Sunday, 6 October 2013

Credit - The False Alarm

"Politics is the last resort for the scoundrels" - George Bernard Shaw

Looking at the on-going US political shenanigans, and given we recently  posited that markets had been "the last refuge of a scoundrel" courtesy of central banks' generosity and "Cantillon effects", we had to reassess our views. It does seem after all that politics have been indeed the true refuge for the scoundrels. 

So we found ourselves once more quoting one of the works of Samuel Johnson, as per our title reference "The False Alarm":
"As we once had a rebellion of the clowns, we have now an opposition of the pedlers. The quiet of the nation has been, for years, disturbed by a faction, against which all factions ought to conspire; for its original principle is the desire of elveling; it is only animated, under the name of zeal, by the natural malignity of the mean against the great." - Samuel Johnson, English author

Like many pundits, we view the on-going political stand-off leading to the US government shutdown more as a false alarm rather than anything else as indicated by the evolution of the S&P 500 in the below graph from CITI's recent Global Macro Strategy note from the 3rd of October entitled: "Complacency justified?":
"With potential fat tail-risks around the US government shutdown and debt ceiling standoff, the resilience of US equities and indeed investor short positions in Treasuries seem a bit surprising. Risk indicators like the VIX and our GRAMI have only nudged up a touch. Investors have taken some risk off the table, but not much.
Markets appear to be taking solace from the limited market damage in previous government shutdowns. For example, while George Bush Senior’s deficit reduction shutdown in 1990 saw volatility rise, the S&P fall 4.6%, and US bond yields and the USD move higher, markets more or less ignored Clinton’s Medicare related shutdowns in November and December 1995.
In 1995, House Speaker Newt Gingrich received the US public’s ire while President Clinton caught a wave of popular approval that helped him to re-election later in 1996. Markets may believe that this makes a deal more likely. But market complacency may ignore the risk that US politics are far more polarised now than then, and that both sides may believe that they have something to gain from holding out. This raises the risk that the shutdown morphs into the debt ceiling deadline on October 15. Also note that it usually takes a sharp shift in opinion polls or a market setback to change the political mindset. Remember 2008 and TARP: voted down until stocks plummeted, then voted in very quickly.
With the debt ceiling there is far more danger. Government shutdowns lead to small and temporary output losses as public workers are typically paid in arrears when government re-opens. But not raising the debt ceiling means a potentially damaging fiscal drag and, eventually, default risk. We assume that even partisan politicians know this and that the ceiling is indeed raised. However, some politicians are reportedly comparing the summer 2011 US sovereign ratings downgrade to an outright default as evidence that it may not matter.
Investors may well want some protection, at least short term, against a potential debt ceiling disaster. 
Meanwhile, the uncertainty surrounding this issue, unless resolved soon, may delay further the Fed’s tapering programme, extending the UST rally a little more, helping beleaguered EM short term and softening further the USD in FX markets." - source CITI

What we are more concerned about is the rise in corporate leverage. While last week we approached valuations from the equities angle, we want to approach the growing leverage issue from the credit side in this week's conversation.

Why is so? Because the leverage cycle does indeed matters for continued outperformance of credit as indicated in CITI's recent note:
"At this point in the leverage cycle we expect equities to keep outperforming credit as corporates increasingly engage in equity friendly and credit unfriendly activity. While credit is starting to look a little compressed, equity valuations remain attractive, giving them greater scope for upside. As we have mentioned before, the beta between credit and equity tends to have a convex relationship. In other words, as markets rally and credit compresses, the scope to outperform equity decreases." - source CITI

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":

Of course, for the "beautiful deleveraging" as illustrated by Ray Dalio in his recent video "How the Economic Machine Works", to continue to proceed in orderly manner, the "scoundrels" in Washington better get their act together otherwise all bets are off, but this is yet another "ramble" of ours.

