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High Yield Hedge Capitulation, Risk-Appetite Back, Or Just More Illqiuidity?

Tyler Durden's picture




 

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. HY (and IG) bonds have been rising in terms of advance-decline (sell-side to buy-side) and are above long-run average, HY relative-value to equities has compressed at the index-comparison level, but HY cash bond liquidity remains light at best and indices have done little except catch up to intrinsics as technicals (flows) leave demand for primary and secondary HY less than stellar despite what you see in HYG or JNK. It may be fun to chase momentum (especially when they offer a decent carry) but we suspect, given below-the-index-level analysis, that risk appetite is just not there and as usual the removal of hedges causing the most pain to the most traders.

Evidence from today's HYG movement relative to HY credit says this was not a concerted risk-on move, but much more likely a mass hedge unwind in what was the HY market's cheapest and most liquid hedge (in anything other than huge size).

 

When a manager of a large portfolio of high-yielding, carry-generating, upward-curve sliding flotsam and jetsam (HY bonds) fears his entire month's carry is about to up in smoke in the next 15mins, he will reach for a bag of his favorite hedging instrument. The favoritism will be biased to how-well-it-worked-last-time, how-cheap-it-is, and how-liquid-it-is with the latter becoming a higher priority as the sell-off accelerates.

We noted the large slides around mid June 2011, early August 2011, and early October 2011 all of which had similar major underperformances of their peers (beta-adjusted), similar magnitudes but the last two major downdrafts saw a seemingly paradoxical rise in shares outstanding. The orange rectangle shows a rather significant drop in price and yet Shares Outstanding continue to rise. Fund flows have been volatile but more positive than negative which obviously drove some demand for creation units but the absolute inversion of the shares outstanding/redemption relative to the share price movement makes little sense...unless funds were able to approach the ETF managers and have them force-buy in the illiquid cash HY market (or direct from the approacher themselves) as manufactured Creation Units. note: Another example of why ETFs are more complex than most want to know.

HY bonds have indeed been bought, though its tough to find a client, friend, colleague who has been aggressive buyers at the single-name level. HY Advance-Decline just shifted above its medium-term average perhaps suggesting cyclically that buy-side buying is peaking. Risk appetite definitley remains low (which sounds odd on a day such as this) but concessions in HY new issues are still incredibly high - SONOCO 10Y recently same at over $5 cheap to market fair-value in order to encourage buyers/lenders...so why do we see mad scramble buy-buy-buy days in HYG like today when risk appetite is low...the answer is hedge/short-covering (among other things agreed).

That is how HYG managed to outperform SPY by an immense 350bps today (apples-to-apples beta/vol adjusted) see chart below.

The performance of the black line is adjusted based on HYG and its empirical performance characteristics with several credit related assets and in sync with SPY. Typically they will be tick-for-tick - today is massively unusual.

It appears quite clear that the huge HYG-trickle-down-hedges that were put on over the last few weeks/months were rapidly unwound today. How do those hedges play out? (in brief)...

Step 1a, professionals use HYG (as the most liquid at the time) to hedge their long HY bond positions (note that with rates so low and spreads so wide that IR duration hedging is a hugely secondary consideration). They will short-sell the ETF (at a borrow AND carry cost). This will cause a dislocation between the value of the ETF and its NAV and then that will trickle down to the underlying components making up the NAV.

 

This chart shows the considerable underperformance of the HYG ETF compared to the performance of the HY credit index in late Sept/early Oct. Liquidity was clearly preferred and HYG was offering more - no matter what the price - to a point.


Step 1b, Professionals use HY (the liquid CDS index) to hedge but at times it can be very expensive, illiquid, and/or technically complex. If there is too much demand for the index protection (hedging/shorts) then there is no direct reason why demand for underlying names will also rise (not like in stocks where real-time tick-for-tick arbitrages keep indices and underlyings tightly in sync).

 

So we see the value of the index fall (in the case of hedging a long portfolio with an index short) much more quickly than the value implied by the underlyings. The index becomes more and more cheap relative to its underlying 'value' and at some point buyers will return as the index has become just too cheap, or hedgers will hedge less expensively.

