Sunday, 8 December 2013

Credit - 2014: the Carry Canary

"That's what the cat said to the canary when he swallowed him - 'You'll be all right.'" - Alvah Bessie, American novelist.

Looking at the continuous rally in the credit space, one has to wonder whether 2014 will indeed be the year of the credit carry trade which, as we posited last week, would be supported by a return of M&A, LBOs, as well as structured credit in similar fashion the year 2007.

Reading through the latest BIS Quarterly report published on the 8th of December, we do indeed share the same concern for the return of riskier credit instruments induced by the generosity of our "Generous Gamblers". As indicated by the BIS and reported by Bloomberg by Kate Linsell in her article "BIS Sounds Alarm Over Record Sales of Payment-in-Kind Junk Bonds", the return of these leverage structure is indicative of the similar pattern taken by the credit markets towards 2007 we think, hence our chosen title:
"Record sales of high-yield payment-in-kind bonds is triggering uneasiness among international regulators who are concerned investors may suffer losses when central banks tighten monetary policy.
Issuance of the notes, which give borrowers the option to repay interest with more debt, more than doubled this year to $16.5 billion from $6.5 billion in 2012, according to data compiled by Bloomberg. About 30 percent of issuers before the 2008 financial crisis have since defaulted, the Bank for International Settlements said in its quarterly review.
Companies are taking advantage of investor demand for riskier debt as central bank stimulus measures suppress interest rates and defaults approach historic lows. The average yield on junk-rated corporate bonds fell to a record 5.94 percent worldwide in May, Bank of America Merrill Lynch index data show, while global default rates dropped to 2.8 percent in October from 3.2 percent a year earlier, according to a Moody’s Investors Service report.
“Low interest rates on benchmark bonds have driven investors to search for yield by extending credit on progressively looser terms to firms in the riskier part of the spectrum,” according to the report from the Basel-based BIS. “This can facilitate refinancing and keep troubled borrowers afloat. Its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.”

The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities.

Biggest PIK
Sales of payment-in-kind bonds last peaked in 2007 when companies issued $11.1 billion of the securities, Bloomberg data show. Offerings fell to $5.4 billion in 2008 and tumbled to $2.7 billion in 2010, the data show." - source Bloomberg.

We also agree with the BIS take that the ongoing "hunt" for yield and the instability it will create down the line:
"In addition to reflecting perceptions of credit risk, spreads may also drive default rates. A low interest rate environment naturally fosters cheap and ample credit. Coupled with the reluctance of crisis-scarred creditors to recognise losses, this can facilitate refinancing and keep troubled borrowers afloat. If such a process is indeed at work, its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.
The ongoing search for yield has coincided with the breakdown in certain regions of a previously stable relationship between credit market and macroeconomic conditions. Over the 15 years ending in 2011, low or negative real growth had gone hand in hand with high default rates and credit spreads (Graph 4).
This pattern prevailed also more recently in the United States. By contrast, default rates in the euro area actually fell from 2012 onwards, even as the region entered a two-year downturn and the share of banks’ non-performing loans trended upwards (see below). 
Similarly, credit spreads in emerging markets dropped between late 2011 and mid-2013, just when local economic growth showed clear signs of weakness. This suggests that investors’ high risk appetite may have been boosting credit valuations in capital markets, keeping a lid on default rates." - source BIS Quarterly report published on the 8th of December.

Of course we would argue that the breakdown between in the relationship between credit market and macroeconomic conditions is due to "financial repression" and massive liquidity injections which have had the desired effect in repressing volatility.

This is clearly illustrated we think with the evolution of the Itraxx Crossover 5 year CDS index (European High Yield risk gauge based on 50 European entities) and Eurostoxx volatility (1 year 100% Moneyness Implied Volatility) - graph source Bloomberg:
"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

On volatility being repressed and the level reached we agree with JP Morgan's recent Cross-Asset volatility snapshot:
"Vol continued its downward trend for the fifth year in a row. YTD, short vol strategies produced a profit even in the case of US rates. The biggest gain was produced by short equity vol strategies, e.g. selling variance swaps on the S&P500 index, and is not only up 11% YTD but it has also recaptured the level it held in early September 2008, just before the Lehman crisis erupted. The very low levels of vol and vol risk premia suggest that there is more upside than downside, and justify a long vol bias currently." - source JP Morgan.

