High Yield

My most recent trip to Calgary gave me a welcome chance to catch up with friends and colleagues in Cow Town's oil and gas sector. I found out about new projects, investigated companies of interest, and came away with an improved feel for the current state of affairs – what's hot, what's not, and why. The outlook from here is not great. When markets turn bearish, investment strategies often turn toward income stocks, and rightly so: if market malaise is expected to keep share prices in check, dividends become a very good place to look for profits. But whenever a particular characteristic – such as a good dividend yield – becomes desirable, it also becomes dangerous. The sad truth is that scammers and profiteers jump aboard the bandwagon and start making offers that seem too good to refuse. It was just such an offer that reminded me of this danger. In the question-and-answer period following my talk in Calgary at the Cambridge House Resource Conference, an audience member asked my opinion of a new, private company that was offering a 14.7% monthly dividend yield.

"In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability!" is how PIMCO's El-Erian introduces the game-theoretic catastrophe that is potentially occurring around us. In a lecture to the St.Louis Fed, the moustachioed maestro of monetary munificence states "let me say right here that the analysis will suggest that central banks can no longer – indeed, should no longer – carry the bulk of the policy burden" and "it is a recognition of the declining effectiveness of central banks’ tools in countering deleveraging forces amid impediments to growth that dominate the outlook. It is also about the growing risk of collateral damage and unintended circumstances." It appears that we have reached the legitimate point of – and the need for – much greater debate on whether the benefits of such unusual central bank activism sufficiently justify the costs and risks. This is not an issue of central banks’ desire to do good in a world facing an “unusually uncertain” outlook. Rather, it relates to questions about diminishing returns and the eroding potency of the current policy stances. The question is will investors remain "numb and sedated…. by the money sloshing around the system?" or will "the welfare of millions in the United States, if not billions of people around the world, will have suffered greatly if central banks end up in the unpleasant position of having to clean up after a parade of advanced nations that headed straight into a global recession and a disorderly debt deflation." Of course, it is a rhetorical question.

We have been pointing to the 'changes' that are evident in the high yield credit market (bonds, credit derivatives, and ETFs) for a few weeks now. The fall in the high-yield bond advance-decline line (and up-in-quality rotation); the decompression of HY credit spreads; and the lack of share creation, discount to NAV, and underperformance of JNK/HYG; but these canaries-in-the-coalmine pale in comparison to the massively over-crowded nature of the high-yield credit protection bullish positioning among arguably levered market participants. As Morgan Stanley notes: "US High Yield Investors Are 'Full Overweight'". Remember large crowds and small doors are no fun.

The fact that the High Yield ETFs are trading at a discount should be a big concern to anyone in the high yield market, not just those who own the ETF.  There is a real risk that this discount can translate into arb activity which leads to further declines. We are very concerned that the same index-arbitrage process occurring in CDS markets can occur in the HY bond market and liquidity, as bad as it is in a strong market, is far worse in a down market.  As of yet there is no sign that this is happening in a meaningful way, but JNK has seen outflows for a few days and HYG saw outflows yesterday.

There is a lot of talk about IG9 these days.  We think the JPMorgan 'Iksil' story has a lot more to do with tranches than with outright selling of the index. Noone knows what exactly is going on, but we think selling tranches without delta explains far more than just selling the index, given the size and leverage. Critically, in the end it is all speculation as what (if any) trade they have on but if our belief on this being a tranche exposure (for the thesis reasons we explain) then the explanation is far less scary.

Despite a grumpy open in the major cash equity indices - which opened pretty much in line with where S&P futures had closed on Friday morning - equity indices provided some BTFD reassurance for any and everyone who wanted to get on TV today. In sad reality, a lot of this equity index performance was due to Apple's 2% rally off pre-open lows, as it made new highs and vol continued to push higher. Financials, Industrials, and Materials all underperformed on the day (and Utes outperformed but still lost 0.5%). The majors were hurt most once again but remain notably expensive still to their credit-market perspective. On an admittedly quiet volume day (with Europe closed), the credit market (especially HYG) underperformed equity's resilience open to close but an after-hours reality check dragged ES down to VWAP once again on notably above average trade size and volume for the day. VIX managed top almost reach 19%, leaked back under 18 before pushing back up to near its highs of the day by the close - breaking back above its 50DMA (as the Dow broke below its 50DMA but the S&P remains above). Treasuries shrugged off the equity resilience and stayed in very narrow range near their low yields as stocks diverged once again (until after hours). FX markets were very quiet with JPY crosses getting some action as EUR and AUD managed to drag the USD down a little. Commodities were mixed off Thursday's close with Copper the major loser and Gold outperforming. Oil managed a decent intraday recovery today most notably back over $102. The weakness after-hours in ES (the S&P 500 e-mini future) is worrisome as its lost the support of AAPL and its options. At the cash market close, ES peaked for the day at 1382.75 and has since drifted back all the way to 1374.25 - just shy of the day's lows.