 

 

The most recent on-the-run index is in green and has only traded for a few weeks but note how the index price (dotted green) has remains below the intrinsics (solid green) for most of the upswing and for the previous index (in purple) the same starting back in late August when the index was clearly offered as its demand as a macro overlay/hedge remained high.

 

Step 1c, professionals will try and buy individual  (CDS) protection on those names they fear the most and ride the wave. Given the potential richness of the underlying single-names when a market switches to index-based hedging, many may choose to shift specific risks at the single-name level as a situation develops. As the technical flows from demand for single-name protection hit they will push the cost of protection up notably above the credit risk premium of the underlying bonds (suggesting basis trade or to sell yr relatively over-priced bonds).

 

Step 1d, professionals will sell their longs (sell bonds). We haven't seen dramatic HY bond selling days recently - we suspect it is largely due to the Nash Equilibrium that all traders find themselves when faced with an illiquid market and a mission to cover. Everyone knows that they can't offer enough of their inventory without causing a broader sell-off which will drag down asset values across the rest of the book. This step does tend to be the last and most desperate (or the first and most simple if you are really good at timing).

 

Step 2 - Wait. Hold your breath as all the basis (drivers of differences between hedge MtMs and portfolio MtMs) we discussed above (and likely others) provide daily risk flares across your book.

 

Step 2a, Profit/Loss. With any luck, the hedge may have a higher delta/beta (or even gamma) than the underlying portfolio and make you money even as you are hedged (or in a worse case the cost of protection outweighs the carry of the book).

 

Step 3 - Cover. At some point a manager will become comfortable enough with the outlook to remove hedges and revert back to his long duration strategy. The other side is of course that at some point the use of a hedge becomes irrelevant as a manager becomes convinced given perhaps binary outlooks and scenario analysis that is incapable of providing any useful mean for valuation. In the latter case, the hedge will be lifted and so will the longs.

 

Done well, this can be performed in a step-wise fashion - unwinding short index positions into an up-trend will exaggerate the movement and encourage more buyers of HY in general as the momentum jockeys jump on. Then you simply turn around and sell your single-name positions into the buying herd (as in today).

So the bottom line from all of this: HYG outperformed SPY dramatically (suggesting forced covering or unwinds as opposed to rotation), HYG outperformed HY dramatically (suggesting a more flow focused hedge unwind), HY outperformed intrinsics dramatically (HY -35bps vs intrinsics -5bps), HY term structure flattened with the short-end actually broadly wider today!!, and while TRACE shows notable net-buying today it was very much butterfly-based as short- and long-end bonds were net-sold as 3-12Y were most net-bought.

 

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.

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

Charts: Bloomberg

 

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Mon, 10/24/2011 - 19:19 | 1806366 Mike2756
Mike2756's picture

Very good, wondered what was up with hyg today.

Mon, 10/24/2011 - 19:22 | 1806373 wombats
wombats's picture

Looks like Greece is such an irresistable bargain.

Mon, 10/24/2011 - 19:23 | 1806375 howswave5workin...
howswave5workingforyou's picture

Nice to see something that attempts fundamental analysis rather than convoluted, sensationalist noise on this website. So here is the dilemma. The majority of market analysts will say that high yield represents very good value. Due to their sins of 10 years ago the majority of non finacials have kept very healthy leverage and cash flow profiles. Now we have a growth, austerity, tax, problem to pay for the consumer/bank/govt spending bubble. so what happens next? Well people buy high yielding debt.why? Well if you assume 1930's default rates and low recovery rates you still make a retun in excess of risk free. Not bad if growth is rubbish right? I hope 1930s is sensationalist enough for the readers. Now here is the riddle. Can you identify a period in modern market history where high yield spreads have tightened and equities have not rallied? I don't think you will. And that is th problem. Away from banks and government cash flows are good and when credit tightens you will see what happens to NPV when the discount rate falls. Good luck.

Mon, 10/24/2011 - 19:35 | 1806393 Mike2756
Mon, 10/24/2011 - 19:55 | 1806451 Melin
Melin's picture

Now here is the riddle: Does the gratuitous snark add or detract from your comment?

