Thursday 22 March 2018

Macro and Credit - The Zimmermann Telegram

"No matter what political reasons are given for war, the underlying reason is always economic." - A. J. P. Taylor, British historian

Looking at the evolution of the trade war rhetoric in conjunction with cold war 2.0 heating up following the events in London as of late, as well as the weakness in risky asset prices and issues surrounding FANG stocks darling Facebook, when it came to selecting our title analogy we reacquainted ourselves with the "Zimmerman Telegram". The Zimmermann Telegram was a secret diplomatic communication issued from the German Foreign Office in January 1917 that proposed a military alliance between Germany and Mexico in the prior event of the United States entering World War I against Germany. Mexico would recover Texas, Arizona, and New Mexico. The proposal was intercepted and decoded by British intelligence. Revelation of the contents enraged American public opinion, especially after the German Foreign Secretary Arthur Zimmermann publicly admitted the telegram was genuine on March 3rd 1917, and helped generate support for the United States declaration of war on Germany in April 1917. The decryption was described as the most significant intelligence triumph for Britain during World War I, and one of the earliest occasions on which a piece of signals intelligence influenced world events. One could indeed make a parallel and wonder if the latest disclosure on privacy issues relating to Facebook will not mark a turning point for the strong winners (FANG stocks) of the rally seen in recent years in equities.

In this week's conversation, we would like to look at the US dollar funding pressure which has been highlighted by many pundits particularly given that the Libor-OIS spread, has more than doubled since the end of January to 55 basis points, a level unseen since 2009 reflecting an increasing scarcity of dollar funding it seems with large implications as per the below Bloomberg charts as well as US corporate leverage:
- source Bloomberg

  • Macro and Credit - Libor and leverage, my dear Watson...
  • Final charts - Dispersion matters 

  • Macro and Credit - Libor and leverage, my dear Watson...
No doubt the returns on everything beta including the Russell 2000 since Trump's election in the US has been stellar but, we are seeing it seems a change in the narrative since early 2018 with the continuous hiking pattern of the Fed, making markets more prone to heightened volatility and questioning the continuation of the "goldilocks environment" which had prevailed so far in credit markets. One most sensitive candidate we think for a "short" bias when the markets will eventually turn in the footsteps of the Fed's hiking course that will in the end "break something" is the Russell 2000 small cap index we think. Given that more than 40 percent of debt issued by Russell 2000 companies is floating, they are therefore susceptible to the rise in the benchmark rate namely our old friend Libor. While the CFOs of some of these firms have made good use of derivatives to effectively swap from floating-rate into fixed obligations, these companies are still more interest-rate sensitive than their larger counterparts that have embarked on a bond-issuance frenzy in recent years particularly so with a significant amount of leverage. At the end of 2017 around 34% of the Russell 2000 was made up of loss-making companies with an average LT debt to Capital of around 35% versus 29% in 2007. In our book higher leverage and rising Libor even if some smart CFOs have swapped some exposure from floating to fixed doesn't look too promising when the market will finally turn to a bearish stance (we are not quite there yet).

On the pressing subject of Libor and OIS rates, we read with interest UBS Global Macro Strategy note from the 2nd of March entitled "USD Funding Pressures: Myth and Reality:
"Here's what's happening
Some investors are worried about the rising gap between LIBOR and OIS rates (Figure 1) as being indicative of a nascent funding problem.

At the root of this widening is an increase in T-bill rates; as Fed funds and T-bill yields rise, so does the cost of unsecured LIBOR funding. The gap between T-bills and LIBOR rates, the Ted spread, has not changed much. Bill rates have been rising particularly sharply since early February, as Congress agreed on further fiscal spending (we estimate net bill issuance in '18 at $475bn vs $200bn in '17). Supply is in play here, not credit issues. The gap between LIBOR and Fed funds rate is hardly out of line with previous hiking cycles (Figure 2).