The evolution of the US Vix index and its European counterpart the V2X tells as well a similar story of volatility being contained by the see of liquidity. Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - graph source Bloomberg:

One space though where volatility has not been contained has been of course in the bond space, as depicted by the significant evolution of the MOVE index as well as for Emerging Markets currencies as indicated by the surge of the EM VYX index, following the Fed's tapering stance in the second quarter of 2013:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

The significant pain inflicted to Emerging Markets in the process has been described in our post "Osmotic pressure" back in August this year:
"Since 2009, the effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - source Macronomics

The effect of the "reverse osmosis" we did put forward can be seen in the outflows which the EM funds have suffered from this rapid flows as depicted in the below graph from Societe Generale Cross Asset 2014 Outlook:
"EM funds suffered net outflows of USD 39bn (equity) and 33bn (bond) since May 22"
- Cumulative net inflows into Equity and Bond funds (ETFs & Mutual funds) since 2007, monthly data
Source: EPFR, SG Cross Asset Research/Global Asset Allocation/ Mutual Fund & ETF Watch

So moving back to our title and as we already posited in last week's conversation, 2014 will indeed be the year of the "Carry Canary" in particular in the convertibles space given M&A and buyback activity are always a catalyst for issuance as posited by Bank of America Merrill Lynch in the Global Convertibles Outlook for 2014:
"In the year ahead, we anticipate firm M&A and buyback activity. Our High Yield Strategy team’s view regarding M&A activity is that in spite of earnings and economic growth, corporations will continue to find the need to expand through acquisitions rather than rely solely on organic growth. With ever growing balance sheets, we anticipate consolidation in many industries, as smaller, less levered companies are bought by larger firms looking to boost earnings without substantially increasing debt. On buybacks, our High Grade Strategy team expects releveraging event risk activity to pick up in the form of both M&A and buyback activity. Their contention is that rising rates, besides serving as a trigger (due to the urgency for locking in financing while costs are still low), changes the landscape of event risk. Yields will likely continue to be low relative to history, suggesting that the risk of re-levering corporate actions, such as share buybacks and debt financed M&A, should remain high next year, particularly as the expected pick-up in economic growth next year will likely lead to rising M&A volumes. Share buybacks were particularly effective to enhancing shareholder value in 2013, and companies that perceive themselves to be undervalued will continue to partake in such activity (Chart 6)."
- source Bank of America Merrill Lynch

As far as our title is concerned, we believe the "Japanification" of the European credit market will lead to further spread compression. To that extent we agree with Morgan Stanley's take in their recent 2014 outlook namely that in the European Investment Grade space, "carry dominates returns" in a base case scenario, but the deflationary risks weighting on Europe makes credit counter-intuitively a good candidate for "Japanification":
"No Longer the Favored Region
-We downgrade European credit to Equal-weight as a supportive technical backdrop is offset by challenging fundamentals and middling valuations.
-IG and HY spreads tightened 20-30% in the last year despite leverage rising. Fundamental improvements are already priced in, we believe.
-Supportive technicals remain intact. In contrast to the consensus, we think demand will be stronger if rates rise, and lower if they fall.
-Europe's valuation discount to the US has been closing rapidly. EUR IG cash now trades at the tightest levels to US IG since 2009 (maturity, ratings, and FX-hedging adjusted)." - source Morgan Stanley

To illustrate further the convergence between Europe and US for investment grade, it clear the gap has been closing since 2011 as per the below graph displaying the Itraxx Europe Main (Investment Grade) CDS index versus its US counterpart CDX IG - graph source Bloomberg:

Whereas trading volumes in the CDS space have gone up, the issue with bank deleveraging has indeed been on the cash side and one of our top concerns when it comes to dwindling liquidity in the credit space with the return of riskier products as the hunt for yields gathers steam, namely our "carry canary" in 2007 fashion.

