Tuesday, 21 November 2017

Macro and Credit - Stress concentration

"Now is the age of anxiety." -  W. H. Auden, English poet

Looking at the outflows in the feeble High Yield ETFs retail crowd in conjunction with the belated anxiety it triggered surrounding the state of the credit markets and their lofty valuations for some parts, when it came to selecting our title analogy we reminded ourselves of "Stress concentration". A "stress concentration" is a location in an object where stress is concentrated. An object is stronger when force is evenly distributed over its area, so a reduction in area, caused by a crack, results in localized increase in stress as in 2016 with the Energy Sector woes seen in the High Yield sector. In similar fashion to materials, financial markets can fail via a propagating crack, or, put it simply, when a concentrated stress exceeds the material and/or market's theoretical cohesive strength. The real fracture strength of a material or of a market is always lower than the theoretical value because most materials contain small cracks or contaminants that concentrate stress. In similar fashion, VaR models, even with a high interval of confidence are inept because their theoretical solidity simply doesn't resist highly non-linear events brewed from rising instability, just like the energy release from a spring that has been coiled for too long but we digress. When it comes to credit markets, one would argue that such a stress concentration appears in High Yield markets today. To some extent, it might be right, given as we pointed out in our previous conversation, we are seeing a return of dispersion, meaning that active management should fare better than passive management.

In this week's conversation, we would like to look at cracks in the narrative in the credit markets, given we are seeing a rise in dispersion, meaning that investors are becoming more discerning valuation wise at the issuer level, as shown recently with stories surrounding French high yield issuer Altice, known to many.

  • Macro and Credit - Cracks in the credit narrative 
  • Final charts -  Oh My God! They Killed Volatility and brought instability...
  • Macro and Credit - Cracks in the credit narrative 
Given the latest weakness witnessed in High Yield in conjunction with the third largest High Yield outflow on record with US high yield funds and ETFs reporting a $4.43 billion in outflows last week and the largest since August 2014, one could argue that High Yield represents "stress concentration". Yet, as we posited in past musings, the retail crowd is heavily engaged in the High Yield ETFs space and therefore akin to nervousness whenever there is a change of narrative. On a more interesting level we think, the party continues to go strong in Investment Grade credit, meaning that in fact the story of the "Great Rotation" is favoring credit rather than equities to the tune of $36.2 billion for the month of October, the second highest on record going back to 1992 according to Bank of America Merrill Lynch, bringing YTD total inflows to US Investment Grade bond funds/ETFs to $227.1 billion, 54% higher than in 2016. As we stated last week, all the fun is going "uphill", to the bond market that is. With $11 trillion of negative yielding bonds, US Investment Grade credit is the new TINA (There Is No Alternative).  Now it's more about quality (Investment Grade) over quantity (High Yield).

But, indeed, in our minds, there is no doubt that there are cracks starting to show up in the narrative, leading to rising dispersion between issuers in the credit space. This means that credit picking is becoming critical at this juncture and one should think that finally active management should clearly outperform passive management in this late stage of the game.

One thing for sure we came close to some nasty widening recently in Europe with credit options expiry for Itraxx Crossover as indicated by DataGrapple in their blog post from the 15th of November entitled "When Technicals Drive The Market":
"Today was a pretty choppy session on credit indices, especially in Europe. The morning was really weak as the earning call of ASTIM (Astaldi) went down very poorly with investors. That name was indicated 15pts wider during the first exchanges, and it put pressure on the whole iTraxx Crossover complex. The index seemed then on its way to breach 260 and was dangerously close to the 262.5bps level, an important strike for options that were maturing today. Indeed, market makers were net sellers of options struck at that level and had to buy protection to hedge themselves, adding to the market momentum. But the widening stalled during the morning – sellers of protection eventually surfaced, enticed by the extra 30bps that were on offer compared with the tightest levels reached this month – and in the afternoon it became obvious that the (in)famous 262.5bps would not be breached, forcing option market makers to sell the protection they had bought earlier in the day. So much so, that iTraxx Crossover closed almost unchanged to conclude a very technical session" - source DataGrapple.
So yes we came close to "stress concentration" at least in the European High Yield synthetic space. Though we must confide that we agree with some investment pundits, that, there are indeed cracks showing up in the credit narrative. Some High Yield issuers are already showing some signs that things could indeed turn nasty fast should there be a clear change in the central banking narrative. This could either come from renewed inflationary pressures as we previously discussed or from an exogenous geopolitical factors and there are plenty to think about in these days and ages.  

