High Yield

Following the recent downgrades of many of the major European banks and insurers and last year's comments by Fitch on insurers' inability to pass on losses to policyholders, the hot-topic of ASSGEN, ALZ, and the rest of the capital-impaired forced-soakers-up-of-new-issue-demand in the European insurance market are under new pressure as The WSJ points out today that new 'rightly punitive' capital rules have been watered down. The 2014 introduction of 'Solvency II' - the insurers' equivalent to banks' Basel III capital rules - did indeed attempt to create risk-weighted capital requirements and better balance assets and liabilities within these firms. However, as Hester Plumridge notes, regulators bowed to industry pressure (again) adding the ability to shift discount rates to get around low-rate-implied valuations for their annuity streams and the introduction of a 'countercyclical premium' to avoid the growing (and negative) spread between distressed assets and rising liabilities. As Plumridge concludes, "a solvency regime that ignores all European sovereign credit risk looks increasingly unrealistic. Investors could end up none the wiser." After some systemic compression, the last week or so has seen insurers start to deteriorate as perhaps the market will enforce its own capital expectations even if regulators are unwilling to.

In spite of the fact that the Greek story has been out there for almost 2 years now, it still drives the market. Virtually all of the big moves this week came on the back of Greek headlines so it is impossible to argue that it is “priced in”. My best guess is that a resolution (which the market believes is most likely) sparks a 2%-4% rally. A default (which I think is most likely) sparks a 5%-10% decline. So at these levels I will be short as I think the most likely move is lower, and the move lower is likely to be bigger. With the market being choppy, being nimble remains a key....The market has a tendency to do well after the credit guys leave on holiday shortened trading days. So with the desire to believe that Europe will not let Greece default (in spite of evidence to the contrary) the markets may remain in rally mode for the day because no one wants to miss the imminent resolution of the crisis. I am far more convinced that we will get some very disappointing headlines because the situation really doesn’t work, and the tone of Europe has switched from “No Default” to “No Disorderly Default”.

Europe has moved into the “pound of flesh” stage of negotiations. Everyone just wants to make their point and the probability of a deal is dropping by the day. Europe is running out of time, and is just clueless. Yesterday has to confirm that even for the most optimistic person out there. They decided they should wait until the elections. Then they realized they had to deal with the March 20th bonds. Then they came up with a “bridge loan”. Clearly they didn’t bother to look up the definition of a bridge loan. A bridge loan is a loan that is meant to be temporary and has such punitive rates over time that the borrower is heavily encouraged to pay it back with new debt. This is just a “small” loan but one that is permanent and probably never getting paid back. I’m not sure if they asked the contributors whether they wanted to put up €16 billion which is somehow now “small”. Then noise came out that maybe Greece just shouldn’t have elections. The Troika and Greece have been negotiating all this time and no effort was spent on figuring out a plan in the event of default. They are scrambling to come up with one. I remain convinced that Greece could do well in default if it is managed properly, but the chances of them doing anything properly is low.

European (like US) stocks remain in a narrow range just above the cliff of the unbelievably good NFP print of 2/3. US and European credit markets have lost significant ground since then and it seems equity investors just want to ignore this 'uglier' reality for now. The BE500 (Bloomberg's broad European equity index) is unchanged from immediately after the NFP 'jump', investment grade credit is +10bps from its post-NFP tights, crossover (or high yield) credit is around 50bps wider, Subordinated financial credit is +50bps off its post-NFP wides at 382bps, and senior financial credit is an incredible 36bps wider at 225bps (by far the largest on a beta adjusted basis). The divergence is very large, increasing, and a week old now and perhaps most importantly as we look forward to LTRO Part Deux, LTRO-ridden banks have underperformed dramatically (40bps wider since 2/7 as opposed to non-LTRO banks which are only 10bps wider) - how's that for a Stigma? Some 'banks' have suggested the underperformance of credit is due to 'technicals' from profit-taking in the CDS market - perhaps they should reflect on why there is profit-taking as opposed to relying on recency bias to maintain their bullish and self-interest positioning as the clear message across all of the credit asset class is - all is not well.

UPDATE: EURUSD back over 1.32 and TSYs +2bps on Greek loan plan news.

Credit (and vol) continue to lead the way as smart deriskers as ES (the e-mini S&P 500 futures contract) ends down only 0.5% - which sadly is the biggest drop since 12/28. The late day surge in ES, which was not supported by IG or HY credit (and very clearly not HYG - the HY bond ETF - which closed at its lows and saw its biggest single-day loss since Thanksgiving), saw heavier volumes and large average trade size which suggest professionals willing to cover longs or add shorts above in order to get filled. Materials stocks underperformed but the major financials had a tough day as their CDS deteriorated to one-week wides. VIX (and its many derivative ETFs) had a very bumpy ride today. VXX (the vol ETF) rose over 14% (most in 3 months) at one point before it pulled back (coming back to settle perfectly at its VWAP so not too worrisome). After the European close, FX markets largely went sideways with the USD inching higher (EUR weaker) as JPY strength reflected on FX carry pair weakness and held stocks down. Treasuries extended their gains from yesterday's peak of the week yields as 7s to 30s rallied around 6bps leaving the 30Y best performer on the week at around unchanged. Commodities generally tracked lower on USD strength with Oil the exception as WTI pushed back up to $99 into the close (ending the week +1.1% and Copper -1.1%). Gold and Silver ended the week down almost in line with USD's gains at around 0.25-0.5%. Broadly speaking risk has been off since around the European close yesterday and ES and CONTEXT have reconverged on a medium-term basis this afternoon (to around NFP-spike levels) as traders await the potential for event risk emerging from Europe.

