Tuesday 17 June 2014

Credit - The Monkey's paw

"'It had a spell put on it by an old fakir,' said the sergeant-major, 'a very holy man. He wanted to show that fate ruled people's lives, and that those who interfered with it did so to their sorrow.'" - The Monkey's paw - Horror short story by W.W. Jacobs published in 1902

After some R&R (Rest and Recuperation), our reconnection to the credit markets validated even further our long standing assertion of a "japonification" process taking place in the credit space in particular and in world growth in general (IMF lowered its 2014 US growth prospect forecast to 2% from 2.4%). 

Of course, all of this is part of the deflationary pressure we have been discussing and highlighting throughout our numerous posts. For illustration purposes we have used the shipping industry to support our deflationary stance and used what was happening with the Drewry Container Rates as an illustration of the tremendous deflationary forces at play. Container lines have made eight general rate increases and one peak season surcharge totaling $3,000 on Asia-U.S. routes since June 2013 and there have been four general increases this year - graph source Bloomberg:
Every single time, the increases have failed to hold because of excess capacity and a sluggish global economy. The benchmark Hong Kong-Los Angeles rate has fallen 7% this year through June 4 and is down 11% yoy. In our Bear Case scenario, slack capacity will continue undermining efforts to raise rates during 2014. Rates have been below $2000 in 16 of the past 17 weeks.

Looking at the growing build up in liquidity concerns which have been stressed on many occasions by market practitioners, it is interesting to see that finally some of the "omnipotent" deities in central banking are waking up to the wonders of the "practice" of their magician tricks given that Federal Reserve officials have discussed whether regulators should impose exit fees on bond funds to avert a potential run by investors, underlining concern about the vulnerability of the $10tn corporate bond market as reported in the Financial Times.

While we previously used many references to the magic tricks used by a "Central Banks" world which was dominated by the "Sorcerer's apprentice" aka Dr Ben Bernanke before his replacement by Janet Yellen, and our "Generous Gambler" aka Mario Draghi in Europe, we thought this time around in continuation to "failing magic trick" references and on-going deception we would use in our title a reference to the Monkey's paw

The story is based on the famous "setup" in which three wishes are granted. In the story, the paw of a dead monkey is a talisman that grants its possessor three wishes, but the wishes come with an enormous price for interfering with fate (deflation). In similar fashion the wishes of our central bankers have come with an enormous price tag for interfering with the most important price of all, the price of money with their ZIRP experiment. Of course the recurring liquidity risk in credit markets has been amplified by the acceleration in disintermediation as well as the reduction in market making activities due to regulatory pressures, deleveraging and balance sheet constraints, leading of course to a growing sense of a nasty build-up in "instability" in true Minsky fashion but we digress.

So in this week conversation we will look again at liquidity constraints as well as interesting development in the subordinated space which so far has been disregarded by credit investors given the appetite for yield has clearly made them forget the notion of "risk".

The "japonification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

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

We commented at the time that the credit markets and equities markets were no exception to "rising forced correlations". In recent years, credit and equities have correlated closely, but, as credit has moved towards a lower bound, Investment Grade for instance have become even more sensitive to interest rates movement, making it incredibly likely that any rate rises will have a large impact given the disappearance of the interest rate risk buffer in the asset class given the on-going spread compression supported by large inflows into the asset class. An illustration of the "positive correlations" we are discussing can be seen, we think in the strong convergence we have seen between the CDX index in the US representative of Investment Grade credit risk and its European counterpart the Itraxx Main Europe 5 year CDS index - graph source Bloomberg:

In August 2013 in our conversation "Alive and Kicking" we argued the following:
For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

It seems to us the central bank "deities" are in fact realising the dangers of using too much the "Monkey's paw" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space, but that even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in credit funds given that the Fed's role is supposedly one of "financial stability". To illustrate further the growing liquidity risks posed by central banks actions, please see the below graphs from Bank of America Merrill Lynch recent situation room from the 16th of June entitled "Geopolitical risk in the Middle-East" displaying the evolution of the capacity for market makers in providing two way markets since 2005:
- source Bank of America Merrill Lynch