Will this widening between LIBOR and OIS persist?
If we're right about T-bills being the real driver of this move, then LIBOR-OIS should not widen much more. The spread between T-bills and OIS is now positive (Figure 3), and this has typically been a limit in the widening.

Note that when funding stresses have risen in the past because of credit reasons, the T-bill to OIS spread has gone the other way. What we're witnessing today is higher rates, not a clogging of financial plumbing. 
Distinguish between the price of funding and access to funding
It is undeniable that higher US rates will have an impact on the 'price' of funding, perhaps globally, and that this will have consequences. But 'access' to funding is a completely different story. We see few signs of this having been compromised thus far. 
Neither credit nor currency markets suggest funding is becoming a problem
As we have argued, the underbelly of the risk trade – the weakest rating buckets in the US HY – are actually outperforming on a beta-adjusted basis. Spreads are remarkably stable in the context of higher front end rates and equity volatility (Figure 4).

Issuance and demand for paper have not been a problem. In currency markets, basis swaps (Figure 5) (difference between local currency and $ funding), risk reversals (the price of a $ call vs a $ put), and volatility are showing no signs of stress.

So, is there nothing to see here? Does the cost of funding not matter at all?
It does. But instead of LIBOR–OIS widening, which is likely a red herring, we need to focus on the right channels to assess changes in market trends. First, watch the hit from yields to floating rate HY credit. We estimate floating rate loans at $2.2tn, of which $1.1tn of loans ($690bn of leveraged loans, $459bn of bank C&I loans) have been extended to issuers rated below BB-. Our recent analysis shows leveraged loan issuers fundamentally will remain resilient to the next 75-100bp increase in Fed Funds rates, but further rises could elevate funding vulnerabilities. Second, watch US growth surprises relative to those in the rest of the world. Widening front end rate differentials will become more meaningful for currency trends if mirrored in growth differentials. We would pay particular attention to China, where data has been mixed to weak. The EM currency complex, thus far calm, may begin to weaken if growth here softens in backdrop of higher US rates (Figure 6).

Third, and most importantly, we would watch term premium in the US. Markets have been worried about the impact of higher rates, but thus far US rates volatility itself hasn’t risen meaningfully, and shouldn't do so unless term premium rises sharply (Figure 7). We have argued against a big shift here.

Where does this leave us?
We are positioned defensively on US HY credit, and are looking for modest trade weighted weakness in EM currencies (Figure 8).

However, we think back-end rates are likely more range-bound here and, based on the facts today, are not inclined to take a negative view on US stocks. We would be watching the three channels above to reassess our view." - source UBS
Obviously when it comes to the LIBOR-OIS widening more, UBS hasn't got it entirely right given, it Libor has been rising for 31 days in row so far. Is it a case of "reflexivity"? We wonder. One thing for certain, we have noticed since the beginning of the year a weaker tone in fund flows, particularly in US High Yield, which, we think could be indicative of the start of the end of the "Goldilocks environment" in credit markets which had still been prevailing in 2017 in the beta part of the market, with the CCC rating bucket posting some strong returns (Russell 2000 as well...).