In a very thin market, the S&P futures came very close to hitting their 50 DMA on Friday. The S&P futures went from a high of 1,418 on Monday, to trade as low as 1,372 on Friday. A 46 point swing is healthy correction at the very least, if not an ominous warning sign of more problems to come. There were 3 key drivers to the negative price action in stocks this week. All 3 of them will continue to dominant issues next week.

We have been warning of the uncomfortable current similarities to last year's (and for that matter cycle after cycle) high-yield credit underperformance / lagging behavior 'canary-in-the-coalmine' relative to the exuberant equity market for a month now. Now, Bank of America provides - in two succinct charts - the fundamental underpinning of this grave concern as across the high-yield credit universe revenues are not catching up with costs - creating significant margin pressures - and at the end of the day, a market that cares more for cash flow sustainability than the latest headline or quarter EPS upgrade from some sell-side pen-pusher is waving a red-flag as margins are the lowest they have been since March 2009 and is falling at a much faster clip than in the fall of 2008 as the reality of money-printing comes home to roost. And just to add salt to this fundamental wound, technicals are starting to hurt as supply picks up and 'opportunistic' issuance turns notably heavy - perhaps helping to explain how the ongoing inflows have been unable to push prices further up in the US. Lastly European high yield is trading tick-for-tick with sovereign risk still - as it has since the middle of last year and so as LTRO-funded carry fades, we would expect it to underperform - especially as austerity slows growth.

The Fed has undertaken the same front-loading of the US economy for three years in a row (QE1, QE2, and Operation Twist) and each of the three times the performance of the US equity market to this sudden flush of liquidity has been almost identical in terms of velocity (speed and direction) - even though the underlying macroeconomic impact has been lesser and lesser as we pointed out here earlier. What is also most notable is that as we head into April (as Biderman reminds us, a typically positive 'flow' month for US equities given the tax-based moves and quarter-start) we are nearing what has been the inflection point in the previous two pump-and-hope episodes. While sounding eerily bullish in the very short-term, Charles is critically clear that he expects the short-lived nature of money-printing's impact on the market economy to fade rapidly as he fully expects the government agencies to revise their growth expectations more in line with his 'fact'-based growth expectations which are considerably lower. Though he notes the timing of the election may mean more of a sustained 'hope', the fact that in 2012 (starting Nov2011) equity performance is better now than the previous two Fed-infused rallies is perhaps why corporate insider-selling is so dominating insider-buying now through March. The avuncular antagonist concludes with his expectations that once the April surge is done with (which it may already have done today?) he fully expects the stock market to give up all its first quarter gains (and need we remind you that high yield credit is sending the very same signals of concern that it did in Q2 of the previous 2 rallies).

With the first quarter of 2012 just about in the books, Nic Colas (of ConvergEx) looks at how the Exchange Traded Fund 'Class of 2012' has done in terms of asset raising to date. There have been 82 new ETFs listed thus far for the year and they have collectively gathered $1.1 billion in new assets through Wednesday’s close of business. While 63% of those funds have been equity-focused, fully 67% of the asset growth for the year has flowed into fixed income products. Just over half the total money invested in these new funds has had two destinations: the iShares Barclays U.S. Treasury Bond Fund (symbol GOVT, with $297 million in flows) and Pimco’s Total Return ETF (symbol TRXT, with $267 million in flows). The standout new equity funds of 2012 in terms of flows are all iShares products – Global Gold Miners (symbol: RING), India Index (symbol: INDA) and World Index (symbol: URTH). Bottom line: even with the continuous innovations of the ETF space, investors are still targeting international and fixed income exposure, a continuation of last year’s risk-averse trends and while 'ETFs destabilize markets' might be the prevailing group-think, this quarter’s money flows into newly launched exchange traded products reveals a strong 'Risk Off' investment bias. Interestingly, the correlation between inception-to-date performance and money flows is essentially zero.

Unlike yesterday's 5 year bond auction, which priced at the lowest Bid To Cover since August, there were no major surprises during the just concluded issuance of $29 billion in 7 Year bonds. The closing high yield was 1.59%, just as the When Issued predicted, which is the highest rate since October. The internals were more or less inline - Indirect takedown of 42.79% was the highest since August's 51.72%, Directs decline modestly from February's soaring 19.27%, to just 13.40%, which still was quite a bit higher than the TTM average 12.23%. Dealers were left with 43.81% of the auction, about 3% below their average. And while the market was sensing a weak auction ahead of the pricing, the subsequent favorable response in the Treasury complex has sent the entire curve tighter again, and money flowing out of stocks, which had hit an intraday high just before the auction completion. In other news, total US debt is now over $15.6 trillion.