Another illustration of the growing risk posed by the gigantic growth of the credit space can be seen in another graph coming from the same Bank of America Merrill Lynch report:
- source Bank of America Merrill Lynch

In this note Bank of America Merrill Lynch made the following interesting comments:
"Just to re-iterate our concern – the Fed’s rate hiking cycle tends to be associated with wider credit spreads (Figure 9). 
Three developments make us concerned that it may actually be much worse this time. 
1) The Fed’s zero interest rate policy has led to an unprecedented reach for yield for more than five years – when the Fed hikes rates the “un-reach” for yield is going to be unprecedented as well. 
2) Dealers have little ability to act as buffer in a sell-off this time, as balance sheets have collapsed due to new regulation (Figure 5 above ). And finally 
3) The mutual fund/ETF ownership share of the corporate bond market is much higher than we have seen in the past – and this is the “hot money” in the corporate bond market (Figure 6 above). However, in the short term we still view the initial increase in interest rates over the past two weeks as modestly bullish for credit spreads, as institutional investors come out and retail flows react to returns only with a lag." - source Bank of America Merrill Lynch

Higher interest rates so far in June have indeed highlighted rising interest rate risk for US high grade spreads and the lack of a significant buffer to counteract rising rates. 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 convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

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.

We concluded at the time:
"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..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment.

Moving on to the subordinated space which has been a pet subject of ours in recent years (as we predicted in timely fashion skip of calls, bond tenders, and debt to equity swaps in the European banking space - see our conversations "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"), the new TLTRO set by the ECB is preventing additional liability management taking place in the subordinated space. As we argued in our previous conversation, what European banks lack is not liquidity but lack of capital. Liability management exercises meaning buying back or exchanging subordinated debt usually well below par value took place before the introduction of the LTRO in December 2011. These exercises provided some support for subordinated bond prices at the time. On the back of the ECB's support most prices of Tier 1 subordinated bonds rallied hard closer to par for most in 2013 given the liability exercises took place in 2011 and 2012 and for some peripheral banks took place at a later stage in 2013. 

What has been interesting indeed is the convergence we have seen between the Itraxx Financial Senior 5 year CDS index with the Itraxx Financial Subordinated 5 year CDS index - graph source Bloomberg:
This convergence can indeed be explained by the central banks support which has so far prevented further liability management exercises by providing more than enough liquidity to provide additional support in the on-going deleveraging process and capital raising exercise taking place in the European banking space.

Again, the use of the Monkey paw by central bankers has indeed clearly created mis-pricing and induced mis-allocation as indicated by the induced compression between financial senior risk and subordinated risk we think. For instance a recent example of the mis-perception and mis-pricing of risk in the subordinated space has been highlighted by the threat of the Austrian government towards subordinated creditors of Austrian distressed real estate bank Hypo Alper-Adria-Bank (HAA). The Austrian government in this specific case is trying to pass a law to impose haircuts on investors who thought were insured given the bonds have deficiency guarantee from the state of Carinthia in Austria. This is in effect putting into a new perspective regional government guarantees. The spillover effect of the HAA story had of course some impact on the Austrian financial sector and led S&P on the 10th of June to put the ratings of seven Austrian banks and four Austrian states under review for downgrade. As reported by CreditSights in their Euro Financial Movers report of the 15th of June:
"The government is also proposing to cancel loans of €800 mn provided by the bank's former owner Bayerische Landesbank (BayernLB), while a further €1.5 bn of loans from BayernLB will not be repaid or paid interest until June 2019 at the earliest. BayernLB has reacted angrily, not unexpectedly (see Bayerische Landesbank: HAA Bail-in Challenge), as this move could hit its capital ratios and potentially might require it to take further provisions or impairment charges." - source CreditSights

