-rated
bonds and bank loans as collateral in its own lending, and cut
reserve requirements, potentially freeing up another 100 billion
euros of collateral, according to JPMorgan Chase & Co.
     “Everyone wants collateral, everyone wants dollars,” said
Mehrling at Barnard College. “If the central bank accepts bad
collateral, then bad collateral goes out of the system. But that
releases good collateral that the central bank would otherwise
be demanding.”

slewie the pi-rat's picture

"buy cheap straddles"  [anon. fringe blog publisher]

Zero Govt's picture

"Citi lays out five scenarios for 2012's credit market.."

Is this the multiple choice section of Citi's advise???

Could they boil it down to 1 please... or go put their heads in a microwave and boil their multi-hedging (clueless) brains out. Thank you

Moe Howard's picture

Citibank seems to have only one plan for recovery - spamming me with credit card applications. I get three a week now from them for various cards. If they are counting on me to save them, they are fucked.

swani's picture

Do what feel wrong? You mean, vote for Obama? Go long on the Euro? Buy B of A? Stock up on European bonds?  Dump gold? Turn on the TV?

swani's picture

I think if I'm going to gamble, I should just go to Vegas and put all of my money on Red. Less stress and I will feel more macho.