When it comes to releveraging, it does indeed starts to matter when it comes to valuation. On that subject we agree with CITI's recent note from the 3rd of October entitled "Corporate leverage in the crosshairs":
"-It's taken only five years for leverage at America's most credit worthy companies to reach levels last seen at the depth of the Great Financial Recession. Yet there's a key difference this time: In 2009, investment-grade gross leverage climbed by roughly 0.5 turns to 2.3x largely due to a broad-based decline in revenue/EBITDA whereas the steady increase in corporate non-financial leverage that's occurred during the past three years has been intentional.
-For much of the past 3 years, bondholders have been willing participants in the releveraging of corporate America. Indeed, demand for new supply has been tremendous thanks to central bank liquidity injections that have resulted in record inflows into bond funds while simultaneously removing the supply of higher-quality fixed income securities like Treasuries and mortgages.
-But there's evidence that bondholders' attitudes toward releveraging are starting to change." - source CITI

CITI's leverage clock:

Leverage does indeed matter in the credit world as in can have a nasty effect in acute "repricing" in the secondary space. Identifying well in advance the LBOs and M&A has indeed been more "credit friendly" for a credit portfolio than anything else as illustrated by CITI:
"Frankly, one of the most profitable strategies of 2013 has been to identify credits that are likely to relever in a material way and underweight those credits well in advance (and then buy the new debt in the primary market). No doubt, the most spectacular example of the year is Verizon, where bonds of maturity greater than 5 years widened an average of 64bp (weighted by market value) before the much telegraphed deal to acquire the remaining 45% stake of Verizon Wireless the company didn't already own was announced.
Indeed, among the worst performing large-cap non-financials of 2013, many owe their widening to releveraging concerns of the intentional variety (with EM and mining credits also underperforming). In addition to the telecom sector coming under significant pressure, healthcare and independent E&P credits have been the primary targets for shareholder activists and levering M&A transactions." - source CITI

And when ones look back at the Global Credit Channel Clock, from our friends at Rcube, and as per our conversation in May this year entitled "What - We Worry?", we do think the credit cycle is going to be shorter this time around and liquidity is on top of our concerns as we argued in May:
"If you think liquidity is coming back in the credit space, then you are indeed suffering from "Anterograde amnesia" caused by the liquidity induced sugar rush" - Macronomics

It seems CITI has well shared our concerns for the lack of liquidity:
"Frankly, the potential for outflows to get much worse than the market has already experienced, and by extension demand for lower quality credit to deteriorate further, can’t be easily dismissed. A simple glance at how much total return money has found its way into credit in such a short period time period should provide some level of concern that it could flow out of credit just as quickly under the right conditions. Of course, evidence of a "great rotation" can be difficult to find, and we tend to avoid sensationalizing a risk that has already been well highlighted, arguably overly so.
Yet if one looks at the ETF world as a much smaller microcosm of the mutual fund world, it's clear that a rotation from bonds into equities is already underway and the swings in AUM, at least on a percentage basis, should keep credit investors awake at night in the event that the mutual fund industry, which is 30 times larger, were to experience flows of a similar percentage magnitude (Figure 9). 
Indeed, if outflows on that scale were to occur, we reckon it wouldn't just be lower quality credit that suffered, especially as the flows would likely overwhelm the Street's capacity to intermediate risk without significant price disruption (Figure 8).
In short: as the QE technical fades, we expect that corporate releveraging to have even more of an impact on spreads than it has so far. Moreover, presuming outflows don't entirely overwhelm the market—not our base case, but certainly a tail risk—the market is likely to become more sensitive to credit ratings as institutional demand for credit takes over from retail/total-return demand as the marginal source." - source CITI