When it comes to trading volumes CITI in a recent report published on the 5th of December entitled "2013 Trading Volumes in Europe Credit" clearly indicates the trend of the "Carry Canary":
"European IG investors trade more CDS indices (Main) and fewer bonds. The 13% increase in iTraxx Main (on-the-run) trading volumes in 2013 (vs. 2012) together with the 15% decrease in cash bond volumes (€ iBoxx IG universe) is a reflection of this year’s high uncertainty and low conviction among European investors.
– More hedging via index products: The usage of both indices and especially index options as hedging tools increased this year; at the same time as investors were less keen on trading around their bond positions.
Fears of outflows and lower liquidity in bonds have pushed many investors to (i) maintain higher than usual cash balances and (ii) use CDS index longs to make up the lost carry." - source  CITI

The reduction in trading volumes in Investment Grade bonds is indicated in more details in CITI's report:
"Trading volumes during 2013 in the € iBoxx bond universe have declined both in terms of the total volumes traded (15.0%) and the average amount traded per bond (21%), relative to the equivalent period in 2012. The lower decline in the total volumes traded (vs. the average amount traded per bond) is due to a slight (3.7%) increase in the average outstanding volume of bonds in the index versus the equivalent period last year ."
"€ iBoxx
The € iBoxx index captures all large (> €500mm) fixed rate investment grade corporate bonds with a residual maturity of greater than one year. This is a representative sample of the fixed rate IG European bond market, with short-dated bonds tending to be less liquid (and with no comparable data for FRN trading volumes)." - CITI

Of course 2014 will see a continuation of lower liquidity on dealers' balance sheets, which is a cause for concern as investors dip their toes further higher in the risk spectrum. 

Not only credit will be impacted by dwindling liquidity but the rates markets will also be impacted with increasing regulatory pressure on banks as indicated by Bank of America Merrill Lynch in a report published on the 2nd of December entitled "Will the leverage ratio impact the rates markets? Yes":
"Leverage ratio: the new binding constraint
US fixed income markets face major structural headwinds as regulators shift the focus of bank capital regulations away from risk-based capital in favor of blunt, riskneutral measures such as the Supplementary Leverage Ratio (SLR). Market participants and regulators have expressed divergent views about the potential implications for the rates market since the US SLR proposal was released in July. 

Lower demand for Treasuries and lower liquidity
We expect the leverage ratio to have a significant negative impact on the rates market. This stems from the balance sheet intensive nature of fixed income trading and the effective elimination of the favorable risk-based capital treatment of repo and banks' holdings of Treasuries and agencies under the risk-based capital rules.

The main market impact will occur via two channels: 1) lower demand for Treasuries and agencies and 2) adverse effects on liquidity, transaction costs and trading volumes in these markets. We estimate that price elastic demand for Treasuries and agencies that could be negatively impacted by the SLR could be as high as $850bn.
-Lower demand for Treasuries and agencies, as well as a higher liquidity premium, should result in higher rates, all else equal.
-Treasuries should cheapen to OIS, short dated swap spreads should tighten and coupon strips should cheapen to whole bonds.
-The constraints on dealer balance sheet should increase volatility around events such as Treasury auctions, even as the risk of tail events should decline due to lower systemic risk.
-The higher cost of providing unfunded bank commitments such as corporate revolvers, standby letters of credit and liquidity backstops may result in a sharp decline in corporate CP issuance.

There could be some potential offsets, including carve-outs for certain assets such as cash in the SLR exposure definition, new entrants in the repo market, and a slower pace of Fed tapering. We are skeptical that these offsets will be sufficient to fully neutralize the market impact." - source Bank of America Merrill Lynch

"If you think liquidity is coming back in the credit space, then you are indeed suffering from Anterograde amnesia" - Macronomics - May 2013 - "What - We Worry?"