We pointed out in our last musing that thanks to dispersion, long/short strategies from active managers would be more and more of interest. Clearly the rise in dispersion is not only a sign of the lateness of the credit cycle but as well signs that they are indeed cracks in this long credit narrative. Another indication of "stress concentration was as well highlighted by DataGrapple on the 8th of November on their post entitled "Towards More Stressed Bases?":
"The credit market has been weak over the last few sessions. Credit indices certainly needed to take a breather after their impressive march tighter, but the move was mainly driven by the behaviour of the risk premia of single entities. We have seen a few outsized moves among index constituents, and the biggest were moves wider. The above grapple has many bright red boxes - a red box means the corresponding name has widened over the last 5 trading sessions and the brighter the bigger was the move -, and they represent as many casualties among the corporate population. In the US, the retailers are once again on the move, together with car rental companies and many others that disappointed when they reported earnings. All in all, credit default swaps referencing single entities have widened faster than indices, especially in the iTraxx Crossover and CDX High Yield universe. The basis of CDX HY – the difference between an index quoted value and its theoretical value - is at the widest it has been in a while, and the basis of iTraxx Crossover is now almost flat, while it has been chronically positive - the index protection was more expensive or wider than single name protection - throughout the summer."  - source DataGrapple
In terms of issuer coming into the spotlight, recent equities woes and CDS spread widening surrounding French issuer Altice are of interest when it comes to discussing "stress concentration" on a wider scale for High Yield as an asset class. For the last two years we have been discussing with our good cross-asset friend and occasional contributor about the French issuer Altice. Credit investors tend to look at the credit metrics, ratios at a specific time and so on. Yet, we think they forget about the bigger picture, namely the dynamics within the Telco/Media sector. 

There are indeed a few caveats worth highlighting. There is zero pricing power when it comes to retail clients when you think about mobile price plans, the dynamic for Pay TV when one looks at Canal/beIn Sport in France, ESPN in the US and more. On top of that you have got serious investments coming up with 5G and contents strategies are becoming more and more expensive in a context where there are some disruptive players showing up such as OTT/tech players like Netflix, but more recently with Amazon, Google/Youtube, Facebook and Apple stepping in.

We might be naive, but in this kind of environment we think you need to have the financial flexibility/agility to rapidly adapt to upcoming threats. A high yield balance sheet doesn't offer you the financial flexibility needed to rapidly adapt. But, when one looks at French issuer Altice as an illustration, their growth has been based on increased leverage with their debt rising even more by 18% in a single year to $54 billion. Sure the story being sold to the market is that the operational risk is "utilities" like. We do not share the same view for the points mentioned above. 

The French market is a good illustration of the "leveraged" strategy for Altice group which has spent significant amount of money to purchase sport rights. The idea is that people are going to forego their Orange or Free registrations to switch to SFR (Altice). We think its risky business in France given the country is not a sports fanatic country as some others. If we take beIn which is well distributed among networks, since launched they have managed to lose €1 billion. Their Qataris shareholders are starting to tighten the screws. Overall the dynamic for Numericable/SFR box is not favorable. 

One might rightly ask if operational risk is indeed "low-risk" in the case of Altice. On a micro level, this issuer is a reminder of the overall question of "credit risk premia". In a world where no one is 100% protected against the next disruption of a business model, buying European High Yield around 2% yield is asking for trouble we think. European growth prospects aside, the big picture matters, even at the micro level. The credit graveyard is full of supposedly bulletproof issuers such as Nortel, Nokia, or Kodak to name a few. As pointed out by Exane in a recent report entitled "Altice - Devil is in the debt", some credit investors have had to get a reality check, and this meant some repricing and more dispersion as pointed out above:
"Altice - Devil is in the debt

The background
Since results, there has been a spike in the CDS of Altice - take a look at the chart below for the CDs on Altice LUX. HY analysts say this is a result of credit analysts looking at the equity performance, assuming there must be wrong, and then selling the credit…
Clearly this is something to be concerned about, but to put Altice in the context of some other, albeit smaller, HY issuers - Vallourec, a steel company Exane covers, has had negative EBITDA for the past 3 years and is trading HY credit at 6%!

