Wednesday, 13 January 2016

Macro and Credit - Tangerine Dream

"I don't know where I'm going from here, but I promise it won't be boring." - David Bowie
Looking at the continuing pressure on the Chinese currency, with Hong Kong's yuan interbank rates rising to record highs (overnight rate at 66.82%), and the on-going heightened volatility in various asset classes, we thought this week we needed a dual reference for our title analogy. "Tangerine Dream" is a symbol of false perception of reality, when the situation in the eyes of a person is seen very differently than it is in reality. "Tangerine Dream" is also a German electronic music group founded in 1967 by Edgar Froese who died one year ago, on the 20th of January. For eighties buff like ourselves, you might remember their seminal title "Love on a real train" from 1983 classic "Risky Business", a prominent feature of today's markets, because the movie covered the following themes materialism, loss of innocence, coming of age and capitalism. We could have gone for another musical analogy such as "Under pressure" featuring the maverick David Bowie, that just departed, but, that will be for another time.

When it comes to our "Tangerine Dream" title analogy and markets, if in a dream you are eating a tangerine, it is a sign that in reality the situation is much more complicated and serious than you could have imagined which the case is today. In this case, you should only blame your excessive credulity in relation to central bankers. Therefore it is necessary to percept the events with your own point of view, and not with someone else's (or your usual sell-side analyst); you need to learn how to think and reason independently (like we do) and forget about the "herd mentality" that prevails often in overcrowded positions and markets. Given peak tangerine season lasts from autumn to spring, there is indeed plenty of opportunities for you to eat "tangerines" or dream you are eating "tangerines", but we ramble again...

In this week's conversation, we will look at some of the implications of the troubles in China from a creditor's perspective, given we think many pundits are having a "Tangerine Dream" when it comes to assessing the Asian corporate bankruptcy regimes. We will also look at why size matters in the credit markets and how to mitigate "liquidity" issues from an issuance perspective.

  • The "Tangerine Dream" in the Asian corporate bankruptcy regimes"
  • Credit - Want to mitigate liquidity issues? Size matters
  • Final chart - As in the US the distressed ratio in European High Yield is also rising
  • The "Tangerine Dream" in the Asian corporate bankruptcy regimes"
Many pundits have been "speculating" whereas we have "Small Trouble in Big China" or "Big Trouble in Little China" (yet another 80s movie reference...) as we move from the Year of the Sheep towards the Year of the Fire Monkey. According to Chinese Five Elements Horoscopes, the "Monkey" Chinese sign contains Metal and Water and Metal is connected to gold (no surprise therefore to see a comeback of the precious metal as of late). "Water" is connected to wisdom and danger. Therefore, according to Chinese beliefs, we will deal with more financial events in the year of the Monkey. The Monkey is a smart, naughty, wily and vigilant animal. And, according again on the Chinese Zodiac forecast for 2016, if you want to have "good returns" for your money investment, then you need to "outsmart" the Monkey. Also, according to the same prediction, "Metal" is also connected to "Wind". That implies the status of events will be changing very quickly, hence the clear return, of "volatility" and plenty of "risk reversal" opportunities as we posited recently in our musings.

But, if indeed we are bound for "Big Trouble in Little China", then from a creditor's perspective it is highly relevant to assess the prospects for default and recovery value when the worst could be happening. 

It is, therefore paramount we think, that, "Tangerine Dreamers" focus on the bankruptcy regimes governing specific countries rather than rely on a false perception of reality. From a default and recovery value perspective, we read with interest Bank of America Merrill Lynch's Asian Strategy note from their 8th of January entitled "Default and recovery: What are the prospects when the worst happens?":
"What is the historical recovery experience for bond defaults?
We analyzed default and recovery data for 117 bond default cases by 105 issuers between 1997 and 2015 across ten countries. Of the 117 bond recovery cases assessed, 63 were straight bond defaults and 54 were convertible bond defaults. There is not a huge difference in terms of recoveries for the two bond types although country mixes differ. The results show an average recovery rate of 36%. Looking at unsecured recoveries from 2009, at a recovery rate of 43% Asia compares favorably versus recoveries from other regions including the US. This may come as a surprise considering 74% of our data comes from defaulted companies in China, India and Indonesia where legal systems are not considered particularly creditor friendly.
What factors impact recovery rates?
There are many factors which can influence the level of recovery that investors will get in a default scenario. Seniority and security are the two most important factors. On a macro level, low recoveries tend to be correlated with wide credit high yield spreads, higher default levels and when GDP growth and stock market returns are low.

