Saturday, 4 April 2015

Credit - The Honey Pot

"Man is the only kind of varmint sets his own trap, baits it, then steps in it." - John Steinbeck, American author
Looking at the abandonment with which investors are piling into Corporate Hybrid debt such as Bayer AG 2%⅜ coupon, maturing in 2075 with a spread of 241 bps over Bunds to its first call date in 2022, we reminded ourselves for this week's chosen title analogy of the movie 'The Honey Pot", a 1967 crime comedy-drama film written for the screen and directed by Joseph L. Mankiewicz which was inspired by 1605 English play called Volpone (Italian for "sly fox"), a merciless satire of greed and lust just like today's markets we think. Movie buffs like ourselves will note that Joseph L. Mankiewicz was the brother of Herman J. Mankiewicz, famous for winning an Oscar for co-writing Citizen Kane in 1941 but we ramble again... 
But, moving back to our chosen analogy, as there is always another layer to it, it is also a computer terminology for a trap which is set up to detect, deflect or use as a bait to entice computer hackers. In our credit case, corporate subordinated debt such as hybrid have been effectively used by "sly fox" issuers to lure unsatiated yield hungry investors to dip outside their comfort "risk" zone as aptly described by our friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR in his recent column:
"Subordinated corporate debt is all the rage in a world in need of yield and issuers are not being shy in coming forward in order to oblige. Investors, on the other hand, have been hoovering the stuff up and, not surprisingly, the premium they are being paid in order to take the extra and until recently quite innovative risk has melted away.

Subordinated corporate risk satisfies a string of needs but if fixed income and credit investors think that they are getting the best of the upside, they are sorely mistaken. Corporate sub debt is the ultimate ratings arbitrage. I had, given my background in structured credit , always assumed that the CLO (Collateralised Loan Obligations) was the pinnacle in terms of making a silk purse out of a sow's ear but I am beginning to see corporate hybrid debt as a much more straightforward example of the dark art.

Why, one needs to ask one's self, would a company issue subordinated debt? It didn’t have the capital and reserve restraints which affect banks so who is the winner and why? Look no further than the boardroom. Older readers - that's the over 45s - will recall the world's leading corporate names all being in the triple-A, double-A or occasionally in the rather sad and ignominious single-A ratings space. Management was proud of the high quality of its company's debt. Then, beginning in the mid-1990s, everything became a matter of "shareholder value". Balance sheets were geared up to the ying-yangs and cash returned to shareholders. It was an age of stock-price above all else. At times, the entire stock looked like a board-approved pump-and-dump circus.

The fashion was for "making the balance sheet more efficient". Had executive remuneration not been so closely tied to the stock price, a lot of this might not have occurred. Executives couldn't buy themselves a yacht or a ski chalet from higher debt ratings but they could from a higher stock-price. Ultimately, obviously, there were limits to how far you could reasonably leverage a balance sheet until someone dreamt up the hybrid corporate bond.

The hybrid bond fulfils two principal functions. Firstly, it lets companies borrow without adding further pressure to the senior bond ratings which is good although, of course, the balance sheet is not relieved of debt, thus offering something rather akin to invisible leverage. Secondly, it gives the borrower cheap equity without diluting the share capital and hence negatively influencing the wealth of those who's remuneration is linked to share price performance and is expressed by way of stock awards. It is, in many respects, a victimless crime. There is nothing altruistic in corporates issuing subordinated debt.

And yet, investors are tripping over themselves in pursuit of such paper. Early and enthusiastic investors in hybrids made out like bandits but the juice has gone. Furthermore, as in the case of Additional Tier One (AT1) notes, the sub-class has not yet been tested in a prolonged and properly stressed market which renders the pricing process for such paper a bit of a game of pinning the tail on the donkey. The price of a bond needs to take account of the expected recovery rate in the event of default. I'm not sure anyone has come up with a usable and credible model for this one. Does one insert zero recovery? If so, how should that risk be correctly priced? 241 bps certainly doesn't seem to cover the bases. And that, incidentally, does not even include any meaningful pricing adjustment for the higher liquidity risk of junior sub debt in a stressed market where bids for institutional size will surely once again be scarcer than pink and blue striped unicorns.