Altice debt position
Within Altice's debt structure, there are 6 pools of debt.

Within the US, there are two debt silos: Suddenlink and Optimum, the two OpCOs.
Within Europe, there are three debt pools. Two are operational silos, at SFR and Altice International, and another at Altice Luxembourg - the HoldCo which owns 100% of SFR and Altice International.

The final debt pool is at Altice Corporate Financing. 
 Figure 2 - Altice Group Debt structure as at 3Q17

Refinancing risk

Based on our discussions with HY analysts, this appears to not be a huge problem - there are two reasons:

1)    A strong maturity profile; and
2)    Liquidity.

On point 1, we note that Altice weighted average maturity of 6.3 including revolving credit facilities and a weighted average cost of debt of 5.8%. The chart below shows that maturities in more detail - major maturities only really begin in 2021

The EUR5.1bn of liquidity Altice has available (from net cash and revolving facilities) covers all maturities out to 2020 and it still has EUR1bn of liquidity at hand.
 Figure 3 - Altice Group Maturity Profile

Recent refinancing efforts supportive

Altice recently refinanced a portion of its SFR and Altice International debt at significantly lower rates than the prevailing rates - which should serve to reassure.

* SFR. In early October, SFR priced EUR2.884bn of new 8.25-year Term Loan B's - the proceeds used to refinance existing debt. Of the EUR2.884bn, one loan was a USD2.15bn Loan at a margin of 300bps over Libor and one loan of EUR1.0bn at a margin of 300bps over Euribor. The re-financing resulted in the average cost of debt remaining at 4.7%, but extended the average maturity length from 6.8 year to 7.2 years.

* Altice International (AI). Altice priced EUR1.089bn of new 8.25-year Term Loan B's, with the proceeds used by AI to refinance its EUR300m and USD900m of 6.5% senior secured notes due in January 2022. AI also placed EUR675m of 10.25 senior unsecured notes at 4.75%, a record low coupon within the Group. The net effect of these transactions was to extend AI's maturity from 6.6 year to 7.5 years, with the average cost of debt reducing to 5.5% from 5.8%.

What about the US debt?

Below you will see the debt at Suddenlink and Optimum. At Suddenlink the weighted average cost of debt is 5.4%, while at Optimum it is 6.8%. One of the reasons why Optimum interest levels are so much higher than the rest of the Group relates to the timing of when much of the debt was raised. As a reminder, Altice acquired Optimum (CVC) in September of 2015, right at the time when US HY concerns were at peak (linked to a declining oil price). Moreover, much of the existing debt at Optimum was not callable, and therefore Altice was unable to refinance.
- source Altice

How does one assess the refinancing risk at Altice US, given the recent concerns in US HY?
One simple way is to take a particular bond's coupon rate and compare it to where it is trading. So if a bond has a coupon of 5% but is trading at 90, the inference is that the company would have to refinance at 5%/0.9 = 5.6%. We've done this exercise for the Optimum notes below, which shows if anything - there is more of a refinancing opportunity, rather than risk:

Optimum notes
Senior Notes Acq. - LLC 10.125% 2023 = 112.9 
Senior Notes Acq. - LLC 10.125% 2025 = 120.5 
Senior Notes - LLC 8.625% 2019 = 106.6 
Senior Notes - LLC 6.750% 2021 = 108.4 
Senior Notes - LLC 5.250% 2021 = 97.4 
Senior Notes Corp - LLC 7.750% 2018 = 102.0 
Senior Notes Corp - LLC 8.000% 2020 = 109.2 
Senior Notes Corp - LLC 5.875% 2022 = 100.2 
Figure 5 - Altice USA (Suddenlink + Optimum) net debt/EBITDA progression 

- source Altice

Are there any 'funnies' in the debt? Variability and covenants?

