Via Peter Tchir of TF Market Advisors [10],
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-read [11] “reaching 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 over. Credit 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.