The principal risk which should be worrying us is not, when push comes to shove, the one covering default and recovery but the one of mark to market volatility. The higher convexity which the currently low coupons impose on bonds brings with it higher price volatility and hence much higher risk to investment portfolios. What effect this might have on such matters as the solvency of insurance companies has not, in my opinion been taken on board. In their race to slaughter market liquidity on the altar of transparency, the regulators are doing just what we feared they were, namely they are preparing to re-fight the last war. "- Anthony Peters, strategist at SwissInvest   

Exactly! We agree with our friends when it comes to convexity risk. Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."
So Corporate Hybrids investors beware, because, the reward doesn't justify anymore the risk and the lack of liquidity will one day come back to haunt you when you will be seeking "price discovery" for your holdings rest assured.

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management which we introduced in our conversation "The Night of the Yield Hunter":

In this week's conversation, as we move into the second quarter of 2015, we will look at the current business cycle from a credit perspective and ponder were we stand when it comes to allocation in "nth" inning game.

  • Although "leverage" is rising, it is still "goldilocks" for credit in particular for US Investment Grade Credit
  • In this late credit cycle game, we recommend playing "quality"
  • Global QE is not only leading to the "Honey Pot" but as well extending the game into "overtime"
  • What to do in Q2?
  • Final note: the only "Great Rotation" has been from retail investors to institutional investors

  • Although "leverage" is rising, it is still "goldilocks" for credit in particular for US Investment Grade Credit
As we pointed out in our previous conversation, there is indeed greater enthusiasm for US dollar credit. 

US Investment Grade Credit in terms of returns have been so far more appealing as clearly displayed by Morgan Stanley's Leveraged Finance Chartbook from the 30th of March:
- source Morgan Stanley
But, as indicated by CITI in their March 2015 note entitled "Is the credit cycle headed to extra innings?", leverage in the Investment Grade credit space has been rising, confirming we are indeed in the higher left quadrant of the "Global Credit Channel Clock":
- source CITI

We have long argued that in the "japanification" process, particularly in Europe, credit could outperform equities: 
"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.-Deleveraging is generally bad for equities, but good for credit assets. -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
This outperformance has played out until 2015 which saw the launch of the ECB's QE and a switch in the "regional macro" perspective as we pointed out last week:
"What we find of interest from a pure "regional macro" perspective is that whereas in the last couple of years European credit has clearly outperformed equities, it seems to us that the ECB's actions have reversed the trend by pushing yields towards negative territory and very significant inflows and performances in the European equities space. At this juncture given the different paths followed by the ECB and the Fed, it seems reasonable to switch from favoring European Credit towards US Credit and, in the equities space, to favor European Equities rather than US equities as a whole." - Macronomics, "The camel's nose", March 2015
The current "deflationary" environment is indeed a golden age for credit, and given the "macro regional switch" one should indeed favor a stronger allocation to US Investment Grade in the US while European High Yield remains more enticing than European Investment Grade credit due to the disappearance of the interest rate buffer we discussed last week as well as convexity issues (lower and lower coupons and increased duration). 
In Europe, Investment Grade has had its second best performance in 2014 since 2009 (above 7% versus 5% for European High Yield) and with the largest issuance number since 2007. When one looks at the Asset Class Total Returns in 2015 in the Fixed Income space as displayed in Morgan Stanley's Leveraged Finance Chartbook from the 30th of March, one can see that our positive stance on US Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been validated by returns:
"For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit." - Macronomics, 19th of August 2014.

- source Morgan Stanley
 In our conversation "Sympathy for the Devil" back in September 2014 we argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters." - Macronomics, September 2014
Yes indeed, when it comes to the High Yield space, default perception risk matters and is ultimately linked to leverage. What could significantly impact High Yield spreads would be a sudden rise in defaults rise, particularly coming from the "Energy" sector which has been in the limelight courtesy of the sudden fall in oil prices. 
In Morgan Stanley's Leveraged Finance Chartbook from the 30th of March one can take notice of the "pessimistic" Moody's Forecast versus their much lower baseline scenario:

- source Morgan Stanley
But, as pointed out by our Rcube Global Asset Management friends, from their March 2013 guest post "Long-Term Corporate Credit Returns", credit investors have a very weak predictive power on future default rates:
"Current spreads have virtually no correlation with actual future default losses. They are therefore driven by something else (risk aversion, greed/fear cycle). Corporate credit investors actually seem to care a lot about one thing: current (i.e. trailing 12-month) default rates.
We interpret this as evidence that credit investors are collectively subject to an extrapolation bias.
When default rates are high, credit investors behave as if default rates were going to stay high for the next 5-10 years. They liquidate their portfolios in panic (or because they are forced to do so). This snowball effect leads to spread levels that have no economic rationale. At the height of the latest credit crunch, corporate high-yield spreads were pricing a 33% annualized implied default probability over the following five years (20% / ( 1 – 0.40 )), which is around four times the maximum five year annualized default probability during the Great Depression!