The two most frequent questions we're getting asked about at the moment is the variability of the interest at Altice and also are there any 'funnies' in the debt related to covenants, debt/equity ratios, etc, etc.

Variability of interest

So Altice said that a 5pp increase in Libor and Euribor would increase Group interest (pro-forma run rate of EUR3bn) by EUR300m - i.e. a 1pp increase = EUR60m. Which isn't that sensitive at all. See below for variable debt I've sourced from the individual Altice debt silos.
Figure 6 - Altice variable rate debt

- source Altice

'Funnies' in the Altice debt
High yield issuances tend to have covenants that are cash flow driven, and make no mention of debt/equity splits/commitments - the latter tends to show up certain IG issuances. Altice has confirmed there is no debt with has debt/equity covenants.

The two principal covenants in high yield issuances are maintenance covenants and incurrence covenants.

In a maintenance covenant, the issuer commits to keeping leverage below a certain level at the unit. An incurrence covenant prohibits the issuer from increasing debt (whether for capex, dividends, whatever else) when leverage is beyond a certain level.

For Altice, it has incurrence covenants at Altice Lux, SFR and International, that prevents the upstreaming of cash when leverage is above ~4.0x (we note here are there are some carve-out clauses that allow it to go to 4.5x EBITDA). That does not mean that leverage can't be above 4.0x, it just restricts the issuer from doing what it wants with leverage/cash. At Altice US, the incurrence covenant is 5.5x

Overall, maintenance covenant is less flexible than incurrence - Altice has incurrence, which should allay fears also. 
As a reminder, based on our current estimates, there will be no ability to upstream out of Lux until post 2021 - see Lux net debt/EBITDA chart below.
So what's all the fuss about with Altice and debt?
Well, beyond the obvious (i.e. it has a lot of it), the main concern is technical. If the market gets nervous about HY debt, the market for HY is not liquid enough for 'shorts', so a credit trader will look at the largest issuers and most liquid equities, and then short the more equity.

That is why in November/December 2015 that both Altice and Valeant Pharma really suffered. So, we must absolutely keep a look out for increasing nervousness in the HY markets, because that could be a trigger for increasing short activity in Altice." - source Exane
In similar fashion for those who remember, the credit pressures faced by Deutsche Bank and their Contingent Capital notes (CoCos) in recent times, given high beta such as CoCos and High Yield are not "liquid" enough, "stress concentration" triggers additional pressure on equities in that case. This is the reason why increased nervousness in illiquid high yield markets leads to additional pressure/sell-off on the underlying equities. Also, the acute reduction in investment banks inventories since the Great Financial Crisis (GFC) acts as an accelerator in the move and add to the growing underlying instability in credit markets we think. From a micro level, as shown above, sure credit metrics matter from an issuer risk profile perspective, yet with disruption being so rapid these days we wonder if truly credit risk premia reflect the real level of risk. For some sectors in European High Yield we do not think it is warranted.

We do think that the "micro" pictures seems to indicate in some instances that we are starting to see cracks in the credit narrative with credit investors becoming more discerning hence the rise in dispersion. But, from a "stress concentration" perspective we can easily take some cues from the synthetic CDS markets as pointed out by DataGrapple from their 17th of November blog entitled "That Means Stress":
"This week marked the return of volatility in the credit market, at least on a micro point of view. Indices had their up and downs but the moves were always contained. Peak to trough variations of 15bps – and we have to look at intraday prints to get a double-digit number as daily closes always seem to attract contravariant investors who bring daily moves in check – at best qualify for tempest in a teacup. The real action took place at the single names level, especially in the European high- yield universe. A few corporates have consistently been the focal point of the credit market. ASTIM (Astaldi), ALTICE, SFR, BOPRLN (Boporan) experienced roller coaster rides and they are all closing the week at their recent widest levels. Investors have real concerns about them, and there was a genuine appetite for protection on these names during both the up and downs of the market as a whole. So much so that for the first time in while, the basis of iTraxx Crossover (ITXEX), the index to which they all belong, stayed negative – ie the quoted risk premium of ITXEX was tighter than the sum of the risk premia of its constituents – throughout the whole period. It is what you would expect when ITXEX tightens - indices tend to react faster than single names -, but it is quite unusual when it widens. It is a sign of genuine stress." - source DataGrapple
A positive basis is normal in credit markets. A negative basis is rarely seen. We will be watching closely the evolution of the basis in the months ahead. It is essential on the credit market to follow the basis as the indicator of the liquidity but also as an opportunity of arbitrage. Here is below an illustration of a very negative basis which narrowed back towards more reasonable levels during Q1 2015:

- source DataGrapple

Are all the credit curves affected by the yield curve moves? One might rightly ask. 

