While there has been a lot of noise recently around the SPX vs HY US widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning", this credit uneasiness is also visible in Europe with Investment Grade / High Yield renewed divide - graph source Bloomberg:
Itraxx Main 5 year CDS index versus Itraxx Crossover 5 year CDS index - roll adjusted as of the 20th of November 2014:
What has also been of interest in 2014 when it comes to the performance of credit, yet another "Hidden Fortress" we think, has been the total return performance in the US of High Grade versus High Yield in terms of Total Return as displayed in a chart from Bank of America Merrill Lynch from their 2015 2015 HG Outlook entitled "Un-reaching from yield":
Of course we agree that one of the top main reasons in the behavior of credit spreads has indeed been strong inflows in the asset class as indicated by Bank of America Merrill Lynch in their recent Follow the Flow note entitled "Quality is king" from the 21st of November:
"Non-stop flows into ‘safety’
More of the same for another week it seems. More inflows into high-grade credit funds, and more outflows from equity funds in Europe. Note that euro IG cash is now trading at 2007 levels. So far this year more than $60bn has been added to high-grade funds, while equities have seen inflows of only $14bn. If the recent trend of outflows from equity funds continues at the same pace for the rest of the year, cumulative flows might be close to flat.
Government bond funds have continued to see outflows for a fourth consecutive week, with money-market funds down for a second week in a row. Note that over the last week, only high-grade credit and loan funds have seen inflows.
Credit flows (week ending 19th November)
HG: +$2.0bn (+0.3 %) over the last week, ETF: +$669mn w-o-w
HY: -$700mn (-0.3%) over the last week, ETF: +$20mn w-o-w
Loans: +$41mn (+0.5%) over the last week
Flows into high-yield funds dipped into the negative territory. After a short stint of inflows European HY funds saw a $700mn outflow. YTD outflows now point to $2.5bn. Should HY flows remain in negative territory for the rest of the year that would mark the first year since 2011 of negative flows for the asset class. On the other side, high-grade credit with another $2bn+ inflow last week is set to have its best year according to EPFR data.
Mid and long-term high-grade funds continued to see strong inflows, while short-term funds suffered moderate outflows, as investors are reaching for quality yield.
In total YTD inflows in Investment grade represents $60 billion versus only $14 billion in equities. So much for the "Great Rotation" story of 2014...
When it comes to the gradual move towards higher quality in the credit rating spectrum, this adds validity to what we argued back in October in our conversation "Sprezzatura":
"When it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space. This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit."
In fact, as per Bank of America Merrill Lynch AAA-rated US corporate bonds (9% annualized) outperformed CCC-rated bonds (2%) validating the “flight to quality” theme and quality credit being a somewhat a "Hidden Fortress".
In terms of the impact the rate hiking cycle we have a preference with scenario number two from Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield":
"Why the rate hiking cycle is different for credit this time
There are three reasons why we are particularly concerned about the rate hiking cycle this time. First, we are at the tail end of an unprecedented five years of zero interest rates, which led to an unprecedented reach for yield. Thus we are about to see an unprecedented un-reach from yield. Second, dealer balance sheets have collapsed due to new regulation, and are thus unable to mitigate a situation with heavy outflows. Finally, the less stable mutual fund/ETF ownership share of our market has jumped compared with the 1990s (Figure 5).
The #1 risk to our outlook is that the US economy really takes off and leads to a more rapid rate hiking cycle and much higher long term interest rates. To us the economy looks really strong, and the November reading on Philly Fed being the highest since December 1993 (Figure 6) reminds us about the biggest risk scenario for 2015 – a repeat of 1994, where a strong economy forced the Fed’s hand and financial market conditions became disorderly.
#2 risk – Downside to the economy
We also find it entirely possible that that the US economy slows down meaningfully from here to around 2%-2.5% GDP growth in 2015 (compared with our house forecast of 3.1%). This #2 risk to our outlook would mean that the rate hiking cycle is pushed beyond 2015, and that global investors may become sufficiently comfortable with US interest rate risk that we get a big global reallocation into US fixed income, given ultra-low global yields. Such scenario could lead to lower interest rates and much tighter credit spreads – say, as tight as100bps, with US HG spreads compressing significantly to EUR HG spreads. This provided that the economy does not slow too much. In this scenario HG excess and total returns could be as much as +330bps and +9%, respectively
#3 risk – Upside to the global economy
As #3 risk to our outlook we have that strong US economic growth pulls up the global economy. As we have argued, the US is a relatively closed economy and thus unlikely to be pulled down meaningfully by the weak global economy. However, the US economy is big enough that its imports can serve as an important driver of global economic growth. The problem with this scenario is that it lessens the downward pressure on long term US interest rates asserted by the weak global economy. That means more outflows from credit and further credit spread widening." - source Bank of America Merrill Lynch
When it comes to credit and liquidity, it has been a recurring theme in our musings. On the subject of liquidity we agree with our good friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR from his last post entitled "A confidence in crisis":
ICMA, the International Capital Markets Association – I am honoured to be sitting on one of its committees – has just published a paper titled “The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market”. It is based on a series of interviews with senior market participants from both sides of the street. We might nod knowingly at most of its conclusions but it finely articulates knowledge and concerns of the bond markets for those who don’t fully understand them but who are, nevertheless, responsible for their governance.