Inversely, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to malinvestment, and sows the seeds of the next credit crisis." - source Rcube Global Asset Management
And as per our tile "The Honey Pot", credit markets are indeed a "merciless satire of greed and lust" as concluded by our friend in their 2013 guest post. Credit investors do suffer from "bipolar disorder" and alternate from greed to fear, except that contrary to 2007/2008, during the next "fear" episode, liquidity will not be around:
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates." source Rcube Global Asset Management
While for some it appears to be late in "the Honey Pot" game, one thing for sure is that additional QE from the ECB has been adding extra innings into the "credit" business cycle.

  • In this late credit cycle game, we recommend playing "quality"

In this late credit cycle game, we recommend playing "quality" as clearly displayed by Morgan Stanley's Leveraged Finance Chartbook from the 30th of March, it matters:
- source Morgan Stanley
Looking at the above table, both AAA exposure and CCC, doesn't justify, from a risk exposure the risk/reward due to interest rate volatility for the latter and the expected rise in defaults risk for the former. So where is the value?

On the subject of "credit quality" and given investors interest for the BBB "credit belly", we read with interest Morgan Stanley's take in their 27th of March note entitled "The BBB Tail":
"Near-Term Softness; Longer-Term Value
Credit markets continue to have a late cycle feel. Supply comes at a record pace in spite of the 40bp widening since the tights. IG has underperformed equities over the medium term. Despite the widening, our models say that spreads are slightly rich, as weaker Q1 GDP and the recent rate rally weigh on valuations. Over the longer-term, we look through some of the GDP weakness and expect higher rates, both of which will support IG credit.
Revisiting the BBB Trap
While spreads are roughly flat YTD, Non-Financial BBBs are underperforming, wider by 6bp, whereas A-rated issuers are tighter by 5bp. Though the Energy sector is certainly a reason for BBB underperformance, there are other late cycle reasons including quality deterioration, M&A and buybacks.
The BBB Trap: This is significant, as 50% of the IG market ex Financials is comprised of BBBs (35% are A-rated). Furthermore the spread differential (about 80 bps, driven in part by Energy) makes the credit quality view an important one to get right from a carry perspective. 
Are BBBs Cheap Now?
We don’t think so. Ex-Energy and Financials, BBBs provide only 61bp of spread premium over A-rated issuers. While that premium was below 50bp during the peak of the last cycle, the average premium over the past 10 years is about 84bp.
The Trap Becomes a Tail
BBBs are a significant source of dispersion relative to A-rated issuers. The formation of this tail is happening rather quickly, and in our view, represents the fallen angel class of issuers in this cycle." - source Morgan Stanley
In their note Morgan Stanley also highlight the dispersion risk involved in the "BBB" credit bucket and how to avoid it:
"How Does One Avoid the Dispersion Risk? Outside of avoiding BBB risk, credit analysis is the obvious answer, but that assumes realizing a good batting average. Within structured credit, senior tranches are the natural choice, as they are fairly immune to credit dispersion as long as overall spreads are healthy. From the short side, we would recommend protection positions in legacy CDX IG indices which tend to experience credit-quality deterioration at this point in the cycle."
- source Morgan Stanley
Even leveraged credit can be less risky than unleveraged equities as credit is far less volatile than equities, some leverage is sensible.

  • Global QE is not only leading to the "Honey Pot" but as well extending the game into "overtime"
QE has indeed been stimulating on a grand scale flows not only into specific asset allocation but, as well to regional allocation (European equities) as we pointed out in our last conversation. A good proxy of the "over-stimulation" of the "Honey Pot" can be seen we think through the prism of year to date flows as a percentage of AUM as indicated in Bank of America Merrill Lynch's Situation Room note from the 2nd of April entitled "Selling stocks but holding on to bonds":
"Outflows from stocks funds increased to $9.15bn last week from a $4.40bn outflow in the prior week. High yield bond funds had a small $0.58bn inflow, while short-term high grade (- $0.45bn) and loans (-$0.20bn) continued to report outflows. Outside of short-term funds high grade flows were little changed from the prior week at $3.16bn. However, weekly data for high grade outside of short-term funds tend to be inflated by PIMCO-related flows, and PIMCO again reported outflows for the month of March." - source Bank of America Merrill Lynch
When it comes to the supposedly "Great Rotation" story of 2014 from bonds to equities, with YTD inflows of $31.7 bn into High grade versus $20.2 bn into equities, the only great rotation story of 2015 has been in Europe with significant inflows into equities courtesy of the ECB's QE.