Yes, but to various degrees. The better the credit (Investment Grade), the less the credit curve is sensitive to yield changes (that seems counter-intuitive due to convexity). To the opposite, the weaker the credit (High Yield), the more the credit curve will be affected: it will reproduce or amplify the movements of the yield curve. 

Generic curve for 2 years and 10 years swaps. We can see a major flattening movement of the yield curve from early June 2015 mars 2016:
- source Bloomberg

If we consider Itraxx Crossover CDS indices (basket of issuers with weak credit metrics) over 5 years and 10 years maturities, we can see a flatening of the credit curves since the end of June 2015 in the below chart:
- source Bloomberg

Interest rate moves started 2 weeks prior to credit moves as a reminder.  The current situation we think means more distortion and more arbitrage opportunities ahead in this late credit cycle thanks to pockets of "stress concentration" and cracks in the credit narrative in some well identified sectors for now (Healthcare, Telecom, Staples to name a few).

It would be difficult for us to argue that some parts of credit are very expensive from a valuation perspective, but then again we did indicate in various conversations that we would hit 11 on the credit amplifier in true Spinal Tap fashion. This is due to $11 trillion worth of negative yielding bonds not to mention the recent 3 year French Veolia negative yielding issue just launched. As we put it simply recently, the unabated bid for US Investment Grade is due to TINA (There Is No Alternative), particularly when most of the support for US credit markets is "Made in Japan". For those of you who like to worry while some others prefer to "carry on" in true credit fashion, we would like to point out to Société Générale's Market Wrap-up note from the 20th of November entitled "The credit valuation chart that worries us most":
"Market thoughts
Corporate bonds are typically valued in one of three ways: the yield, the spread to benchmark, and the asset swap levels. On all three bases, global credit currently looks expensive. Chart 1 shows the current yield of a global credit index, made up of the iTraxx USD-denominated, euro-denominated and sterling-denominated IG and HY indices (weighted by the notional amount of the debt).

Using this measure, credit is not quite as expensive as it was during the mid-2016 trough (just ahead of Donald Trump’s election), but it is getting close. Credit yields are useful when comparing the asset class against other assets such as equities. Yields conflate credit risk and rate risk, however; to just concentrate on credit risk, we prefer to focus on spreads. Chart 2 shows the spread to benchmarks of this same global credit index.

At the start of November, spreads were below the lowest levels seen in mid-2014. They have since bounced slightly above this point but remain very close to multi-year lows.
Spreads to benchmarks are the most important yardstick of value for investors who chose between corporate and sovereign bonds (such as insurance companies, multi-product fixed income investors, or private investors choosing where to allocate their fixed income investments). Banks who swap corporate bonds look at credit on an asset-swap basis, as we do in Chart 3.

Once again, the spread on this basis is tight – slightly below the trough levels of 2014.
There is a fourth way of valuing credit, used by investors who are comparing corporate bonds to governments. This is the spread to benchmarks as a percentage of yield, which we show in Chart 4 above. Once again, the numbers do not look good. The rise in yields and fall in spreads has driven the global ratio of spreads to yields from a peak of 2.1 in the summer of 2016 down to less than 1 now, broadly in line with the 2014 summer tights.
So credit is expensive more or less any way you look at it. The data that worries us the most, however, is shown in Chart 5, i.e., the one-year break-evens on global credit. The falls in duration and spreads have conspired to push the break-even well below the trough levels of 2014.