No wonder Deutsche Bank and its competitors are trying to set up a multi-dealer US bond trading platform to ease the liquidity squeeze for their clients as reported by Matthew Leising in Bloomberg on the 26th of September in his article "Deutsche Bank Said to Propose Creating Bond Platform With Rivals": 
"Deutsche Bank AG is trying to drum up interest with some of its largest competitors to create a multi-dealer U.S. bond trading platform at the same time that asset managers discuss ways to make buying and selling debt easier, according to people familiar with the matter. Europe’s biggest investment bank by revenue has pitched its plan for an electronic trading network to JPMorgan Chase & Co., Citigroup Inc. and Barclays Plc, according to five people briefed on the talks, who asked to not be named because the discussions are private. Executives at State Street Corp. and FMR LLC’s Fidelity Investments are among institutional investors that have held a series of meetings, the last one in July in New-York, to address the difficulty of finding the bonds they want to trade, according to two different people.
The bank discussions on forming a platform and asset managers’ search for solutions comes amid a 76 percent decline in corporate debt inventory at the world’s biggest dealers since a 2007 peak. The pullback by market makers, which is spurring concern that the risk of trading disruptions has risen, comes amid stricter capital requirements from the Basel Committee on Banking Supervision and speculation that the U.S. Dodd-Frank Act will weaken their ability to facilitate bond trades." - source Bloomberg

As we posited in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

From our May conversation, we remind ourselves from the wise word from our friend and credit mentor Anthony Peters when it comes to liquidity:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk

We rest our case. But, moving on to the issue of credit rating sensitivity and spreads, High Yield comes to the front line. When looking at Fitch's recent US High Yield Default Insight, the trailing default rate ended September at 1.7%, but there are two large defaults looming for the fourth quarter, Energy Future Holdings (EFH) and Brazilian oil company OGX Petroleo e Gas Participa├žoes SA (OGX) which could add $20 billion to this year default rate to an estimated 3.5%:
"An EFH bankruptcy would qualify as the fifth largest on record for a nonfinancial entity. Using current market prices as a proxy, the par weighted average recovery rate on EFH bonds is estimated at 57%, with secured issues currently trading at an average of 86% of par and unsecured bonds at 19%. While the company’s troubles have been known for some time, the unsecured issues in particular ($7 billion in face value) were trading at a more robust 44% of par at the beginning of the year. Current prices result in a 2013 mark to market loss on EFH bonds of $2.4 billion. The mark to market loss on OGX bonds — now trading at 15% of par — is larger at $2.6 billion. For perspective, the year to date loss on all defaults January through September is $2.2 billion (on these issues, there was a 17% erosion in par value when comparing beginning of the year versus prices shortly after default)." - source FITCH

What is of interest to us of course is that what credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation. It is therefore interesting, we think to track, the US High Yield Default and Recovery Rates from 2000 and 2012 because it does show not only a fall in the recovery rates but, an increase in the average par value of bond defaults per issuer as per Fitch's report:

If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward - graph source Fitch:
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.

So what is driving default rates you might ask us again (we did answer in May)?
"For us and our good friends at Rcube Global Macro Research, the most predictive variable for default rates remains credit availability. Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey)"

We indicated at the time another indicator used by UBS being:
"Average leverage of non-financial corporate sector (Nonfinancial Corp Debt/Nonfinancial Corp Earnings, source Federal Reserve)."
"In terms of predictive value, the SLO survey and Non-financial leverage are two clear winners and these two factors alone produce an R^2 of about 0.6 in the best two-factor model." - source UBS

As we indicated in November 2012 in our conversation "The Omnipotence Paradox", zero growth should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults.
While the US government shutdown appears to us as a false alarm, we will continue to monitor the Federal Reserve Senior Loan Officer Survey - Percentage of Banks Tightening Standards on C&I Loans - graph source Fitch:

Of course one has to also look at defaults versus macroeconomic trends - graph source Fitch:
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator.

So looking back at our credit channel clock and CITI's leverage clock, one can rightly ask our close are we to another ratings downgrade cycle. CITI's note on leverage provided us with some interesting points on that matter:
"Is the next ratings downgrade cycle imminent?
As such, even though there seems to be a political and regulatory bias toward ensuring less dependence on credit ratings going forward, we expect rating agencies to grow in importance as far as their influence on valuations in the medium term. That credit ratings have a history of being a lagging indicator of credit quality—especially when it comes to releveraging transactions—is of some concern, to our minds. Indeed, apart from a few notable exceptions, the releveraging of corporate America hasn't been much of a ratings event. For instance, the overall credit quality of the non-financial portion of Citi's Broad Investment Grade Corporate Index is actually higher than where it was pre-crisis—there's obviously been a significant de-rating of financials over the same period (Figure 11).
So how overrated is corporate America at this point, and how close is the market to a downgrade cycle? It's a difficult question to answer, but arguably very important for identifying when the market has hit the tights of the current credit cycle. Indeed, for quite some time there's been a persistent gap between the fundamentals and valuations; broadly speaking, spreads have continued to tighten as some fundamental metrics, like leverage, have deteriorated (Figure 10). 
What's more, that disconnect runs counter to historical experience as spreads and leverage have been closely correlated. But given the right catalysts, we argue there's a risk that the gap closes well before the economic cycle turns and the economy enters recession. The removal of QE, a rise in bond yields that precipitates outflows, or a substantial pick up in the number of downgrades, could be just the sort of catalysts that prod spreads into alignment with leverage levels."

Monitoring how stretched current ratings are is one way to assess how imminent the next downgrade cycle is. Rating agencies, like Moody's, publish industry methodologies that detail ranges used to assign a given rating to a credit. As one would expect, there are many metrics and criteria that are incorporated into a rating. But when it comes to most non-financial corporates, a leverage metric of some variety is ubiquitous and on average contributes 13% to the final rating1. What's more, other criteria, like a firm’s financial policy, can effectively double how much influence leverage plays in determining a rating depending on the intentions of management. As such, it's possible to get a sense whether a given company is over-, under-, or correctly-rated given its leverage (usually gross) and current rating.
The results of such an analysis should raise concerns. As Figure 12 illustrates, the percentage of companies that are operating with gross leverage that’s higher than the upper bound of the range corresponding to their current rating is approaching 2009’s peak at more than 40%. 
Likewise, the number of companies operating with leverage headroom—i.e., they have capacity to add leverage without threatening their current rating—has declined to below 25%, a six-year low that’s below even the first quarter of 2009." - source CITI

Looking back on how our Rcube friends' "Global Credit Channel Clock" operates, it does seem indeed that the US is moving faster towards the upper left quadrant of the clock, namely re-leveraging and weakening balance sheets overall. While buybacks are great at driving multiple expansions as we argued recently, the overall objective and courtesy of the "wealth effect" thanks to central bankers' generosity, is of course leading CEOs to reach for incentive-based pay structures, it is human nature after all - graph source CITI:
"No stopping the releveraging train once it’s left the station 
But of all the strategies one might choose to employ with respect to navigating the corporate releveraging cycle, one centered on the idea that companies will have mercy on bondholders seems the least defensible, at least at an aggregate level. After all, there’s precious little evidence that corporate releveraging will stop anytime soon or that leveraging cycles are self-correcting—absent a recession. For instance, share buybacks are strongly correlated to the level of the S&P500, suggesting that companies often behave sub-optimally, buying high and selling low (Figure 15).
 Presumably, repurchasing shares is less about making a wise investment decision and more about signaling confidence, presumably with the aim of driving multiple expansion and meeting incentive-based pay structures." - source CITI

The "Cantillon effect" at play, the rise of S&P 500 and the rise of NYSE leverage - source Bloomberg:

As far as we can see in the credit space the US Government shutdown is akin to a false alarm, whereas corporate releveraging and the increasing speculative trends or "Cantillon effects" in risky asset prices are still building courtesy of on-going liquidity induced Fed reflation trend and like we said earlier in May:
"So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door"

We have therefore continued to dance, but we have been quietly moving closer towards the exit door.

On a final note, because the tapering fears have been postponed courtesy of our political scoundrels in the US, we think EM FX has more room to rebound in the near term has indicated by the below graph indicating the relationship between world PMIs and the JP Morgan index for EM FX currencies - graph source Bloomberg:

"As a man inebriated only by vapours soon recovers in the open air; a nation discontented to madness, without any adequate cause, will return to its wits and its allegiance, when a little pause has cooled its reflection. Nothing, therefore, is necessary, at this alarming crisis, but to consider the alarm as false." - Samuel Johnson, English author

Stay tuned!

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