Answer: -1

Mon, 10/24/2011 - 19:32 | 1806390 buzzsaw99
buzzsaw99's picture

I'd flush my $ down the toilet rather than lend it to CIT or John Thain.

Mon, 10/24/2011 - 19:55 | 1806441 HD
HD's picture

It would end up in the same place...washed away on a river of shit.

Mon, 10/24/2011 - 19:36 | 1806397 long-shorty
long-shorty's picture

sold all of our jnk and hyg today.

very high conviction short in PHK.

Mon, 10/24/2011 - 19:44 | 1806415 Mike2756
Mike2756's picture

Don't think it will get pulled to the 200 day?

Mon, 10/24/2011 - 19:51 | 1806439 long-shorty
long-shorty's picture

Two ways to interpret this powerful rally in equity and HY. Either the beginning of a great blast-off in risk assets (e.g. 1982), or else a brutal, enthusiastic short, sharp short-covering rally. I find myself agreeing with Katie Stockton of MKM that there are a lot of chart similarities to 2008 here, and that worries me. Normally there is a lot of trend persistence in HY funds, so you wouldn't want to be fading a powerful move like this, but today's move was so large to the upside that I think this may mark an important top. The nice thing is, if I'm wrong and there is follow through, I'll know within a matter of a couple of days that I am wrong.

Mon, 10/24/2011 - 19:56 | 1806454 Mike2756
Mike2756's picture

Thank you, i did go after some hyg puts today didn't quite catch the top. I see what you mean about trend followers, this thing has been trading goofy since july. Here we are back at the old highs in 3 weeks time.

Mon, 10/24/2011 - 20:10 | 1806493 vamoose1
vamoose1's picture

 

young man   tyler   stop  humiliating yourself,  yes,      you   got run  out of the industry   for   misconduct,   now you   will get   run off the web  for   witlessness.

 

    Your   horseshit   dow  is   going into  the 20s, your   numerator   visits the sewer,   grow   up  and think.

Mon, 10/24/2011 - 19:37 | 1806399 msmith
msmith's picture
The EURUSD is likely an indicator for a potential top that is near for equities.   Another final push higher could put in a top?  http://bit.ly/s9rYU1
Mon, 10/24/2011 - 19:39 | 1806405 howswave5workin...
howswave5workingforyou's picture

What does that comment have to do with the article? It's just hysterical noise you overheard in some blog that sounds cool? We are discussing fundamental non finance sector cash flows. The real world. Is there some auto generation monte carlo buzzword machine on this blog? That throws out these comments?

Mon, 10/24/2011 - 19:49 | 1806432 Stoploss
Stoploss's picture

Well please excuse the fuck out of us for daring to post on YOUR thread.  

Mon, 10/24/2011 - 19:40 | 1806408 howswave5workin...
howswave5workingforyou's picture

This is in reference to 19:32 comment

Mon, 10/24/2011 - 19:47 | 1806426 buzzsaw99
buzzsaw99's picture

You don't know how to work the "reply" button yet you would presume to lecture me on the relevance of my comment? LMAO!

Mon, 10/24/2011 - 19:44 | 1806417 howswave5workin...
howswave5workingforyou's picture

Greece represents same value as Mexico in 1994, argentina in 2001, Thailand in 1998, Russia in 1997. 75%,at least from peak, with "default" en route.

Mon, 10/24/2011 - 19:46 | 1806422 Stoploss
Stoploss's picture

Don't forget 2's 5's 7's auctions tomorrow, wed, thur. I doubt a euro fix by wednesday anyway, but never fear, another auction is here! Funny, they have to have something every single day now to prop the pig up. Today was...   Mergerrrrrrr Mondayyyyyy! (In your favorite monster jam track voice) 2 Yearrrr Tuesday!!!  Nothing happens Friday anyway execpt: Melt up Fridayyyy!!  

Mon, 10/24/2011 - 20:22 | 1806525 Everybodys All ...
Everybodys All American's picture

Watching the financial networks coverage of the markets more often than not give you the feeling you are watching theater. Two bit actors orchestrating the whole show for public consumption. At some point the media will pay a huge price for their part in this financial debaucle.