The type of event precipitating default will also strongly impact recoveries. Other factors which we believe are relevant in Asia include complexity of group structure, management willingness to work with creditors and differences across legal jurisdictions. For more on the legal frameworks pertaining to insolvency, bankruptcy and restructuring please refer to our Primer: Asian corporate bankruptcy regimes.
What were some of our findings?
(1) There is a nice correlation between high yield spreads and recovery levels, (2) recoveries have been quite high despite slowing growth which is most likely due to the strong appetite for risk and yield. Recoveries could fall from the above 50% average levels over the last two years to around 30% based on growth today, (3) recoveries for distressed exchange/tenders are much higher than for missed payment and bankruptcy/liquidation situations. The Winsway bondholder who tendered in 2013 received 16% more than those who held to default, (4) secured bonds recovered less than unsecured bonds contrary to convention as bonds were actually unsecured in structure or secured on few hard assets so it pays to read the fine print, and (5) by industry, real estate provided the highest average recoveries and financials/basic industry the lowest.

We take a closer look at results in China, India and Indonesia
China: The average recovery rate is surprisingly high at 39% considering bonds are structurally subordinated to on-shore creditors putting them on par with equity. We believe this is because three quarters of the data comes from defaults in 2009 or later. In a broader downturn, recoveries are unlikely to be as high. India: We were very surprised to find that average recovery level was 40%. We surmise that the lack of trading liquidity for CBs (all data was based on CBs) led to imperfect pricing post default. Taking data based on latest/last prices (where available) the average recovery falls to 22% which is more in line with expectations. Indonesia: Has one of the lowest average recovery rates in the region at 28%. While there are a variety of factors we could point to, the key factor appears to be the weak legal system for dealing with bankruptcies, insolvency and restructuring." - source Bank of America Merrill Lynch
From a US credit perspective, as we have argued back in June 2015 in our conversation "Eternal Return", the "de-equitisation" process thanks to buybacks is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think. When corporate balance sheet leverage rises, default probability increases down the line. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers.

As we reported in our last conversation, half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%) while oil prices continue to fall. While this dispersion doesn’t bode well for US HY, default and distress ratios are increasing, even outside commodities. When it comes to assessing recovery levels, spreads do correlate as indicated by Bank of America Merrill Lynch's note:
"Spreads correlate well with recovery levels
While it intuitively makes sense that higher default rates would depress recoveries (too much distressed debt can overwhelm the capacity of distressed debt buyers to absorb the supply which negatively impacts prices), the relationship between recovery rates and default levels does not look particularly strong for Asia. This we believe is due (1) the size of the Asian high yield bond market was small in the late 1990s/early 2000s and; (2) we use convertible bond data for our recovery analysis which does not get included in the default rates (based on defaults in our bond index) impacting the results.

We find that high yield spreads provide a better relationship with recovery rates as spreads provide a good indication of risk appetite. We note the recovery level was low in 2006 which should not generally be the case given the tight spreads (and risk appetite strong). We chalk this up to the small sample size as two recovery points is hardly statistically significant. More telling is the lack of defaults during this period in general. Recovery rates have been quite strong over the last couple of years - not surprising given the overall market liquidity conditions.
Recoveries high despite slower growth and lower earnings
Recovery levels should correlate with economic growth and corporate earnings. We find that over the last few years recoveries have been quite high despite slowing growth. This is most likely due to the strong appetite for risk and yield.

However what this suggests is that recoveries could fall from the above 50% average levels over the last two years to around 30% based on growth today and lower if growth slows further."
 - source Bank of America Merrill Lynch
Where we disagree with Bank of America Merrill Lynch's take is that during last downturn the central banks "put" via QEs quickly came to the rescue which avoided a "distressed" glut and accelerated the recovery in prices, which led to a faster price recovery for many issuers in the process. The significant rise of "distressed" bonds in the US and the rising trend in Europe could weight in the next downturn on "recovery" values rest assured.

In similar fashion we played the "central bank put" game in European credit during 2011 in October when we bought BPCE 12.5% Tier 1 bonds at 94.5 cash price before the December LTROs from the ECB that "saved the day" for the increasing dollar liquidity crisis building up (liquidity crisis always lead to financial crisis...). The "ECB put" for financials enabled us to see our bond price surge by a cool 41% until we sold them this Monday at a cash price of 133, while enjoying some decent coupons in the process. 
On a side note, the implementation of the "Bail-in" process for financial bonds in Europe as of the 1st of January 2016 makes us much more wary of financials particularly in the light of the latest episode we commented recently on Novo Banco. While some care about the "carry", we decided to take profit as we do not want to get "carried away" given the weaker tone in credit as of late (yes, it is weaker in the US relative to Europe, cf Itraxx Main Europe 5 year vs CDX IG...).