This illustrates not only the unpredictability of government action but also the mis-pricing of risk in the subordinated space we think, particularly in the light of the upcoming revamp of the CDS market in September 2014 with the new design for CDS contracts which should lead to a significant widening of subordinated spreads to reflect the changes in the new contracts. The lower recovery rate expectations in the new European bank CDS contracts will widen spreads but should end of the day benefit the protection buyer as the sub-level events given successor provisions which will be introduced mean that senior and sub debt will be tracked separately to determine successors meaning it reduces orphaning risk (lack of deliverable bonds). As a reminder in the experience of Bankia/BFA sub debt moved to BFA, but the majority of senior debt and sub and senior CDS moved to Bankia.

In relation to the widening expected, Barclays in their note from the 6th of June 2014 entitled "Implied valuations of '14 bank CDS definitions" expect a widening of 50 bps:
"We expect sub CDS to be up to 50bp wider, on average, with senior CDS 15bp tighter. Though September is a few months away, two trading implications that are relevant right now are to sell sub protection in names with positive CDS-cash basis and to own (or not be underweight) LT2 bonds in tier 2 banks." - source Barclays

Therefore the Bloomberg graph above displaying the on-going relationship between Itraxx Financial Senior with Itraxx Financial Subordinated 5 year CDS index is somewhat an anomaly which has been induced by investors once again over-reaching for yield in their buying spree.

On a final note as always, regardless of the final melt up in asset prices, credit prices will indeed be giving clues for a stock market correction as indicated by Bank of America Merrill Lynch in the below graph from their recent Thundering Word note from the 12th of June entitled "The Greatest Risk of All":
"We are a buyer of vol into fall when correction risks rise significantly: either Q3 growth is +3% confirming recovery and cause rates to rise or speculative excesses appear causing central banks to start "talking down" asset prices. Clues to stock market correction include rising gold prices and decline in credit prices (as in 1987 –Chart 1)." - source Bank of America Merrill Lynch

The Monkey's paw story is as follows:
" The story involves Mr. and Mrs. White and their adult son, Herbert. Sergeant-Major Morris, a friend of the Whites who has been part of the British Army in India, introduces them to the monkey's paw, telling of its mysterious powers to grant three wishes and of its journey from an old fakir to his comrade, who used his third wish to wish for death.

Sergeant-Major Morris, having had a bad experience upon using the paw, throws the monkey's paw into the fire but White quickly retrieves it. Morris warns White, but White, thinking about what the paw could be used for, ignores him.

Mr. White wishes for £200 to be used as the final payment on his house. The next day his son Herbert leaves for work. Some time later, the young man is killed by machinery at the factory where he works, and the couple receives compensation of £200 from his employer.

Ten days after the funeral, Mrs. White, almost mad with grief, asks her husband to use the paw to wish Herbert back to life. Reluctantly, he does so. Shortly afterwards there is a knock at the door. Mrs. White fumbles at the locks in an attempt to open the door. Mr. White knows, however, that he cannot allow their revived son in, as his appearance will be too hideous. Mr. White was required to identify the body, which had been mutilated by the accident. It has now lain buried for more than a week. While Mrs. White tries to open the door, Mr. White makes his third wish, and the knocking stops. Mrs. White opens the door to find no one there." - source Wikipedia

Maybe Mr Central Banker, in similar fashion to Mr White knows that he cannot allow a fast revival of normal interest rates as the re-appearance will be "too hideous" for risky asset prices as a whole.

As far as we are concerned we have our doubts in the much vaunted "recovery" story but do agree that vol's cheapness is indeed inversely correlated to the rising "complacency" making new highs on a regular basis in the market place.

From Monkey's paw to Monkey business...

"An American monkey, after getting drunk on brandy, would never touch it again, and thus is much wiser than most men." - Charles Darwin

Stay tuned!

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