While recently we have touched on the "hidden" leverage in the US consumer in our conversation "Intermezzo", if Libor is indeed a growing concern for some credit market and sell-side pundits then obviously one need to take into account "leverage". As per the explosion of the yield pig's short vol straw house in February akin to the equity tranche in the capital structure of our complex markets, identifying the leveraged players is essential as the credit cycle shows clear signs of fatigue and the start of tightening thanks to the hiking path of the Fed (and QT). On that particular question about leverage we read with interest UBS Global Credit Strategy note from the 19th of March entitled "Is US corporate leverage higher than reported?" and below is the summary before we go into their detailed note:
"Key questions
The state of US corporate balance sheets and the outlook is one of the key debates for fixed income investors. The consensus is, while we are in the later stages of the US credit cycle, a recession is not on the horizon. We agree. But we believe identifying those pockets within credit markets where credit and leverage growth has been excessive is crucial to capturing a potential inflection point in the credit cycle early and to calibrating the extent of the fallout.
Where are US corporate credit market excesses? A focus on loans
Our view is there are three corporate credit market imbalances in this cycle. First, the rise in lower-rated, longer dated investment grade debt1; second, a 100% increase in the number of triple C rated issuers to over 1,400, many of which have floating-rate liabilities; and third, excessive debt growth in the technology, electronics and pharmaceutical sectors. Our focus here is on US leveraged loans (LL), where $1.1tn in lower rated, spec grade loans is more vulnerable to our house view for 7 Fed hikes and a material flatting in the US yield curve through '19.
Leverage is high. After normalizing for addbacks, it is even higher.
US leveraged loan gross issuance hit $500bn in 2017, with 60% used for M&A, LBOs or recapitalizations. Total leverage on new deals is 5x, and near 5x since 2014, while 1st lien leverage is 3.9x, the highest in two decades. But are these figures understated? EBITDA add-backs are rampant and material, averaging 20-21% for M&A related deals in 2017 and 26% for large sponsor deals YTD (largest in the tech, metals and food sectors). The jury is still out on add-back realization rates, but a conservative view would push average total/ 1st lien leverage to 6.2x and 5x, respectively, on M&A deals.
What are the early warning signals and current prognosis?
Corporate leverage is therefore a structural risk. But are we at an inflection point in the credit cycle? Leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) YTD even as LL default rates have risen moderately to 2.2% (from 1.4% in Q3 '17). First, we have created a proprietary non-bank LL liquidity indicator to assess if lenders are beginning to ration loan supply. This metric led spread widening in '15 and '07, but currently the indicator is at -2%, indicative of slight easing and a stable backdrop. Second, the key demand source for LL is collateralized debt obligations (CLOs), and portfolio concentrations are highest in technology (13-15%), healthcare (11-12%) and cable/media (8-9%). Our recent flows analysis suggests rising USD hedging costs and duration concerns are driving more foreign investors into loans. And while total returns in the above sectors are lagging the LL index, they remain in positive territory.
How to position credit portfolios?
Overall bank and non-bank lending standards are not showing signs of tightening credit, our credit-based recession gauge is at a modest 13% through Q3 '18 and broad US credit valuations are moderately overvalued. With the house view calling for materially higher short rates but a modest rise in long end yields and USD depreciation, we favour EM over DM corporate credit and US leveraged loans over US high yield. Our HY spread target remains 380bp vs 341bp current. We maintain the view that corporate credit markets can absorb the next several rate hikes, but spread tightening is over and investors should be more cautious as the hiking cycle matures. And we remain structurally underweight healthcare and tech across credit portfolios for 2018." - source UBS
We do agree with the above, namely that we would favor EM over DM in corporate credit. The recent outperformance of local-currency emerging-markets credit has been impressive, with the debt returning 2.4% so far this year while U.S. IG credit has lost 2.5%. If indeed the weaker tone in the US dollar continues its course, then again having exposure to Emerging Markets Local Currency debt is still an enticing proposal, even in the light of recent outperformance of the asset class. Regardless of some Zimmermann Telegram and Cold War 2.0 narrative, Russian debt continues to be appealing we think, and much more appealing than dangerously overpriced European Government bonds which in fact, like the German bund as of late, are barely trading in similar fashion to what happened with Japanese Government Bonds market (which in effect has ceased to trade). Getting Japanese? We really think so: Private investors hold only 10% of German government bonds. It’s impressive that this market functions at all.
- source IMF and ECB

