How ZIRP and SNAC Made It Easier To Short Credit

Via Peter Tchir of TF Market Advisors

Much has been made of "unintended consequences" of various policies.  Even ZIRP is gaining more attention.  ZIRP punishes savers. ZIRP forces bond managers to move out in duration or down in credit quality to get enough income to provide some semblance of a return after fees.  ZIRP may be encouraging people to wait on home purchases as they don't think interest rates or mortgages will rise anytime soon.  ZIRP has played a role in the credit crisis as well.  As has the SNAC protocol for CDS.

On a simplistic level, shorting credit is expensive.  Contrary to the popular opinion, shorting credit is difficult way to make money.  You pay away interest and you run the risk of spread tightening.  More money has been lost being short Radioshack, The Gap, Brunswick, Tyson, and Macy's than any other 5 big companies I can think of (almost every CDS trader has a story about getting caught short one of these credits that inexplicably always find a way to rebound).  Keeping rates so low has made it easier to short credit.  It is easier to run a short credit position because of ZIRP, so when problems are found in a company or a country they can see their spreads blow out much faster.

It is just common sense that is cheaper to short a bond yielding 4% than one yield 7%.  By setting rates so low, investors, speculators, and hedgers could take short positions much more easily.  If you have concerns about a country's finances, but the bonds yields only 4%, it is a much easier decision to short, than if the bonds are yielding 7%.  Your cost of carry and risk of being wrong are dramatically reduced.

The other direct impact of ZIRP is that it artificially inflates spreads. Various products have a natural floor on yields.  High Yield is often said to be a market that exists well between 7 and 11%.  When yields get tighter than that, you cannot be compensated for the risk of defaults in a portfolio, and when they are tighter than that, it is distressed is trading as pseudo-equity rather than credit.  If the ECB overnight rate was at 4%, would Spanish 5 year yields being more than 5% be a topic of conversation? Spain and Italy have enough problems that how low their yields can go is a function of credit, and not short term rates.  This increases their spread to bunds and heightens tension in the markets.


Chart: Bloomberg

This chart looks at TLH (a 10-20 year treasury iShares product) and CDX IG16 since July.  Whenever TLH goes up in price (yields go lower), credit spreads widen.  Similarly whenever TLH is selling off (yields go higher) the credit spreads are decreasing.  This tells me that the world is reasonably comfortable with investment grade credit, but it has hit a yield where it cannot go much lower.  It just isn't worth it for investors to go long investment grade bonds below a certain yield.  They aren't compensated for the lack of liquidity and risk.  So when treasuries rally due to real fear, or ZIRP, or operation TWIST, credit lags and is wider, but artificially wider.  The investment grade bonds aren't selling off much in yield terms (in some cases the yields are improving), but when looked at versus the spread to artificially low treasury yields, it looks like there is a problem.  The converse is true when treasuries sell off.  The spread tightening is artificial as well.  Investors aren't necessarily bidding up the bonds, the yields are just stable, giving the impression of spread tightening. 

This is just another case where "risk-free" yields have been set so artificially low, spreads are distorted because the underlying assets are effectively capped.  You can invest in High Yield if you want, but if you are investing solely because "spreads" are historically cheap - you have to be careful, as the potential for spread tightening just isn't there at these yield levels.

ZIRP and SNAC and Greece

Greek 5 year CDS has been trading in a range of 50 points up front to 63 points up front for quite awhile.  In spite of all the headlines of how CDS on sovereign debt is useless, it is still incredibly well bid.  Sovereign CDS is less appealing for banks to own and they will take down their "basis books" (long bonds and short via CDS) because of the pressure that can be put on them, but until Greece is really sustainable, the CDS will have value to non IIF participants (so far the IIF progress has been limited, so that is another reason CDS remains so well bid).

What do ZIRP and SNAC have to do with Greek CDS being so well bid for so long?  If you buy Greek CDS and pay 60 points up front (Friday's trading level), you have to pay 60 points up front, and 100 bps running.  What is your cost of carry being short this?  There is almost no running cost to being short.  The 100 bps per annum is negligible (that is SNAC), but there is almost no opportunity cost on the 60 points up front either.  By making rates so low, there is no carrying cost on the amount of up front premium paid.

Pre-SNAC days, once a name trades "points up front" it would trade with 500 bps running.  So instead of paying 100 bps, you would be paying 500 bps per annum.  What would the right "price" of this CDS be?  If there is no default, a buyer of protection paying 500 bps, would have to pay 20% over the life of the trade.  But since Greek default is so likely, who would sell the protection for much less than 60 points?  The risk of default is extremely high, the bonds trade pretty flat across the curve, so my guess is that 500 running CDS would trade at about 56 if 100 bps running was trading at 60  (just over a year's worth of carry?).

Although in theory everyone should be "risk neutral" we have seen over history that carry plays a bigger role in credit decisions than it should. No matter how much someone talks about yield, or OAS, there is a tendency to focus on current yield or coupon.  If SNAC protocol included shifting to a different running spread of weak credits, it may have a positive impact on the market.  "Speculators" tend to stop themselves out more when the position goes against them AND they have high negative carry.  I'm not sure it makes sense, but it is how the market works.

SNAC has been a great step for the market, though it should have encouraged exchange traded CDS long ago, but some additional features should be added to balance the simplicity with market needs.  The whole product should be brought on to exchanges - there can be no doubt that at this point the fears about CDS (whether right or wrong) have far too negative an impact on the markets as a whole to be ignored for another 4 years.

Nothing will be done about ZIRP because in spite of the evidence it hasn't done much, everyone just says it would have been worse without it, and brushes aside "unintended consequences" as transitory or wrong.


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