The ECB QE factor has been driving equities flows in Europe. It can be ascertained from Bank of America Merrill Lynch's Flow Show chart from the 2nd of April entitled "My Herd is My Bond". The European "Honey Pot" à la Japan:
"My Herd is My Bond: another week, another week of inflows ($8.5bn) to fixed income; indeed 2015 has seen biggest first quarter of fixed income inflows ($102bn) since 2001.
Dollar driving equity flows: inflows to Europe & Japan, outflows from US & EM; overall $9.1bn weekly redemptions from equity funds.
Everyone loved QE: as noted last week ECB QE-inspired inflows to European equities now v similar as % of AUM to Japan equity inflows during launch of BoJ QE in 2013 (Chart 1)."
Cash smashed: very large $53bn outflows from Money Market funds, largest since Oct'13 US government shutdown. - source Bank of America Merrill Lynch.
As pointed out in their note as well, Europe has seen very significant inflows courtesy of our "Generous Gambler" aka Mario Draghi:
- source Bank of America Merrill Lynch.
Global QE and increasing negative yield in Europe have led to investors being led to the "Honey Pot" to smash the Piggy bank (money market outflows) and to run into overdrive towards fixed income. So much for the "Great Rotation" story...

The global easing and QE policies have effectively led to a late continuation of the the business cycle as indicated by Bank of America Merrill Lynch's US Economic Weekly note from the 2nd of April entitled "The continuing case for risk assets":
"The benefits of clean living
A popular view is that business cycles die of old age. If this were true, then the length of recoveries would tend to cluster around a certain number of years. In reality, the length of recoveries has a very flat distribution, extending from 12 to 120 months (Chart 2).

 Moreover, if anything, economic recoveries have tended to get longer over time. In the “good old days” of the gold standard the average recovery lasted only two or three years, and the economy was in recession almost as much as it was in expansion. Since World War II the average recovery has increased to 58 months. Even more telling, the last three recoveries have been among the four longest in history. By this standard, the current recovery is middle-aged, not old.
Recoveries don’t die of old age, they end due to three kinds of excesses—major asset bubbles, overexpansion of cyclical sectors and high inflation. In addition, a related excess, the shock of higher oil prices, has been an important cause of many recessions. None of these health risks are evident today:
  • Healthy diet: unlike during the housing and tech bubbles, in the current cycle easy credit has been used for balance sheet repair. While there may be minibubbles in parts of the markets, there is no sign of a bubble in major asset markets such as housing and the stock market.
  • Low cholesterol: Historically, the three cyclical sectors of the economy— consumer durable spending, housing and business equipment investment— tend to collapse during recessions and then over-expand late in the recovery. Today, all three sectors have taken back only about half of their decline as a share of GDP (Chart 3).
  • Non smoker: Inflation remains low and given strong global headwinds it is unlikely to pick up significantly any time soon.
  • Drink in moderation: Oil prices are a long way from levels that have triggered recessions in the past and are unlikely to return to their highs any time soon (Chart 4).
 - source Bank of America Merrill Lynch
Of course we disagree with Bank of America Merrill Lynch's take who is not seeing froth into any major asset class. As per our earlier rant of our current credit conversation, the European corporate credit hybrid space is a clear case of "overreaching" investors!

  • What to do in Q2?
When it comes to the "pain trade" we benefitted from the February weakness into US Treasuries to add to our long duration exposure (partly via ETF ZROZ). The 126K weaker than expected print for Nonfarm payrolls well below the "optimism bias" economists forecast of 247K, validated even more our cautious long standing "deflationary" stance.  We continue to see value in being long duration via US Treasuries. The macro data in the US continue to point out that the US economy is much weaker than it seems and we do not see the Fed hiking in June and hiking in 2015 even. The Fed has clearly stated it is data dependent.