But moving back to our US leverage story, UBS looks into details about the state of the US corporate leverage:
"Is US corporate leverage higher than reported?
The health of corporate balance sheets, particularly speculative grade and private firms, was one of the key thematic debates during our client visits in London. We break down the genesis of the questions into three sub-themes: first, within the US corporate credit markets where are the excesses? Second, how concerned are you about levels of leverage, and to what extent are earnings add-backs hiding risks? And third, what early warning signals are you monitoring and what is the current outlook?
Where are corporate credit market excesses?
We have previously outlined three corporate credit market imbalances that bear close tracking, with the latter two in focus in this piece3. First, in high grade the rise in lower-rated, longer dated issuance with the ratio of BBB/BB 10yr+ debt rising from 4.8x to 13.3x. Second, in speculative grade a doubling in the number of triple C rated issuers to over 1,400 (US corporate debt: revisiting financial stability concerns). A majority of these issuers have funding in the US leveraged loan market, issuing secured loans to boost issue level ratings; B-rated loans outstanding have risen from $195bn to $467bn since 2012 (Figure 1).

And third, above average debt growth in the technology, electronics and pharmaceutical sectors; for US leveraged loans specifically this thesis is evident in the growth of the broad manufacturing and sectors which have grown from $117 to $295bn and $256 to $448bn, respectively, since 2012 (Figure 2).

By sub-industry growth, manufacturing has been primarily electronics ($124bn from $52bn). In services, business services ($98bn from $77bn) and lodging/ leisure ($87bn vs. $52bn) have led the increase.
More recently, we have discussed lower rated firms as structurally more vulnerable to rising interest rates with near-peak leverage and relatively low interest coverage (Lesson Learned: The Underbelly of US Tightening). And we argued that $1.1trn of lower rated, spec grade loans were the fulcrum – i.e., more vulnerable to our house interest rate outlook characterized by aggressive Fed rate hikes (7 through '19) but significant yield curve flattening (with 5yr Treasuries projected to remain below 3% through '19). Our analysis suggested these issuers would be resilient to 3-4 Fed rate hikes, but 4 more would lower coverage ratios near pre-crisis ('06) levels (A deeper dive into US credit markets more vulnerable to aggressive Fed hikes).
How concerning are leverage levels, and are earnings add-backs hiding risks
US leveraged loan gross issuance hit a record of approximately $500bn in 2017, with about 60% of use of proceeds for leveraged buyouts (LBOs), M&A/acquisition or recapitalizations (Figure 3).

While the theme of LBOs is less prevalent this cycle vs the prior, M&A has been a more persistent theme – primarily between private/sponsor firms. The market has been a sellers/borrowers market in recent months, in part driven by duration concerns which are fueling inflows into floating rate products (The Technical Pulse: Where will yield-hungry investors next leave their global footprint?), the perceived safety of secured debt and financial deregulation (with bank adherence to the 2013 Leveraged Lending Guidance fading). While median total leverage metrics have declined from peak levels of 5x to 4.5x post-crisis, they are still above the 4.25-4.5x pre-crisis. In addition, the negative tail remains fatter as the proportion of issuers with leverage above 6x is 29% (vs a post-crisis high of 35%, and 19% pre-crisis).
To reiterate, these figures represent the median leverage for public leveraged loan issuers outstanding (i.e., leverage on the stock of public issuer loans). But 65% of the lev loans are actually from private firms. While we do not have median leverage data on the stock of private issuer loans outstanding, credit metrics are available on all new deals – public and private (i.e., the flow). This data shows average total leverage for all deals at 5x, with private leverage running at 5.2x (c1x higher than on new public deals). Total leverage on new private deals has been running above 5x on average since early 2014; in the last cycle, average leverage above 5x was seen from Mar '07 to Mar '08 (Figure 4).

Across the capital  structure, however, leverage through the 1st lien for all new deals is at 3.9x, and has been running higher than prior peaks since 2013 – one key reason why lev loan investors have heightened recovery rate concerns in this cycle (Figure 5).