For the last month or so, despite ongoing fund inflows, high-yield credit's performance has been generally muted. Compared to the exuberance of the equity market it has been downright flaccid and given how 'empirically' cheap it is on a normalized spread basis through the cycle (and the fortress-like balance sheets we hear so much about) some would expect it to be the high-beta long of choice in the new-new normal rally-to-infinity. However, it is not (and has not been since late January). There are some technical factors including a bifurcated HY credit market (between really 'good's and really 'bad's and illiquids and liquids), low rate implications on callability and negative convexity affecting price but the lack of share creation in the HYG (high-yield bond) ETF also suggests a lagging of support for high-yield credit. This is a very similar pattern to what was seen in Q1/Q2 last year as equity kept rallying away from a less sanguine credit market only to eventually collapse under the weight of its own reality-check. European credit and equity markets are much more in sync together as they have fallen recently but financials in the US exaggerate this credit-signaling-ongoing-concerns trend while equity goes on about its bullish business. Another canary dead?

Today's $35 billion 5 Year auction was not very pretty: coming at a high yield of 1.04%, it was a tail to the When Issued trading 1.03% at 1pm, and the highest rate since October's 1.055%, and the first 1%+ print in 2012. Also notable was the drop in the Bid To Cover to 2.85, which in turn was the lowest since the 2.71 in August of last year. Aside from that the internals were in line: Directs took down 11.3%, in line with the 11.4% average, Indiricts 41.9%, just below the 42.8% TTM average, and the remainder was Dealers, whose 46.8% allocation was just slightly lower than the 45.8% they have taken down previously. All in all another auction that squeezed by courtesy of the PD syndicate, which as has been noted before, is already loaded to the gills with the short-term bonds that Uncle Ben is selling. More importantly, this is the auction that in conjunction with tomorrow's last of three, will send total US debt higher by another $39 billion and brings it to a fresh record high $15.6 trillion. There is now about $700 billion in debt issuance capacity before the debt ceiling is breached again. At this run rate, this is just under 6 months before the debt ceiling scandal ramp up again, or just in time to be used by the GOP as the biggest trump card in the Obama reelection debates, just as we suggested here first back in February.

With volatility so low and risk seemingly removed from any- and every-one's vernacular, perhaps it is time to refresh our perspective on downside and tail-risk concerns. While most think only in terms of equity derivatives as serving to create a tail-wagging-the-dog type of reflexive move, there is a growing and increasingly liquid (just like the old days with CDOs, so be warned) market for options on CDS. Concentrated in the major and most liquid indices, swaption volumes have risen notably as have gross and net notional outstandings. Puts and Calls on credit risk - known as Payers and Receivers (Payers being the equivalent of a put option on a bond, or call option on its spread) have been actively quoted since 2006 but the last 2-3 years has seen their popularity increase as a 'cheap' way to protect (or take on) credit risk - most specifically tail risk scenarios. Morgan Stanley recently published another useful primer on these instruments - as the sell-side's new favorite wide-margin offering to wistful buy-siders and wannabe quants - noting the three main uses for swaptions as Hedging, Upside, and Yield Enhancement. These all have their own nuances but as spreads compress and managers look for ever more inventive ways to add yield so the specter of negative gamma appears - chasing markets up into rallies and down into sell-offs - and the inevitable rips and gaps this causes can wreak havoc in markets that have momentum anyway. Given the leverage and average notionals involved, understanding this seemingly niche space may become very important if we see another tail risk flare and as the Fed knows only too well (as it suggested here) like selling Treasury Puts, derivatives on credit are for more effective at establishing directional moves in the the underlying than simple open market operations.

Turning on the screens this morning to red pixels was an odd feeling for anyone who has traded stocks this year and while the low was put in soon after the US open the slow and steady weak volume limp higher in equities (led by financials and too-hot-to-handle Apple) got ES (the e-mini S&P futures contract) back up to close at 1400 on the nose (-4pts on the day). Investment grade credit was generally an outperformer relative to stocks today (though AAA corporates were net sold perhaps on rotation back into Treasuries) though the roll in credit derivative markets hinders comparisons a little, however, high yield credit dwindled a little (on light flows) into the close. Commodities were the hardest hit of the day - dramatically underperforming the implied weakness of a modestly stronger USD. Silver, which recovered well off its lows of the day, was equal worst performer with Copper as China's slowdown story dominated. Interestingly Oil also fell as increased supply news hit pushing WTI under $106. Gold outperformed (though was lower on the day) and stands down only 0.6% on the week now (less than half the losses of the other metals/oil). Treasuries (as we already noted) broke their record losing streak with a modest 1-2bps compression in yields close to close (after being closed for the Japan session last night). A relatively large jump up in EURUSD near the US day session open was the biggest news in FX markets but that leaked away all day as the USD limped high off that low (helped by AUD and JPY weakness). VIX managed to rise once again.