But moving back to defaults and bankruptcy regimes in Asia in particular and "Tangerine Dreamers" alike, there are large differences in recovery values depending on countries as posited by Bank of America Merrill Lynch note:
"Country specific recoveries
In Chart 12 we look at the average recoveries by country and then compare them to data from the World Bank’s resolving insolvency report in Chart 13.
This is not an apples-to-apples comparison given the World Bank recoveries are based on secured loans but broadly we would expect higher recoveries from the more developed markets. This is not always the case based on the bond data. Recoveries in Singapore, HK and Malaysia are quite low relative to China, India and the Philippines where interestingly, the average recoveries from bonds are higher than the World Bank findings on secured loans. For the most part we can chalk this up to the small data set for a number of the countries on the bond side. Some of the data is based on defaults in the late 1990s/early 2000s which can also impact recoveries. We look more closely at the three biggest markets, China, India and Indonesia where we have the most data.

Shouldn’t recoveries be lower given structural subordination?
The average recovery rate for China is 39% which is surprisingly high considering that under China’s capital-account control regulations, funds from foreign creditors lent to an off-shore subsidiary are usually remitted to its on-shore parent in the form of an equity injection. Therefore, foreign creditors are structurally subordinated to on-shore creditors and are effectively on-par with equity.
We would attribute this to two things (1) 76% of the bond defaults in our China cohort have come from defaults in 2009 or later. The large amount of stimulus provided to the economy after the 2008 global financial crisis led to a strong rebound providing a better environment for restructuring and recovery and; (2) given the quick turnaround in economic growth we believe has led to a greater management willingness to work with creditors in order to ‘get on with business’.
What we do find is that there been quite a wide dispersion in recovery levels. In circumstances where there was some form of fraud involved, recovery for bonds has been negligible. There have also been a high number of distressed exchanges (which have all been since 2009) where recovery tends to be higher. On average though, if we exclude the fraud/distressed exchange situations, the average recovery is still quite high at 33%. However, as growth slows and defaults rise, particularly on-shore, we would expect recovery levels for off-shore investors to fall." - source Bank of America Merrill Lynch
So "Tangerine Dreamers", you have been warned, if you own Chinese off-shore bonds, as foreign creditors, you are structurally subordinated to on-shore creditors and are effectively on-par with equity hence your risk of false perception of reality when it comes to assuming the recovery value of your "off-shore" bond investment in China.

We also read with interest some interesting points made by Bank of America Merrill Lynch in their Asian Credit Strategy note from the 8th of January entitled "Asian corporate bankruptcy regimes":
"China is not a signatory to any significant international treaty relating to insolvency.
Apart from debt approval and registration requirements set by the State Administration of Foreign Exchange, there are currently no special procedures for foreign creditors. It is often more difficult for a foreign creditor to recover assets from a Chinese debtor due to the lack of recognition procedures. It is believed that treatment of creditors is based on whether they lent to onshore or offshore entities, not whether they were foreign or local lenders. To date, there are few bonds issued by Chinese companies offshore which have guarantees from the onshore operating subsidiary unless the company plans to utilize the funds off-shore due to the difficulty of obtaining approval from the Chinese authorities. Funds for use onshore can be injected as equity or in a shareholder loan format although the latter is less common. Funds injected as equity are effectively structurally subordinated to onshore borrowings and may not be party to any creditor agreements.
Hong Kong
Legal Infrastructure
Hong Kong’s insolvency framework is based on laws of England and Wales, contained within the Companies (Winding Up and Miscellaneous Provisions) Ordinance, Bankruptcy Ordinance, and the Companies (Winding-Up) Rules. Hong Kong does not have a dedicated bankruptcy court nor dedicated bankruptcy judges although it does have a companies judge who hears most corporate bankruptcy matters. The framework provides formal guidelines on bankruptcy processes other than rehabilitation, in which area Hong Kong has to date been unable to pass legislation.
Key risks
It is common to have large groups of banks (10-20) from different countries involved in a Hong Kong reorganization process and therefore reaching a consensus among creditors can be particularly difficult. Additionally, as Hong Kong does not have a statutory procedure for the rehabilitation of companies, there is little early recognition of financial difficulties on the part of companies. Further, despite the strong economic and trade relationship between China and Hong Kong, neither of them have devised a special procedure for effectively handling an onshore-offshore corporate insolvency situations. As there is no formal judicial recognition mechanism available to foreign creditors, foreign creditors who have received rulings in Hong Kong will have to initiate separate bankruptcy procedures according to China’s EBL." - source Bank of America Merrill Lynch
Should indeed we move towards a "Big Trouble in Little China" scenario, then, from a "restructuring" and "recovery" perspective, things could get interesting indeed, particularly for onshore-offshore insolvency situations when one takes into account that various Asian countries are not party to any international treaties for foreign insolvency procedures and they do not provide for the recognition of foreign insolvency proceedings. When it comes to "Asian recoveries" don't dream too much about "tangerines".