Credit markets are continuing the trend of the last couple of days with this afternoon seeing their underperformance accelerating. Major underperformance this week in investment grade and high yield credit markets relative to stocks (and as we noted this morning, we are also seeing financial credit in Europe notably underperforming) as Maiden Lane II assets are sold and high yield issuance peaks (and liquidity dries up). Adding to the concerns, VIX futures saw their biggest 2-day jump in over two months despite equity's modest rally. On a day when Pisani tells us there was much to rejoice about, stocks managed only negligible gains (even with broad risk assets in risk-on mode, TSY yields up, FX carry up, Oil up) and while stocks are limping higher now (aside from AAPL of course) with financials underperforming, perhaps this week of notably higher average trade size in equity futures is the calm before the real storm gets going - as credit and vol seems to be hinting at.

Somehow, once again, we managed to rally EURUSD (to 2 month highs) on the back of Greek deal hopes (even as Merkel stomped her feet, Hollande flexed his muscles, and Dallara/Venizelos had nothing to report) which maintained a modicum of support for equity markets (which also got a little late day push from another record-breaking Consumer-Credit expansion) as cash S&P made it to early July 2011 levels. Unfortunately, with Utilities leading S&P sectors, credit diverging wider in investment grade and high-yield, Copper underperforming (post overnight China reality checks), WTI's exuberance (relative to Brent at least), and implied correlation diverging bearishly from VIX, we can't say this was a wholly supported rally. Broad risk-asset proxy (CONTEXT) did stay in sync with ES (the e-mini S&P 500 futures contract) after the European close as Treasuries held up near the day's high yields and FX carry stabilized. Financials lagged with the majors actually underperforming for a change as we note the late-day surge in ES to new highs saw significant average trade size suggesting more professionals covering longs into strength rather than adding at the top. Volume was above yesterday's dismal performance but remained below the year's average so far. Credit and equity vol are back in line and credit has now been flat and underperforming for the last three days (even as HY issuance has been high).

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. 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. The ETFs 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? 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.

The real meaning of a treasury bear market may not be a flight out of treasuries into another asset class. Rather it real import could be the lack of liquidity available anywhere for nearly any asset class... Liquidity acts in a financial system like ample water, ambient temperature, and clean air act in an ecosystem. It makes trading strategies proliferate. Further, it makes meaningful intermediation possible, fostering the growth in high yield bonds and marketable loans. Yes, derivatives like vanilla stock options and others too. A financial system without liquidity is like a tropical ecosystem dried into a desert. Without liquidity, it is an open question whether the arbitrage pricing revolution will outlast the antiquated mark-ups of reinsurers. Liquidity makes random processes stationary, which is crucial to make the probabilistic foundations of risk neutral pricing work. Is it intuitively possible to price (and even more buy and sell) credit and interest rate risk without some liquidity in the underlying? How can a bank generate carry when the curve is flat and there is no appreciable differential anywhere that has a minimum tolerance of liquidity?

Equity and credit markets eked out small gains on the day as Treasuries limped a few bps lower in yield (with 30Y the notable underperformer) and the EUR lost some ground to the USD. ES (the e-mini S&P futures contract) saw its lowest volume of the year today at 1.35mm contracts (30% below its 50DMA) as NYSE volumes -10% from yesterday but average for the month. Another small range day in almost every market aside from commodities which saw significant divergence with Silver (best today) and Gold surging (up around 1.15% on the week) while Oil and Copper dived (down 2.6-3% or so on the week) with the former managing to scramble back above $96 into the close. ES and the broad risk proxy CONTEXT maintained their very high correlation as Oil and 2s10s30s compression dragged on ES but AUDJPY and TSYs post-Europe inching higher in yields helped ES. HYG underperformed all day (often a canary but we have killed so many canaries recently). Energy names outperformed on the day (as Brent and WTI diverged notably) but financials did well with the majors now back up to the late October (Greek PSI deal) highs. All-in-all, eerily quiet ahead of NFP but it feels like something is stirring under the covers as European exuberance didn't carry through over here (except in ZNGA and FFN!).