But what if leverage (and coverage) figures are wrong? The issue of earnings adjustments (or engineering) has consistently reared its ugly head in our client discussions for several years, and it is certainly not confined to US leveraged loans – but the rhetoric from leveraged finance/distressed credit investors has grown stronger. Market participants suggest nearly every acquisition-related deal now has its share of EBITDA add-backs, and a number of long term investors have suggested this cycle is unlike any others they have witnessed. Figure 6 depicts our best estimate of the average EBITDA add-back (expressed as a turn of total leverage) for M&A deals over time.

We would posit that the phenomenon of EBITDA add-backs is partly an unintended consequence of macroprudential regulation. The 2013 Leveraged Lending Guidelines (not enforced until late 20147) capped pro forma leverage at 6x (and required 50% debt amortization within 5-7 years8), incentivizing issuers to manage pro forma EBITDA such that leverage would remain below the 6x threshold. Rising add-backs are likely also a byproduct of low interest rates and QE, which have pushed up asset valuations and M&A deal multiples and contributed to reach-for-yield behaviour and material easing in lending standards.
Aggregate data on the magnitude of EBITDA add-backs is not easily sourced. For this we have leveraged the work of Covenant Review, and more specifically data from their CR Trendlines Topical Reports. Their work suggests that EBITDA addbacks for M&A - related deals across sponsor/ non-sponsor deals in 2017 were approximately 20-21% of Pro Forma Adjusted EBITDA. In 2017, the tendency seemed to be greater add-backs appeared first among large sponsor deals, and then spread across mid-sized and non-sponsored loans. And in 2018 this seems to be taking shape again, as EBITDA add-backs for M&A-related deals for large sponsors are averaging 26% of Pro Forma Adjusted EBITDA – suggesting another "high water mark" for EBITDA add-backs is attempting to take shape now (as addbacks for mid-sized sponsored/ non-sponsored loans remain at 20 – 21%).
Finally, in terms of sector outliers, the magnitude of EBITDA add-backs is more aggressive in electronics, software, metals/mining and food/food services (ranging from 24 – 29%). Are the add-backs being realized? The verdict is still out. First, it is difficult to monitor the aggregate credit fundamentals for the stock of private loans post-deal. Second, the credit agreement and covenants typically allow borrowers 24 months or more to realize a majority of the add-backs, in part a function of the significant easing in lending standards post-crisis (consistent with the shift from covenant to covenant-lite loans, 75% in '17 vs. 29% in '07; Figure 7).

For illustrative purposes, if one assumes a liberal view that all add-backs are realized then leverage levels are unchanged; however, if one takes a conservative view and excludes add-backs, total and 1st lien new deal leverage would increase to 5.0x and 6.2x, respectively, on average from 3.9x and 4.9x, respectively (Figure 8).
What early warning signals are you monitoring and what is the prognosis?
At this point, we don't see an inflection in the credit cycle. First, leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) year-to-date amid higher rate and equity volatility, and LL spreads remain firm at 368bp (4yr discounted spread) even as LL default rates tick up moderately to 2.2% from a low of 1.4% in August (Figure 9).

Second, we have also created a proprietary non-bank LL liquidity indicator, following the methodology of our non-bank liquidity indicator (Credit Cycle Turning? Non-bank Liquidity Hits Multi-Year Lows), which calibrates changes in net loan issuance for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. Historically, this proxy proved to be a warning signal in Q3 2007 and Q4 2014 when net tightening in lending standards reached +5 to 10% while spreads were still relatively tight (Figure 10).

Currently the indicator is at -2%, indicative of net easing and a constructive backdrop in the LL primary market.
Third, in terms of market structure and sector risks, the key demand source in terms of flow and stock of LL is collateralized debt obligations (CLOs, Figure 11).