Therefore dealers inventories will continue their downward trajectory, increasing the "instability" in the system as indicated in Bank of America Merrill Lynch note:
"Dealers: inventories to decline as capital requirements rise
Dealers will face higher costs of holding inventory and providing liquidity to clients as capital requirements increase. In our view, this will likely lead to a reduction in demand for duration as dealers scale back inventories. We estimate that Credit Suisse’s rates balance sheet, for example, is 10 times bigger under the SLR than it is under RWA. Under a 3% leverage ratio, this implies a 67% reduction in ROE relative to the risk-based capital framework. Credit Suisse and UBS have already been under pressure from Swiss regulators to reduce leverage, and thus are further along in the process of reducing fixed income trading assets. We expect other SLR-constrained dealers to also reduce their rates balance sheets as ROEs decline, though some level of inventories is required for normal market making." - source Bank of America Merrill Lynch.

Obviously the deleveraging in the US banking system has indeed been much more dramatic than in Europe:
- source Bank of America Merrill Lynch

So if banks are indeed less incline in purchasing US treasuries in 2014, can the Fed simply reduce its QE program? Here is Bank of America Merrill Lynch take on the subject:
"Can the Fed offset the impact though monetary policy?
As we discussed before, the price elastic demand for Treasuries and agencies that could be negatively impacted by the SLR could amount to as much as 60% of the Fed’s asset purchase program per year in duration terms. Thus, it is conceivable that if the Fed increases its program size, it could offset the market impact of lower demand due to the SLR. However, monetary policy is driven by progress toward the Fed’s dual mandate objectives (full employment and inflation) and our economics team is looking for the Fed to begin tapering their asset purchases in March 2014. Nevertheless, if financial conditions were to tighten meaningfully the Fed could slow its exit from QE3." - source Bank of America Merrill Lynch

Hence our doubts on the "tapering" stance from the Fed. 

As we posited in our conversation "Misstra Know-it-all":
"By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns."

On a final note the dollar and the US treasury are now moving hand in hand as displayed by Bloomberg:
"The dollar and Treasury yields are moving together more than at any time on record as Federal Reserve officials say they may cut debt purchases in coming months, drawing funds to the U.S.
The CHART OF THE DAY shows the 120-day correlation between 10-year yields and the U.S. Dollar Index climbed to 0.65, after reaching 0.68 earlier this week. That’s the highest level in data compiled by Bloomberg that goes back to 1971. A figure of 1 would mean they move in tandem. The bottom panel shows overseas holdings of Treasuries rising as the extra yield U.S. notes offer over their Group of Seven counterparts increased.
“I’m buying dollars and Treasuries,” said Will Tseng, a bond trader in Taipei at Mirae Asset Global Investments Co., which oversees $50 billion. “The Fed is going to slow the pace of pumping money into the economy. That removes the downside risk for the dollar. It’s also going to keep the benchmark rate low, making yields attractive.” Fed officials said they may reduce their $85 billion in monthly bond purchases as the economy improves, minutes of their last meeting issued Nov. 20 show. Chairman Ben S. Bernanke said last month the central bank will probably hold its benchmark interest rate near zero long after the asset purchases end.
China added to its holdings of Treasuries in September as benchmark U.S. 10-year yields climbed to 3.01 percent, the highest level since 2011. The largest foreign lender to America increased its stake by 2 percent, the most since February, to $1.29 trillion, Treasury Department data show. Holdings by Japanese money managers, the second-biggest, rose to a record $1.18 trillion.
Ten-year notes yielded 2.87 percent as of yesterday. The yield rose to 47 basis points more than bonds in an index of G-7 peers in November, the most since 2010, data compiled by Bloomberg show." - source Bloomberg.

"Great Rotation"? We are not there yet, same goes with "tapering", we think...

"I Tawt I Taw A Puddy Tat" - Tweety

Stay tuned!

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