One of the major factors in the Central Banks of the world having stepped up the pace of flushing the world with increasing amounts of freshly digitized cash is writ large in the contraction in credit availability to the real economy (even to shipbuilders). Anecdotal examples of this constrained credit are everywhere but much more clearly and unequivocally in tightening lending standards in all of the major economies. As Bank of America's credit team points out, bank lending standards to corporates have tightened globally in Q4 2011 and the picture is ubiquitously consistent across the US, Europe, and Emerging Markets. Whether it is deleveraging, derisking, or simple defending of their balance sheets, banks' credit availability is becoming more constrained. While the Fed's QE and Twist monetization and then most recently the ECB's LTRO has led (aside from self-reinforcing short-dated reach-arounds in BTPs and circular guarantees supposedly reducing tail risk) to nothing but massive increases in bank reserves (as opposed to flowing through to the real economy), we suspect it was designed to halt the significantly tighter corporate lending environment (most significantly in European and Emerging Markets). The critical corollary is that, as BAML confirms, the single best non-market based indicator of future defaults is tightening lending standards and given the velocity of shifts in Europe and EM (and very recent swing in the US), investors reaching for high-yield may be ill-timed at best and disastrous credit cycle timing at worst (bearing in mind the upgrade/downgrade ratio is also shifting dramatically). Liquidity band-aids are not a solution for insolvency cardiac arrests as the dual vicious cycles of bank and sovereign stress remain front-and-center in Europe (with EM a close second) and the hope for real economic growth via credit creation kick-started by an LTRO is the pipe-dream the market is surviving on currently.

The market is back to being excited and bullish. Yesterday’s announcement out of Europe was underwhelming, but no one cares as a Greek PSI announcement is expected any moment.  It will be interesting to finally find out how many bonds sign on at the time of the agreement and who the potential holdouts are. More importantly, once again LTRO is the talk of the town.  Talk is that the demand will be €1 trillion or more (as ZeroHedge discussed here first over two weeks ago).  It will be interesting to see if the number approaches that or is far smaller.  We continue to believe that banks are using it to prefund redemptions and not as cheap financing to start a new round of asset gathering.  All the talk about the “carry” trade makes it sound like something new that the banks have just figured out, when it is the exact trade that got them in trouble in the first place.  Why did banks sell naked CDS on companies and countries (write protection)?  Because they got carry with no funding worries. Listening to the “chatter” you would think the market is on fire, yet S&P is barely up in almost 2 weeks (it closed 1308 on the 18th).  For the past couple of weeks, fading rallies has been working well, and we don’t see that changing as more and more people become convinced that “Europe is priced in” and ignore that strong earnings were priced in and aren’t really materializing.

"Reach for yield" is a phrase that never gets old, does it? Whether it's the "why hold Treasuries when a stock has a great dividend?" or "if this bond yields 3% then why not grab the 7% yield bond - it's a bond, right?" argument, we constantly struggle with the 100% focus on return (yield not capital appreciation) and almost complete lack of comprehension of risk - loss of capital (or why the yield/risk premium is high). Arguing over high-yield valuations is at once a focus on idiosyncrasies (covenants, cash-flow, etc.), and technicals (flow-based demand and supply), as well as systemic and macro cycles, which play an increasingly critical part. Up until very recently, high yield bonds (based on our framework) offered considerably more upside (if you had a bullish bias) than stocks and indeed they outperformed (with HYG - the high-yield bond ETF - apparently soaking up more and more of that demand and outperformance as its shares outstanding surged). With stocks and high-yield credit now 'close' to each other in value, we note Barclay's excellent note today on both the seasonals (December/January are always big months for high yield excess return) and the low-rate, low-yield implications (negative convexity challenges) the asset-class faces going forward. The high-beta (asymmetric) nature of high-yield credit to systemic macro shocks, combined with the seasonality-downdraft and callability-drag suggests if you need to reach for yield then there will better entry points later in the year (for the surviving credits).

Markets have become far less volatile than last year, but many investors remain focused on the Credit Markets for signs and cues as to the next move.  With so many people looking to moves in credit markets and trying to determine how successful an auction has been, we thought it would make sense to go through some examples of how credit trades.  At one extreme you have a real market like for the E-mini S&P futures.  That trades from Sunday at 6pm EST until Friday at 4:15 EST.  It is virtually continuous and at any given time you can see the bids and offers of the entire market.  Then you have credit trading, which has almost nothing in common with ES futures and their incredible liquidity and transparency.

With the Fed expected to at least extend the period of guaranteed ZIRP from 2013 to 2014 tomorrow, it is no surprise that the just priced $35 billion in 2 year bonds did so very uneventfully, and at a high yield of 0.25% (38.96% allotted), in line with the When Issued, the note priced like what is was: an issue explicitly guaranteed by the Fed, and a yield reflecting it. The pricing was uneventful in the headline, and in the internals, with the Directs taking down 8.27% (quite lower than the TTM 13.05%), Indirects in line with average at 32.89% and Primary Dealers as usual accounting for more than a majority, or 58.84%. The Bid To Cover was a solid 3.75 if not a record. And now the Dealers will promptly reverse repo the bond back to the as nobody can do anything with a 0.25% yield in an environment in which investors demand double digits ROEs. Most importantly, however, was that this was merely the latest bond auction concluding even with the US debt ceiling still not getting an extension, and even more plundering from the G-fund. Once the ceiling is finally lifted, total US debt will move the maximum $15.2 trillion to well over $15.3 trillion overnight, maybe higher, just as it did back in August.