And CLO portfolio exposures can be quite diverse, suggesting investors should pay attention to concentration risks. In this respect, we are focused on the outlook for technology (13-15% average exposure in CLOs), mainly software given robust debt growth, M&A activity and EBITDA add-backs and, secondarily, the healthcare (11-12%) and cable/media (8-9%) industries10. YTD total returns in these sectors are lagging the overall index modestly (electronics 0.90%, healthcare 1.12%, cable television 0.86%), but remain positive overall. 
Lastly and more broadly, bank and non-bank lending standards are not showing signs of tightening credit, our proprietary credit-based recession gauge is a modest 13% through Q3 '18, and broader US credit valuations look 0.8 standard deviations rich (vs. 2 standard deviations back in Q2 '07; Where are we in the credit cycle?)." - source UBS
One thing for certain is that the M&A wave we foresaw for 2018 has been staggering and as a late cycle red flag it is as clear as you can get with global deal making this year crossing the $1tn mark on Tuesday, the fastest it has ever reached that level, as a wave of consolidation spreads across the US and activity in the UK, China, Germany and Japan accelerates. You don't need no Zimmermann Telegram to tell you this but it certainly feels like late 2007 all over again and even early 2008 one could posit given we are seeing the return of Mega M&A deals as indicated by Wells Fargo in their Credit Spotlight note from the 15th of March entitled "Mega Deals Strike Back":
"Animal spirits continue to swirl in corporate boardrooms as evidenced by the recently announced Cigna/Express Scripts and Comcast/Sky proposed acquisitions. Industry consolidation is clearly en vogue across a range of sectors, and with debt markets willing to finance mega debt cap-structures, it seems unlikely to stop anytime soon. As a result, despite a healthy economic backdrop, credit investors need to tread cautiously as they navigate an upsurge of idiosyncratic risk, and for index oriented investors, what you don’t own could be just as important as what you do when it comes to performance.
We expect a record amount of M&A in 2018. This should result in another year of record bond issuance in the IG market.
M&A Update – Continue to Expect a Record Year
Mega Cap M&A continues to be a key driver of U.S. credit markets, both as a driver of leverage and a driver of bond issuance. We continue to expect M&A in 2018 to move to a new all-time high and lead to increased bond issuance in the IG market. There has been more than $387 billion of M&A announced so far in 2018, on pace to be the largest first quarter of M&A announcements on record. In fact, M&A is currently on pace to reach $1.8 trillion, breaking the previous record of $1.7 trillion from 2015.
We expect M&A to be the main driver of increased bond issuance in 2018 as we expect M&A-related funding to rise from $175 billion to $250 billion, accounting for substantially all of our increase in net supply for the year. We expect the Consumer Non-Cyclical sector to be the primary driver as M&A heats up in each of the Health Care, Pharmaceutical, Food & Beverage and Consumer Products subsectors. The rising M&A and issuance need are the key drivers of our Underweight recommendation on the sector.
The mega deals have really been the driver of increased M&A over the past few years. In each of 2016 and 2018 over 20% of the total M&A volume has come from deals over $40 billion. In addition, with the exception of 2017 over 40% of the M&A volume has come from deals in excess of $10 billion.

The increase in the propensity of these larger deals also has increased the funding need in the IG bond market and has led to a significant increase in the size of the average capital structure within the market. These large cap structures are now nearly on par with the mega banks in terms of index weightings." - source Wells Fargo.
The return of large M&A mega deals is clearly as stated a late cycle behavior we think akin to what we saw in 2007. If indeed the credit amplifier is still going to 11 in true spinal tap fashion, then again a flattening US yield curve and the rise in the front end, will make Investment Grade credit less and less alluring we think from a pure allocation perspective in the current environment. No doubt overall the liquidity picture is changing and you should take notice and start to be more defensive in regards to "cyclicals" at least, even if the FOMC shows greater "optimism" on the economic cycle.

In November in both our conversations "Stress concentration" and "The Roots of Coincidence" we argued that we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. We added that rising dispersion meant better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversations, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. In our final point below, we would like to look again at dispersion given rising dispersion in our book amounts to credit deterioration.