It is a fine piece of work by Andy Hill but it carries one big and stark warning which is that most players are patently aware that debt markets are living in a liquidity fed vortex and that nobody has a clue what might happen when if, as and when the cheap money is withdrawn. What they are certain of, it would seem, is that whatever the outcome might be, it will be pretty bloody and ugly." - source IFR - Anthony Peters
A good illustration from this report pointed out by our good friend is the RBS Liqui-o-Meter graph measuring market liquidity we think:
"The RBS Liquid-o-Meter, which attempts to quantify US bond market liquidity, suggests that liquidity in the US credit markets has declined by 70% since the crisis, and continues to worsen. Anecdotal evidence suggests that this is equally applicable to the European corporate bond markets.
From the same Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield" here is another illustration of the lack of liquidity premium in the credit space:
"When the tide goes out
Currently we think that investors are not getting paid sufficiently for taking liquidity risk. Furthermore the most obvious consequence of the lack of retail inflows and institutional outflows, when short term interest rates go up, is that liquidity deteriorates. Hence we prefer positioning in liquid bonds.
For credit the most prominent unintended consequence of increased financial regulation is reduced liquidity via the collapse in dealer balance sheets (among other things, Figure 12).
However, this effect has been masked as strong technicals from significant inflows to HG, and credit spreads moving toward new tights meant investors were forced to reach for yield in off-the-run names and maturities. As a consequence, again, the liquidity premium has collapsed (although very recently there has been a small increase, Figure 13).
This also means that our HG index spreads of presently around 130bps are artificially tight. In fact, if our index is priced under next year’s deteriorating liquidity conditions we think spreads would be about 10bps wider (given that the vast majority of bonds are illiquid). That represents formidable headwinds for HG credit next year. Add a rate hiking cycle to much worse liquidity conditions and we look for HG credit volatility to increase significantly next year from currently around 44% (1m ATM options on the CDX IG) to 80% - thus exceeding levels seen last year during the taper tantrum" - source Bank of America Merrill Lynch
The Hidden Fortress in the credit space lies therefore in high quality and liquid bond we think.
Moving back to the subject of the potential downside to the US economy, what we find of interest is that the "Cantillon Effects" have indeed generated positive correlations. The world is much more intertwined macro wise.
Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson
Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.
Another factor explaining the global trend in lower yields has of course been the role played by Japan and its pension funds allocation, in particular the GPIF which is reducing its domestic bonds exposure aggressively while pursuing a higher share in risky assets: domestic equities, foreign equities as well as foreign bonds as disclosed its July-September quarter financial results published on the 25th of November and as reported by Nomura in their note entitled "GPIF still has room for a portfolio shift":
"The GPIF, the biggest pension fund, announced its Jul-Sep quarter financial result today. The share of domestic bonds in its portfolio declined to 49.6%, the lowest share ever, from 53.4% the previous quarter (Figure 1).
We note that the allocation to international bonds from end of June at 11.1% increased to 12.1% and given the maximum target portfolio new target has increased from 16% to 19% and the target portfolio is set at 15% therefore there is room for further yield compression we think in the global sovereign space.
Moving to another case of "Hidden Fortress", we continue to think US treasuries are compelling, particularly in the long end as we believe the US is far from normalizing and investors might yet again be disappointed in 2015.
The potential catalyst for US Treasuries has been summed up nicely by Societe Generale in their November publication entitled "The Japanization of the US economy? What if the US follows Japan (and the Eurozone) down the rabbit hole of deflation?":
"Potential catalysts for US Treasuries:
• Differential between US, Eurozone and Japan rates are at historically high levels, in part based on the belief that US can avoid global deflation
• What could push US into same vicious spiral as Europe and Japan?
