More worrinyingly, liquidity wise, as we have pointed out on numerous occasions on this blog, the degree of liquidity that can be provided by market makers is nothing comparable to what could be provided back then. Dealers simply do not have the inventories or the risk appetite to absorb a large sell-off should it occur in the market place. For instance, from a discussion with a large interdealer broker in the CDS space, it appears that only two banks are providing large enough liquidity in the High Yield CDS single name space in decent clip size (20-30 million of notional amount) whereas most of the time ticket size in the CDS single name space would be around 2-3 million per name in the CDS space. Markets have become indeed more defensive than in 2006-2007, particularly so when CDS dealers have a hard time recycling CDS bids being hit continuously with spread compression with no large loan books hedging taking place lifting protection in the process given the on-going deleveraging taking place in the European banking sector.
The latest move from the ECB has as well closed the gap between Investment Grade in Europe as seen in the credit index Itraxx Main Europe 5 year with its US counterpart CDX IG as illustrated recently by Bank of America Merrill Lynch's graph from their recent Credit Strategist note from the 6th of June entitled "Return to Order":
What of course the continuous tightening has done to Investment Grade Credit has been to increase the instability to sudden shock in rising rates, making the asset class increasingly more vulnerable than High Yield which from a convexity point of view is less sensitive to rates movements as indicated in the same report from Bank of America Merrill Lynch:
"The emerging June seasonal in rates
For the second consecutive year financial markets are working hard to establish a very bearish June seasonal for Treasuries, as 10-year interest rates two business days into the month have risen already 12bps. That represents the biggest 2-day increase in interest rates in more than six months (since 11/20/2013), but ranks only 15th since rates began to increase in May last year (Figure 21).
However a representative IG ETF (long term) has declined 1.29% over the last two days – a move not seen since 7/5/2013, and the 6th biggest move since May last year. A benchmark HY ETF is down 0.76% over the same period, a move we have seen earlier this year, and only the 23rd biggest decline since May last year. Clearly this recent increase in rates is disproportionally adverse to IG returns compared with anything we have seen recently. The main reason is that, as credit spreads have rallied significantly, there is very little spread cushion available to offset the increase in interest rates. Clearly high yield has more capacity, and thus returns are faring better.
The past two days compare with the period 10/29/2013-12/31/2013, where the same representative IG ETF declined similarly (1.21% negative price return). However, that was on a 50bps move higher in 10-year interest rates (from 2.5% to 3.0%). One of the big differences is that back then credit spreads started at 144bps compared with just 112bps currently, and thus could play a bigger role in offsetting the rates move (Figure 22).
Thus eventually retail inflows end, which should more than offset the increase in institutional demand and lead to less favorable liquidity conditions and higher spread volatility." - source Bank of America Merrill Lynch
To illustrate further more interest sensitivity in conjunction with lack of liquidity, we discussed recently this very subject with our cross-asset friend and fellow blogger "Sormiou". For instance there are some new issues in investment grade in the primary market in the 300/400 million euro range size coming to the market. They are obviously smaller than the traditional 500 million benchmark size deals being generally placed and bought by mutual funds. They come with 10 year maturities with spread comprised between 70 and 90 bps. The problem is that on the secondary space these bonds are being priced by market makers with 10 bps bid/offer spread meaning that with a duration sensitivity of around 7/8 you lose 1 year of carry in the secondary space should you decide to part with your recently acquired bonds. So dear Investment Grade investors welcome to "Japonification" and "buy and hold" for the next 10 years...
The recent ECB decisions will of course reinforce the technical bid for credit even more and compressing even further already very tight spreads in the market place. In this environment, no doubt European High Yield will continue to perform as the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We therefore expect financials to outperform significantly non-financials, and in particular Italian financials credit and equities to be as well the big beneficiaries from the latest generosity from our "Generous Gambler" aka Mario Draghi. Let's face it, when your central bank offers you 400 billion 4 year loans at 25 bps, it is hardly an offer you can refuse to play the "carry" game even further. While the ECB is hoping that banks will use to pass it on to corporate via increase lending, the deception in "Operation Mincemeat" is that it will be used rather as yet another source of cheap funding given the real constraint face by the European financial sector has more to do with capital issues rather than liquidity issues.
What seems to be happening as well with the recent additional help of "Operation Mincemeat" by the ECB, is that investors are indeed pushed out even further out on the risk curve as confirmed by Morgan Stanley's Leveraged Finance Insights note from the 6th of June entitled "Here What You Own":
The latest round of central bank generosity will further trigger additional yield seeking investment and boost no doubt asset prices further up as illustrated by the performance of European High Yield versus Equities since 2009 as displayed by Bank of America Merrill Lynch in their latest Thundering Word report entitled "So it begins":
Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"
We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4% these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great magicians. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:
On a final note and to illustrate further our "deception" analogy from our chosen title as well as our gently twisted starting quote from above, Mario Draghi is truly a great magician when it comes to deception tricks as indicated by the below Bank of America Merrill Lynch graph from their latest Thundering Word note entitled "So it begins" given that Italy now appears more creditworthy than the US:
"From ZIRP to NIRP
ECB policy ease induced a phenomenal rally in European credit markets. 5-year Italian bonds yielded 700bps more than US 5-year bonds less than 3 years ago; now they trade 25bps below (Chart 2)."
For us it seems we are indeed moving from ZIRP to NIRP, to ZILCH, when it comes to yield levels and no doubt the last leg of the rally has some more room to "overshoot" on the way up rest assured.
"Profit is sweet, even if it comes from deception." - Sophocles