When it comes to "credit" and "liquidity", which has been a pet subject of ours and many others in the financial sphere, another way of "mitigating" liquidity issues, could be by selecting smaller issue size from a "contrarian" perspective as per our next bullet point.

  • Credit - Want to mitigate liquidity issues? Size matters
As per our last conversation where we highlighted the rise of idiosyncratic risks thanks to central banks' "overmedication", the recent Novo Banco "bungee jump" drop in price to close an eventful 2015 was a reminder of the instability created by the rise of "positive correlations".

From a "contrarian" perspective, we read with interest Bank of America Merrill Lynch European Credit Strategist note from the 8th of January entitled "Go small, and go home":
"Welcome to the bear market
We believe so much monetary policy has become counterproductive for the IG credit market in Europe. “Yield fatigue” due to QE is the issue. And as a consequence, the functioning of the credit market is deteriorating.
The end of big inflows
The low yield environment has left the high-grade market more imbalanced between the “buyers” and “sellers” of credit risk. The “buyers” of credit risk – i.e. investors – are vacating the market. The “sellers” of credit risk – i.e. issuers – are coming in force. Nowhere is this first point more clear than in the flow data. Chart 4 shows that retail investors have withdrawn close to $30bn from European credit since June last year. 

The outflows have been relentless, and reflect far more than just a blip in preferences (previous outflows were much smaller around the Taper Tantrum and peripheral shocks). We believe we are seeing structural outflows from the asset class – driven by the realisation of a (very) low for longer yield backdrop.
At the same time, while the “sellers” of credit risk (i.e. issuers) continue to flock to Europe, the lack of inflows means that the new issue machine poses a greater strain on the market. Supply is being bought increasingly on switch, rather than with fresh cash. Thus high new issue premiums invariably reprice secondaries (as shown by the Daimler deal earlier this week).
This is a worry as January and February have historically each accounted for 10% of annual supply.

What if the credit market is not so deep?
With outflows and a tricky new issue machine, the consequence has been deteriorating credit market liquidity. Chart 5 shows that average bid-offer spreads in investment grade continue to rise. In fact the deterioration has been clear ever since the ECB first cut rates into negative territory. In all, we see a shallower credit market for 2016.

But what are the implications for other asset classes? For the equity market, a less healthy credit backdrop is likely to reduce some support for share price performance. However, our European equity strategist James Barty makes the key point that SX5E dividend yields of 3.7% still provide a strong tailwind for stocks.
What’s clear is that the “depth” of the credit market is past its best. Chart 6 shows that the average new issue size in European credit has been trending down for a number of years – but the decline was especially clear last year.
If debt funding capacity is lower in Europe, this could have a second order effect on equity sentiment. While this is unlikely to alter perceptions of debt-funded share buybacks in Europe (they are much less prevalent than in the US anyway), it may question the ability of European M&A to rise decisively this year. Chart 7 shows that US M&A (filtered by US companies acquiring), is past its previous peak. Yet, European M&A (filtered by European companies acquiring) is still way below the ‘07 highs.
When big isn’t so beautiful
To add fuel to the fire, ongoing idiosyncratic risk in credit is becoming troubling. Novo Banco bonds dropped 80pts in the final few days of 2015 (after senior debt was transferred to BES), Areva bonds have fallen 13 points this year on a rating downgrade (from BB- to B+) and Rallye spreads have also widened materially. This follows a 2015 when credit investors were greeted with the events of VW, Abengoa and the miners.
But we worry that idiosyncratic risk is starting to become a systemic risk for the credit market.
Why? Because “blow ups” are frequently happening to the larger credits in the market, and not to the small “overlooked” names (which has tended to be the perception of idiosyncratic risk in the past).
Nowhere is this more apparent than in the European HY market. In December, high-yield bonds widened close to 70bp, while investment-grade bonds widened by just 3bp – thus a massive relative underperformance of high-yield vs. investment-grade. Away from Novo, material widening in big credits – such as Portel – was detrimental to overall HY performance.
Chart 8 highlights the problem. The universe of European distressed bonds (issuers with bond prices below 85pts) is increasingly being made up of “large” names (i.e. credits with debt outstanding in excess of Eur 1bn). In fact, “large” names now account for 25% of the European distressed index.

