Why Blackrock (And Every Other Bondholder) Is Freaking Out (In 1 Simple Chart)

Just last week, we explained why Blackrock - the largest asset manager in the world - is gravely concerned about the 'broken' corporate bond market. Simply put, thanks to The Fed's continued presence in the Treasury market has left the corporate bond market a liquidity-starved ticking time-bomb if faith in the stability of defaults ever falters (with firm balance sheets at record high leverage) and "selling" begins. As the following chart from Deutsche Bank highlights, the current level of liquid assets as a proportion of total HY assets is about as low as it has been tracking data back around 25 years.

 

In other words, the massive (and likely levered) positions The Fed has forced the world to take on by its repression face a dramatic liquidity risk cost if they are ever to 'realize' any gains from the Fed's handouts (by actually selling).

That's what every bond manager 'knows'...

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As Blackrock concluded,

To BlackRock, the dangers of price gaps and scant liquidity have been masked in a benign, low interest-rate environment, and need to be addressed before market stress returns.

 

...

 

The risk posed by investors trying to dump bonds after the Federal Reserve raises interest rates is “percolating right under” the noses of regulators, he said.

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And so here we are...

1. Corporate Bond Managers "KNOW" they can't sell as much as they want/need to (due to the illiquidty), so..

2. They Hedge.. first through CDS (HY CDX small sample and does not cover risk of the lowest crappiest names that many firms have bid up as the search for yield accelerated),

2a. or HYG/JNK (but that includes rate risk so the hedge is liquid but less accurate), so...

3. They Hedge... through stocks (beta-adjusted hedges - akin to capital structure arbitrage - can help more idiosyncratic risk control in the HY portfolio), and

4. They Hedge... through volatility (credit spreads and equity volatility are explicitly linked via the firm's asset - or business - uncertainty).

 

 

That's why small caps have suffered more as credit fell (as more directly linked to the weaker balance sheets).

How this ends... the hedges start to fail (i.e. MTM differences between portfolio delta and hedge delta grow large), someone else decides to "sell" and throw in the towel and prices gap down in HY... and the avalanche begins...

That's what Blackrock fears.

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Bonus Chart 1: Forget "best balance sheets ever", Leverage has never been higher...

 

Bonus Chart 2: The Fed is leaving the building and it's time to realize this 'spread'...