Moreover, as Chart 6 shows, breakevens are lower than the previous trough levels in every ratings class in every geography. Even assuming defaults are zero over the next 12 months, this chart highlights the big mark-to-market risk that investors who buy at current levels are taking on.
- source Société Générale

Of course it isn't a surprise to us, the credit mouse trap has been set by our dear central bankers. No offense to Société Générale but, what is expensive, is going to become outrageously expensive, to 11 that is. The credit valuation chart that worries us most in response to Société Générale is as follows:
- source Pitchbook

The above chart depicts the M&A multiples for Private Equity (PE). It is definitely something to keep an eye on we think when it comes to "stress concentration". Debt-financed M&A deals can be very impactful to corporate creditors as they not only can increase a company’s leverage but can also lead to a material funding requirement. As a credit investor, you should in 2018 dust up your LBO screener because a raft in M&A PE related deals could deliver serious sucker punches to your Investment Grade issuers in true 2007 fashion we think. You could see some serious CDS widening on M&A related deals in 2018, though it is true that historically M&A volumes are highly correlated to equity prices and that announced M&A was down by 34% in 2017 so far. With current policy uncertainty, it seems to us that investors are waiting for more clarifications before striking some new deals in 2018, on that subject tax rates matter and in particular interest deductions at 30% of EBITDA or EBIT. The deductibility of interest is essential to determine the cost of capital to be deployed. With large-cap non-financial US corporates sitting on $2 trillion of cash, 2018 could trigger a M&A boon.

Despite the sharp move in High Yield put forward by the usual "permabears", a sober look at fundamentals and technicals suggests the sell-off was just another (brief) correction in an otherwise supportive market for TINA. As long as the volatility in rates remains subdued, it is still "goldilocks" for credit markets and the fun continues to run "uphill", to the bond market that is. For now our central bankers have managed to tame volatility, and not only in rates. We wonder in our final charts how long we have to keep dancing...

  • Final charts -  Oh My God! They Killed Volatility and brought instability...
Back in July 2017 in our conversation "The Rebound effect", we argued the following:
"One could easily opine that the biggest effect from overmedication from our "Generous Gamblers" aka our central bankers, has been the disappearance of volatility thanks to financial repression. As our tongue in cheek bullet point reference to the old South Park catch phrase, one might wonder if this low volatility regime will end, now that the narrative has been more hawkish somewhat as per our recent conversation "The Trail of the Hawk".
In similar fashion to Le Chiffre, aka Mario Draghi from the ECB, Janet Yellen has as well steered towards "Credit mumbo jumbo", which has had a much vaunted "Rebound effect", at least for US equities. Yet Janet Yellen's "rich" valuation word has been totally ignored by the leveraged and carry crowd, particularly in European High Yield seeing as well not only record issuance numbers but also loose covenants and record tight credit spreads." - source Macronomics, July 2017
Some of us have been mesmerized by the low volatility regime which has been slowly killing the "macro" hedge funds returns in recent years. The low volatility regime has not only been a VIX or a MOVE index story. It has also been the case in various asset classes as indicated by Bank of America Merrill Lynch in their presentation from the 6th of November entitled "Why volatility and alpha have disappeared" where they show that low volatility is not merely a US equity phenomenon:
"Low volatility is not merely a US equity phenomenon; has been pervasive across asset classes and globally in 2017 apart from FX
Since 2014 markets across asset classes have also set multidecade records for instability
The physics of a depressed volatility and alpha-starved market; Low conviction, crowding and high fragility ~ not “fake news”
- source Bank of America Merrill Lynch

While we recently mused that gamma hedges in credit were cheap, while credit remains an attractive carry trade in this long in the tooth credit Goldilocks scenario, it's not only in the VIX that there has been systematic selling of volatility for income. The game has also been played in the credit world. In the current environment, Credit payers and Gold calls screen as best value tail hedges. We agree with Bank of America Merrill Lynch, record gold/real rates correl creates value in owning gold or gold miners upside to hedge political and geopolitical uncertainty which by the way is rising by the day. We reminded ourselves to what Janet Yellen at the Fed said in September 2016:
  "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
If asset values aren't out of line with historical norms volatility certainly is from a "stress concentration" perspective, no wonder she decided not to stick around too long at the Fed, but we ramble again...

"The seed of revolution is repression." - Woodrow Wilson
Stay tuned!

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