Beating the event-risk blues: go small in ‘16
Avoiding the next idiosyncratic name in credit is, by definition, tricky. But a clear consequence of rising event risk in big issuers is that spreads of small issuers are starting to behave much more defensively. We see this trend continuing and expect spreads of “small” issuers to fare relatively better than spreads of “big” issuers this year.
As chart 9 shows, spreads of “small” names (defined as €1bn of debt outstanding and below) fared much better than spreads for “large” names in 2015. In fact, excess returns for “small” names in European HY were 6%, compared to just 0.3% for “large” names.

 - source Bank of America Merrill Lynch
This has, we think, profound implications for "Tangerine Dreamers" and we would like to make additional points that will alter somewhat your "perception of reality" (us breaking again the "fourth wall"). As per our conversation "The Cantillon Effects" from September 2013, if we take the art market as a proxy for the effect of QEs on asset prices and taking into account that art is removed from the capital structure, it is also worth pointing out that the higher returns of the art market also come with lower volatility. While the AMR Art 100 has an annual volatility rate of 12 percent from 1985 until 2012, the MSCI World Index had a volatility rate of 16 percent. Counterintuitively, this illiquid market is prone to less volatility. In the case of  European High Yield, counterintuitively, this "illiquidity" linked to the "size" of the issuer, as highlighted by Bank of America Merrill Lynch, is prone to less volatility and generates higher excess returns. To mitigate somewhat this "European High Yield" perception we would like to add that last few years in Europe, we have seen many "financials" particularly from peripheral countries migrating lower into the High Yield sector and indexes. Quod erat demonstrandum.

Interestingly enough, to add more thoughts to the concept of "liquidity" and "instability", we would like to point out the rising disconnect between European cash High Yield versus the Itraxx Crossover 5 year CDS index which is often used as a hedging tool. This disconnected is pointed out by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 13th of January entitled "The price of liquidity":
"Sell € iBoxx HY TRS, as a better hedge for HY portfolios
The Crossover CDS index has not been the perfect hedge for high-yield cash. December has been a month to forget for high-yield investors. The cash index (HE00) was almost 70bp wider, while Crossover was only 25bp wider. This was mainly on the back of name composition mismatch but also the differences of index weighting (equally for the CDS index, market value for the cash market).
This proves our point that high-yield cash investors need to stay close to home, and hedge with TRS. The € iBoxx HY TRS can insulate risks against wider spreads, with minimal tracking error (depending on benchmark)." - source Bank of America Merrill Lynch

This not a surprise to us.  Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
"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":"CDS benefits from positive convexityFor CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays"
Given callable high yield notes are generally "negatively convex", and are a "dominant" risk feature in the high yield space,  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. 

We concluded at the time our "Alive and Kicking" conversation as follows:
"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.
The decoupling between High Yield cash and the CDS market is also a reflection of CDS being positively convex versus cash high yield being negatively convex (due to callable features).

When it comes to surging defaults and the low recovery risk link to a potential "distressed debt glut" is something that needs to be taken into account by "Tangerine Dreamers" as per our final point.

  • Final chart - As in the US the distressed ratio in European High Yield is also rising
While we pointed out earlier the difficulty in clearing a "distressed debt" glut without central banks support à la QE1, the recovery levels in the next downturn will be depending on the evolution of distressed ratios on a global basis, taking into account as well the various bankruptcy and restructuring laws available. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 8th of January entitled "Go small, and go home" and shows that the distressed ratio in European High Yield has risen from 8% to 12% since mid-November. For reference the distressed ratio in US High Yield is 25% currently due mostly to the "Energy" sector for now:
- source Bank of America Merrill Lynch
While spreads of small issuers are starting to behave much more defensively, should you want to hedge accordingly your High Yield exposure in Europe via the Itraxx Crossover 5 year CDS index, you might want to think of "overcompensating" your exposure, buying more protection in notional terms than your overall exposure...but, that's might be another "Tangerine Dream"...
"Who looks outside, dreams; who looks inside, awakes." - Carl Jung, Swiss psychologist

Stay tuned!

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