  • Final charts - Dispersion matters 
Normally, higher dispersion should drive eventually spreads wider. Since 2013, balance sheet leverage has been widening, therefore on top of Libor woes building up, investors should be wise in tracking leverage ratios in 2018. One of our final charts comes from Barclays note from the 16th of March 2018 entitled "Lessons in Leverage" and displays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials):

"Figure 5 overlays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials), with dispersion measured as the difference in turns of net leverage between the 80th and 20th percentiles of high yield credits at any point in time. While there are many drivers of spreads, we could expect at least a reasonable relationship between the dispersion of leverage and the overall market spread - namely , high and increasing dispersion likely coincides with periods of credit deterioration derived from macro challenges, and vice versa. Note that the dispersion of leverage remains reasonably far above the 2014 lows (given the drivers and observations noted above), while the high yield market spread is less dislocated. That may suggest that any credit improvement that might occur in 2018 (particularly for lower-quality segments) has already largely been factored in and that a further tightening of credit risk premia would have to be sourced from other drivers besides fundamentals" - source Barclays
This trend of rising dispersion can also be seen in the synthetic derivatives part in the US credit market namely in the CDX HY index where dispersion is also on the rise as indicated by CITI in their Global Credit Strategy Focus note from the 15th of March entitled "What is happening with CDX IG volatility?":
"There are several reasons why CDX HY may not be a good tail risk hedge at the moment. First, the default environment is expected to remain benign going forward. In addition to the decline in HY defaults over the past year, Moody’s is expecting the HY default rate to fall even further over the next year. Second, two other metrics of HY cash portfolios also provide reasons for optimism.
The maturity distribution for the Bloomberg Barclays cash HY index indicates that less than 5% of the entire portfolio by notional will mature over the next 2 years, out of which less than 1% is expected to mature in the next year. In other words, even if rates were to rise, the total amount of HY debt coming up for refinancing is quite small. there is a fairly limited overlap between CDX HY constituents and the Bloomberg Barclays cash HY index. We find only 35% of the total notional in the cash index corresponds to the names in the CDX HY index (see Figure 4 (left)). Given that a significant component of tail risk in HY is a pick-up in defaults, using CDX HY as a hedge against cash HY portfolios would leave a large portion of the average cash HY portfolio exposed.
All of these reasons have contributed to investors currently staying away from using CDX HY payers as a tail risk hedge. Instead, what we are observing at the moment in HY hedging is investor activity targeted at individual names, which has also caused dispersion to rise in the CDX HY portfolio (see Figure 4 (right)).

In contrast to CDX HY which is more sensitive to (idiosyncratic) default risk, CDX IG is more sensitive to macro risks. One of the major tail risks on investors’ radar is rising inflation. As investors digest the effects of the newly instituted tariffs on aluminum and steel, the rising risk from potential trade war scenarios and the overall wealth effects from tax cuts, we are seeing inflation tick higher, as evidenced by the rise in 5y inflation breakevens.

Our analysis of data during a past rising rate environment (1963-1981) has shown that higher inflation can potentially drive credit spreads wider (see Figure 5 right), and here) for a more detailed discussion. Such dynamics would make CDX IG spreads an appropriate choice for inflation-driven tail risk for credit investors.
At the current time, markets are pricing in roughly 3 (25bp) rate hikes over the next year, which is also the base case projection from Citi economists (see here). However, a 4th rate hike has not been completely ruled out, and if it were to materialize, we could see another sell-off in credit spreads, especially concentrated in IG since IG credit is more sensitive to duration risk." - source CITI
Rising credit dispersion, rising inflation and a potential trade war means that no matter how you look at your Zimmermann Telegram from the credit markets, the Goldilocks narrative which has been prevailing for so long look to us increasingly at risk in 2018.

"Like most of those who study history, he (Napoleon III) learned from the mistakes of the past how to make new ones." -  A. J. P. Taylor, British historian

Stay tuned ! 

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