Looking again at the upper left quadrant of the "Global Credit Channel Clock" from Rcube Global Asset Management friends, you should:
  • remain long volatility
  • remain long US Government Bonds
  • remain long gold
  • continue to play yield curves flattening

Our position is relatively similar to what has been advocated by Bank of America Merrill Lynch in their Thundering Word latest note entitled "Moment of Truth" when it comes to being long volatility:
"We remain a buyer of volatility (so at margin add to gold and cash). Without doubt the key Q2 call is can the US economy recovery its mojo (i.e. Q2 GDP pops above 3%) or not (GDP for 3rd consecutive quarter fails to break much above 2%). Big GDP...Fed hikes get priced-in. Small GDP ..."secular stagnation" back in play, investor "buyers strike" in overvalued corporate bonds and equities. In either scenario, volatility performs well. Vol remains the "buy the dip" trade of 2015.
Lower exposure to spread product. BAML house view is US GDP above 3.5% Q2. This likely to put upward pressure on bond yields as June/Sept in play for hike. In turn this is likely to widen spreads across corporate bonds, a trend that at any moment can be exacerbated by latent investor fears on market liquidity, speculative excesses in "yield" products, and levered ETF risk parity strategies." - source Bank of America Merrill Lynch.
Where we disagree strongly is with their "house view" of US GDP above 3.5% in Q2. It will not happen for the following reasons:

  • Only 34,000 jobs were added in March, according to the Household Survey. 96,000 Americans, meanwhile, left the labor force. The Labor Force Participation Rate has fallen back to post-1978 lows. The 126 K NFP print along with downward revisions of 69,000 for January and February shows that the U.S. economy is an a dead stall. The Atlanta Fed GDPNow tracking forecast shows zero growth during the first quarter.
  • New York’s ISM purchasing managers’ survey came in at 50, vs. 63.1 the previous month and a survey expectation of 62.
  • Most pundits assumed that cheaper oil would spur consumer spending. Check latest retail sales...
  • Earnings are vulnerable to big disappointments. Factset reported on the 1st of April (not April's fool day on that matter) that positive guidance is at the lowest level since 2006: 
“For Q1 2015, 85 companies in the S&P 500 have issued negative EPS guidance and 16 companies have issued positive EPS guidance. If 16 is the final number of companies issuing positive EPS guidance for the quarter, it will mark the lowest number since Q1 2006. The number of companies issuing negative EPS guidance for Q1 2015 is above the trailing five-year average (76), but slightly below the trailing one-year average (87) for a quarter.”
"That’s mostly price movements, to be sure, but the collapse of export prices in dollar terms reduces capacity to service dollar debt. Deficit = death in this kind of market."
  • The Chicago MNI Business Barometer came out at 46.3 in March, barely above the 45.8 reading in April, indicating more contraction. The consensus estimate called for a recovery to 51.7. Yet another miss by the "optimism bias" crowd of pundits. 
  • Dallas Fed Manufacturing Survey printed at -17.4, the worst since 2011.
  • Real personal consumption fell by 0.1% in February, the second-biggest drop since the 2009 crisis. It was forecast to rise by 0.2%.
  • Durable goods orders were down -1.4% in February vs. a consensus estimate of +0.2.
 So all in all we do agree with Bank of America Merrill Lynch's note title: "Moment of Truth".

We could go on with the weaker than "expected" data releases in the US, but hey, "bad news" is "good news" given markets seem increasingly dependent on super easy monetary policy to go on for longer (hence the extended duration of the credit business cycle into overtime until sudden death or penalty shoot-out maybe?).

In that context think European equities investors would be wise to take a few chips from the table given the significant rally since the beginning of the year. Take a break and lock some profits.
Same apply to the short Euro crowd, beware of strong risk reversal in Q2. While the US equities crowd, we think, will continue to face disappointment, in the form of earnings, this time around. Tread cautiously in Q2.

  • Final note: the only "Great Rotation" has been from retail investors to institutional investors
On a final note we leave you with a chart from CITI's March 2015 note entitled "Is the credit cycle headed to extra innings?" displaying that no matter how the Fed central bankers would like to spin it, there has not been wealth effect, only "cantillon effects":
"But if stocks go down, it’s even worse" - source CITI
What is of interest is that while quietly institutional investors have been cashing in such as Private Equity, retail investors have been piling in, indicative of the lateness in of the credit business cycle driven  by central bankers. In last 3weeks in Europe, a Portfolio Manager friend has seen big share blocks placed after market closure. It seems Insiders/PE guys really believe in the much vaunted recovery...The "Honey Pot" is indeed a satire of greed and lust...

« Murphy Junior’s law »: My central banker is too optimistic”.  - Macronomics
Stay tuned!

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