• Consensus has not priced in risk of deflationary conditions in the US
• Deflation in the US would be very bullish for US Treasuries but there are additional factors driving capital flows into US Treasuries
1) Chinese official sector buying Treasuries - underinvested in Treasuries since Fed started QE-III
2) ECB negative discount rate policy drives EM reserves out of € into US reserve deposits
3) Return of the geopolitical crises; Greece and Venezuela/Argentina induced by China
4) US dollar should continue to appreciate, which is disinflationary and compresses rates
5) US elections – GOP control over Congress leads to lower deficits, lower growth
6) Lack of alternative, dollar denominated, risk free assets
7) Mortgage pre-payment hedging – Mortgage investors have to buy Treasuries to hedge pre-payment risks
8) Fed will likely remain more dovish than many currently forecast
9) Demographics - Surging retirement of 75ml baby boomers will drive investments into Treasuries
10) Regulation – Fed and US regulators forcing financials to hold more Treasuries"- source Societe Generale
As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).
When it comes to Europe, the deleveraging continues and amounts to goldilocks period for credit particularly in the banking space whereas banking equities will continue to underperform we think.
We pointed out in our conversation "Actus Tragicus" the attractiveness of European investment grade credit:
"While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura
We also argued at the time:
"We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...)."
"The relative fall in banks’ shares vs credit reflects a capital structure analysis
The banking sector has underperformed the whole market by 9% since the beginning of November. At the same time, the credit spreads of banks have accompanied those of the whole market. This is a normal capital structure pattern. The market anticipates a value transfer from equity holders to debt holders. This is the case when a company or a sector reduces its leverage, for example through disposals, capital increases, or improved market conditions. Such moves reduce the risk borne by debt holders but reduce the speculative time value of equity holders."
The banking system arbitrage is so simple that it can be explained using the Merton model, notwithstanding the model can be refined. To allow for complex capital structure analysis and arbitrage, we generally use our proprietary ALRG™ model.
Debt and equity are seen as options on the assets.
– The debt holder gets back the nominal debt value if the company is solvent and receives the residual value of the assets in the event of default; the payoff of the position is MIN (debt, asset). The equity value is seen as a call option on the assets, the amount of debt is the strike.
– The equity holder owns the net asset value if the company is solvent but loses everything in the event of default; the payoff is MAX (0, asset - debt). The credit spread is the premium of a put option on the assets, the amount of debt is the strike.
The equity (call option) value includes intrinsic value (asset value less the amount of debt) and time value (speculative value).
The put option has no intrinsic value, as long as the value of the assets is greater that the debt amount. Yet, it essentially has time value.
A deleveraging is a very simple move: the strike is lowered. Doing so, the risk borne by debt holders is reduced. This is reflected by the value of the put option sold by the bond holder. With a lower strike, its value is lower. And of course, due to the call/put parity, this value is taken from the equity holder. The speculative value of equities is reduced.
In the real world, things are more complex and worse:
1) Banks hold an implicit guarantee “offered” by central banks and/or governments. Its value is reduced by the deleveraging. This is the target of the too-big-to-fail regulation. Consequently, the deleveraging also has a negative impact on assets value, increasing the transfer from equity to debt holders.
2) Like any other company, a bank has to bear significant operating costs – which do not come down with reduced leverage. The expected equity return is reduced, but the costs to obtain this return will remain the same.
To offer a caricature, a “perfect” bank would only hold treasury bonds and would be fully financed with equities. In this case, the shareholder’s return is defined by the treasury yields minus operating expenses and taxes. This is not a very good investment." - source Exane BNP Paribas Research
On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" which displays Europe earnings as % of global earnings:
25 years on from the Fall of the Berlin Wall and Europe is arguably one recession away from severe political and social stress. 24,512,000 men and women are currently unemployed across the continent and anti-establishment political parties are surging in popularity across the continent. Monetary convergence between 1989 and 1999 (as disinflation from Eastern Europe and the promise of good fiscal behavior initiated a decline in interest rates toward German levels) and the monetary union of 1999 and 2008, has been replaced by a monetary divorce as bond markets price-in various sovereign risks. Meanwhile, Europe’sshare of global profits has collapsed (see Chart 4)." - source Bank of America Merrill Lynch
When it comes to QE in Europe in general, and the ECB in particular, we think our last quote resume appropriately the "Japanication" situation:
"If you keep your sword drawn and wield it about then no one will dare approach you and you will have no allies. But if you never draw it, it will dull and rust and people will assume that you are feeble." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai