Saturday 29 March 2014

Credit - Too Big To Fall

"Risk comes from not knowing what you're doing." - Warren Buffett

Watching with interest the ever compressing credit space with the Europe High Yield CDS risk gauge Itraxx Crossover tighter by 30 bps to 290 bps since the new series launched on the 20th of March, we are indeed feeling the same nervousness around the rapidity of the spread compression we experienced firsthand in 2007. We also reminded ourselves lately of the epitome of the financial crisis namely the expression  "Too Big To Fail" which led to the definition of systemic importance for some banks. We decided this time around to play along this famous or infamous expression (whichever you prefer) in our chosen title given the abandon and frenzy with which investors seems to be seeking whatever is on offer in the credit space with a decent coupon, regardless of the risk (or covenant protection in some instances), but more importantly disregarding the growing "liquidity" risk we have often warned about, leading us to our chosen title, as we believe credit markets are indeed becoming "Too Big To Fall" given the shrinking balance sheet of  banks has led to paltry dealers book to accommodate any major selling pressure should it materialise in the near future.

On the subject of liquidity and credit markets, we could not agree more with Axa's recent take on the subject as reported on the 21st of March by Roxana Zega in Bloomberg:
"Regulatory change imposed on banks to make them safer may ironically end up sparking systemic risk, with current spreads failing to compensate for greater illiquidity, Mark Benstead, global head of SmartBeta Credit at Axa IM says in 2014 outlook.
 -Regulation has stopped market makers from being either willing or able to supply former levels of market depth for corporate credit
 -Central bank liquidity has engineered falsely low default rates
 -Axa says there’s a mismatch between size of credit market and the ability to trade it
 -Carry will be the main source of return for credit as capital appreciation is unlikely this year, with yields barely expected to budge
 -“Credit events” could dent returns, so careful selection is needed to dodge isolated risks
 -Expects central bank policy to be more divergent in 2014 than at any other time in past 5 years
 -Axa IM managed ~EU547b as of end 2013
 -Note: BNP said March 13 that low liquidity is main risk to credit" - source Bloomberg

A good illustration we think of risks coming from "not knowing what you are doing", from a credit perspective, can be ascertained from the growth of convertibles under ETF format in the US in assets under management (AUM), particularly when one looks at the growth of CWB US, the US convertibles ETF (SPDR State Street) which includes convertibles and preferred, leading it to be highly "equity" sensitive. Please keep in mind that when it comes to convertibles issuance, the US market has seen a strong pick-up in issuance from the technology and biotechnology sectors.

The surge in AUM has indeed been staggering - graph source Bloomberg - ETF Market Capitalisation:
- graph source Bloomberg

Of course the surge in the AUM has been closely following the surge in the price of the aforementioned ETF:
- graph source Bloomberg.

As we indicated recently there is a great article in Forbes by Bill Feingold on the high price being paid on some convertibles:
"A wise trader once said, “There are no bad bonds, only bad prices.”

If you’ve been following this space, you know that I’ve been trying to encourage companies to take advantage of a historic opportunity to issue convertible bonds on favorable terms.  The opportunity has come about for the same reason most things get more expensive:  increasing demand and limited supply.

Here’s a statistic that should get your attention. I mentioned it the other day but once was not enough. The only significant exchange-traded fund dedicated to U.S. convertible bonds, CWB, has seen its assets explode over the past 12 months. Barely over $1 billion a year ago, the fund now has nearly $2.5 billion under management.  It’s a passively managed fund designed to track Barclays BCS +0.45%’ index of large U.S. convertible bonds (each component must be over $500 million, or about twice the size of an average convertible).

That growth should tell you all you need to know about how demand for convertible bonds has been expanding. It’s understandable—investors and their advisors are worried about rising interest rates but want to stay with an asset class that, unlike stocks, promises principal repayment.

However, companies haven’t been issuing convertibles nearly enough. New issuance in the U.S. bottomed at $20 billion in 2012, compared with around $100 billion annually in the years leading up to the financial crisis. 2013 was a lot better, with almost $50 billion, but that was barely enough to replace maturing deals.  Current issuance is simply nowhere near enough to keep up with demand.

Unfortunately, this means that in many cases, investors who are just now putting their money into a generally terrific asset class may be getting on the wrong side of value. In some cases, this can be rather severe."  - source Forbes, Bill Feingold.

We think there are growing risks of seeing liquidity vortexes where the lack of bid will make prices gap down violently, hence our chosen title. New Basel regulations have pushed banks to re-assess their balance sheets and are less in a position to absorb secondary offerings when markets turn South. Like others, such as Matt King from Citi, we have been warning about the fact that spreads reflect less and less "liquidity" risk in the current environment, convertibles being no exception, as clearly indicated by Bill Feingold in his Forbes article. 

As posited more recently by Matt King from Citi, liquidity is indeed a growing concern because it is extremely fat-tailed:
Citi Matt King - Investing in fake markets - March 2014 - How is the distribution in markets?
- source CITI - Matt King - March 2014 - Investing in fake markets.

Highly leveraged funds in the case of a sell-off will be particularly hit hard in that case. The issue of course would be to hold a higher proportion of cash to mitigate the redemption risk, unfortunately, cash buffers have been going down in many cases. Negative convexity risk in callable bonds for instance can be as well mitigated by increasingly playing credit via the CDS market. Recent hybrid calls at 101 for Telecom Italia and Arcelor Mittal are stark reminder of the need of pricing "optionality". Another advantage of the CDS market is the added liquidity on the credit exposure you want to add to your portfolio. Of course you are somewhat switching liquidity risk for counterparty risk. It is never a zero sum game but we ramble again. For illustrative purposes, the graph below from Matt King from Citi, illustrates further the liquidity issue, volatility and risk you run between cash bonds and CDS:
 "The vol you see is not the risk you're running"
- source CITI - Matt King - March 2014 - Investing in fake markets.

When we talk about investors getting outside their comfort zone and adding risk they might not perceive, the Junk-Loan ETF space is growing at a very rapid space in an environment which is becoming more and more reminiscent of 2007 as indicated by Sridhar Natarajan in his Bloomberg article from the 26th of March entitled "Junk-Loan ETF Asset Surge Heralds Higher Rates":
"Investors just can’t get enough of exchange-traded funds that buy junk-rated loans.
After more than tripling their assets in 2013, the loan funds are now growing four times as fast as the rest of the $262 billion market for fixed-income ETFs, according to data compiled by Bloomberg. The biggest leveraged-loan ETF, Invesco Ltd.’s $7.4 billion PowerShares Senior Loan Portfolio, has already amassed almost a billion dollars in new money this year.
The popularity of speculative-grade loans, which have rates that rise with benchmarks, has soared with debt investors seeking shelter from higher borrowing costs as the Federal Reserve moves up its rate-increase projections. While the demand has been a boon for ETFs that invest in loans to the neediest companies, it’s also prompted regulators to warn that excesses which contributed to the credit crisis may be creeping back." - source Bloomberg

As Warren Buffet quote goes, risk does indeed comes from not knowing what you are doing given that single-B rated loans now make up the largest portion of the junk-loan market compared with 2007, when double-B rated loans were the most popular. As a reminder, during the credit crisis, loans were the worst performers among the major credit asset classes, losing 23 percent in the last quarter of 2008.

Loan ETFs are yet to be tested, by our "liquidity" fat-tail concerns but they are sure becoming "Too Big To Fall", and if indeed selling pressure does materialise, they will probably sell-off fare more than the index because they might not be in position to redeem the assets at the pace of the money being pulled out. Caveat investor...

In a world of increasing "positive correlations" where convertibles ETFs as well are getting even more sensitive to "equities", last year's sell-off in the credit ETF space for High Yield (ETF HYG) and Investment Grade (ETF LQD) illustrate, we think the "redemption" risk - graph source Bloomberg:

Another illustration of the "Cantillon Effects" at play and outside the credit space has been the London real estate market courtesy of Central Banks' generosity as indicated by Bank of America Merrill Lynch in their Thundering Word note from the 27th of March entitled "Hey Crude, don't make it bad":
"London...the last great EM “speculative fervor”
Prime London real estate is up 2X since 2006, 3X since 2000 and 4X since 1998.
And yet UK rates are the lowest they have been in 300 years. In our view, London property is a classic outcome of the Max Liquidity-Min Growth backdrop of the past seven years. We believe the risk of "speculative fervor" remains high. The UK could prove a useful early warning system.

Prime London real estate has doubled since 2006, tripled since the 2000 and quadrupled since the last great Asia/EM crisis of 1998 (Chart 3). 
And yet the Bank of England's policy rate is at its lowest level in 300 years (Chart 2)."
- source Bank of America Merrill Lynch - The Thundering Word - 27th of March 2014

As per our conversation "Cantillon Effects", we too, have an our own useful warning system, being the art market in general and Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:
We have argued previously that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

As a reminder, why did we choose art as a reference market in describing "Cantillon Effects" and asset bubbles you might rightly ask?

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:
Δ M  => Δ Asset Prices

Sales of art and antiques increased 8 percent from a year earlier to 47.4 billion euros ($65.9 billion), according to a report compiled by Arts Economics and published on the 12th of March as reported by Bloomberg by Katya Kazakina on the 12th of March in her article "Art Market Nearing Record as Global Sales Reach $66 Billion":  
"The results fell just short of the record 48 billion euros in 2007. The value of postwar and contemporary art transactions increased by 11 percent from 2012, reaching its highest-ever auction sales total of 4.9 billion euros as records were established for artists such as Francis Bacon, Roy Lichtenstein and Andy Warhol." - source Bloomberg.

Yet another example of "illiquid asset" such as London real estate to monitor closely in the near future and another illustration of our 2007 feelings we think.

On a final note and relating to our deflationary monitoring stance, we have been tracking with interest the shipping space as you know and looking at the recent Asia to Europe container shipping rates, it continues to fall and has indeed fallen to a 21 week low:
"Shipping rates for 40-foot containers fell 5.1% to $1,684 for the week ended March 27, marking the ninth-straight weekly decline and the lowest price since mid-December ($1,660), according to World Container Index data. None of the major trade lanes increased. Rates from Shanghai to Rotterdam (11.9% lower) and to Genoa (down 5.7%) declined the most for the fourth consecutive week, as rates for both lanes dipped to the lowest levels since October." - source Bloomberg.

The latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark tells a similar story - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 26, reversing last week's gain and the eighth week in 2014 below the $2,000 mark. Slack capacity continues to pressure prices, with rates 13.4% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase per 40-foot container from Asia to the U.S., effective April 15." - source Bloomberg.

What is of course of interest is the additional rate increases to counter the deflationary forces at play still wreaking havoc on the shipping industry as a whole. As a reminder, Containership lines have announced 13 rate increases, totaling $5,450, on Asia-U.S. routes since the beginning of 2012.

So what is the new trick to offset deflationary forces, you might rightly ask? It is called "Container Liner Alliance" by the U.S. Federal Maritime Commission (FMC) when it should be called "Oligopoly" or more simply a cartel:
"The U.S. Federal Maritime Commission (FMC) approved the alliance of the three largest containerliners Maersk, Mediterranean Shipping and CMA CGM, dubbed P3, on March 20 to set sail in 2Q.
The alliance of 252 vessels (2.6 million 20-foot equivalent units) represents 42% of Asia to Europe, 24% of Trans-Pacific and 40% to 42% of Trans-Atlantic capacity, according to the FMC. P3 may help reduce costs and manage excess capacity, stabilizing rates." - source Bloomberg.

So in the competition of survival of the fittest, the set-up of a de facto "cartel" in the shipping space  with the benediction of US authorities has no doubt "boosted" the probability of survival of the big three. This latest "intervention" does indeed validate our January 2014 musing "Shipping and Deflation - Only the strong survive":
"In a Bear Case scenario, only the strong survive such as Maersk. The world's largest container shipping line with 15% of the world's market share, did report an 11% increase back in November in third-quarter profit after cutting costs by 13% in the quarter helped as well by its new line of triple-E ships being introduced which has been countering the deflationary trend in freight rates." - source Macronomics, 9th of January 2014

Looks like the containers industry is like the banking industry after all, it's "Too Big To Fail".

"If my survival caused another to perish, then death would be sweeter and more beloved." - Khalil Gibran, Lebanese poet

Stay tuned!

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