Mon, 10/24/2011 - 19:49 | 1806433 howswave5workin...
howswave5workingforyou's picture

Us housing mkt? Look at xhb.

Mon, 10/24/2011 - 19:49 | 1806434 howswave5workin...
howswave5workingforyou's picture

Us housing mkt? Look at xhb.

Mon, 10/24/2011 - 19:59 | 1806461 jm
jm's picture

Good post, just talking a bit of shop here. 

HY bonds have indeed been bought, though its tough to find a client, friend, colleague who has been aggressive buyers at the single-name level.

If you are looking for books built with $50M blocks, you aren't going to find it much of anywhere.  The game has changed.  You can't even find a $10M bid anymore.  You can't unwind big blocks without seeing your MTM profit vaporize.

Also, there are a ton of hedges people overlay on credit that have high beta content and are just plain vanilla.  And this works, so I'm not sure that you can attribute all of this move to a hedge unwinds/short squeeze in HYG.  Retail flows can move an ETF, so maybe retail picked up some yield.

 

 

 

Mon, 10/24/2011 - 20:12 | 1806498 Mike2756
Mike2756's picture

Was it capitulation day? Very high volume.

Mon, 10/24/2011 - 20:15 | 1806510 jm
jm's picture

Look at the "ECB put".  Every morning they stick save Italian bonds, and it feeds risk.  The Fed can just sit back and watch.   

Mon, 10/24/2011 - 20:15 | 1806509 ZeroPower
ZeroPower's picture

Yes, good addition. Haven't seen real size going through SovX or XOver even though 10mm clips used to go off without so much as a second glance at where the market was after the hit.

Mon, 10/24/2011 - 21:33 | 1806759 Reese Bobby
Reese Bobby's picture

The Street has no inventory, there has been little new issuance, foreign capital has fled to U.S. credit, QE3 trial balloons scared all shorts AND high yield investors are about as smart as the cast of Jersey Shore.

This article is correct as the junkiest high yield bonds are still 20% off July levels but moving up.  Thanks for a great post.

Mon, 10/24/2011 - 20:06 | 1806487 chump666
chump666's picture

Credit markets get tighter thus equities rallying.  The hedge will flood back into long dated bonds, once equities start to trade above the Aug 3 resistance (S&P 1245).  We are now are in over-bought markets and I can't see fund managers/portfolio players running this long over early August resistance, they will have to find support only on high volume markets, which is not happening.

The short hedges will start once the markets tops out, which it is now. My guess is that Asia will sell first, that's the weak sign, then into European/markets.  We could rally into end Oct, with selling into Nov.  This market won't make new highs

It's all news though and we hang on every headline.  And Zero Hedge is doing a stella job.

Mon, 10/24/2011 - 20:16 | 1806511 ZeroPower
ZeroPower's picture

Kudos to whoever writes this (daily?) piece, one of my favs here.

Mon, 10/24/2011 - 20:48 | 1806602 Snakeeyes
Snakeeyes's picture

Inflation is the invisible dragon hidden by The Fed:

Here is my interview  CNBC after Rick Santelli:

 

http://video.cnbc.com/gallery/?video=3000052988

 

The charts are here: http://confoundedinterest.wordpress.com/

Tue, 10/25/2011 - 00:51 | 1807144 fxrxexexdxoxmx
fxrxexexdxoxmx's picture

Tony,

They were listening but you were not telling them what they wanted to hear. I heard you.

Thanks.

freedom x

 

Mon, 10/24/2011 - 21:05 | 1806662 broke433
broke433's picture

Nikkei is looking ugly

Mon, 10/24/2011 - 22:41 | 1806907 chump666
chump666's picture

Aust market has turned neg.

 

Mon, 10/24/2011 - 21:33 | 1806758 mszh
mszh's picture

"but the absolute inversion of the shares outstanding/redemption relative to the share price movement makes little sense"

Very much possible that new ETF units were created to satisfy the need to borrow. Safer to borrow that way than to do so out at multiple brokers on the street. Outstanding number of ETFs has a lot to do with arbitrage vs its underlying than the price.

Tue, 10/25/2011 - 04:35 | 1807330 abugarance
abugarance's picture

So +1% or +2% on the S&P today?

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