Macro and Credit - Confusion

"When a man's knowledge is not in order, the more of it he has the greater will be his confusion." - Herbert Spencer, English philosopher

Looking at the reversal of our previous thoughts relating to the potential for yen weakening and Nikkei surging in the process given our expectations for new tricks from the Bank of Japan, while disappointed on our recent call, we did not trigger and added on going long Nikkei hedged this time around given the on-going "Confusion" in both macro data and weaker flows at least in gold miners for the time being, we decided that for our chosen title analogy, given our fondness for the music from the 80s and in particular for New Order that our title should reflect our state of mind as well as August 1983 maverick single from the British group. On a side note, we have made a previous reference to New Order's music in our July 2015 conversation entitled "Blue Monday".

While Emerging debt seems to be flow wise the new darling of investors (or "yield hogs"), and when it comes to US High Yield disregarding "safety" for "yield", as pointed recently by BlackRock's recent chart of the week, it seems for them that double-digit returns going forward will be a thing of the past it seems:

- source BlackRock

Given the upcoming European Banking Association "stress tests", we would like to look this week to re-iterate our preference for credit instruments rather than equities when it comes to European banks. We will as well look at Japan again given the details of the fiscal stimulus so far have disappointed the "central banking addicted" investor crowd and the much anticipated decisions coming from the Bank of Japan as well as the FOMC hence the on-going "Confusion".

Synopsis:

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit
• Macro and Credit  - Japan looking for a "helicopter stall"
• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit

As we pointed out on numerous occasions, when it comes to the attractive "valuations" levels pointed out by some "confused" pundits, when it comes to assessing this "value play", we have long been recommending you stick to "credit". In fact, that's exactly we pointed out in our November conversation "Fluctuat nec mergitur":

"In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan".
Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team

No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016" - source Macronomics, November 2015

And of course no "Confusion" there, we were right from the onset of 2016 on this very subject. To further make our point clearer, we read with interest Deutsche Bank's European Banks Capital Structure note from the 27th of July:

"Unlike the sell-off early in the year, the market has generally differentiated quite well between bank credit and equity. The former has been supported by historically high capital ratios and strong liquidity buffers, whereas the latter has suffered from downward earnings pressures.

This is clearly illustrated by Figure 28 and Figure 29.

While the Stoxx Europe Banks equity index is down 27% YTD, the iBoxx EUR Banks Senior index spread is now at 108bp, exactly where it was at the end of 2015. Moreover, while equities are down 13.4% since the Brexit vote, senior credit is 5bp tighter.

Even at the bottom of the debt capital structure, Additional Tier 1 (AT1) securities have done remarkably well relative to equities when compared to their performance in the market sell-off in February. This is shown in Figure 30 and Figure 31.

In total return terms, EUR AT1s are down 2.6% YTD whereas the total return on equities over that period is -24.5%. Since the Brexit vote, it has been 0.1% and -11.8%, respectively.

In February, however, concerns that some banks might miss an AT1-coupon payment led to an abrupt sell-off in those instruments, partly due to the (self-fulfilling) fear that such an event might spark massive volatility across the AT1 market. This was compounded by a lack of clarity about when the so-called Maximum Distributable Amount (MDA) restrictions kick in, preventing banks from paying discretionary coupons among others. As we explained in our report at the height of the sell-off, AT1s are contingently junior to equity both in payouts and capital, which increases their sensitivity to market moves once a certain stress level has been reached. A missed AT1 coupon is lost forever whereas dividends are retained for the benefit of shareholders (in fact just like the unpaid coupon).

Since then, the European Commission has cited precisely this argument as a reason to introduce more transparency and less rigidity into the application of the MDA rules by splitting the so-called Pillar 2 SREP capital buffer into a disclosed formal requirement and a guidance component where the breach of the latter should not constitute an MDA trigger (the “guidance” part would sit at the top of the capital stack rather than below the Combined Buffer, making the latter less likely to be breached and thus trigger MDA restrictions). This was confirmed in early June by the ECB stating that it will refine its SREP methodology in this fashion. This has reduced ambiguity and lowered AT1 coupon risks, bringing down volatility of these instruments as highlighted in Figure 30 and Figure 31.

AT1s need new buyers and we think that the relative resilience of this asset class this time around could bode well for future demand for the product. This is in contrast to February when the P&L damage to many accounts resulted in some key investors withdrawing from this market."  - source Deutsche Bank.

Where we disagree with Deutsche Bank entirely is that regardless of the future demand for AT1s, from a risk/reward perspective, we will re-iterate that we think that CoCos offer very poor value, no "Confusion" there from our perspective. Any serious trader out there will always tell you that you never ever want to be "short gamma". This is exactly what we pointed out in our February conversation "The disappearance of MS München" dealing with risk, VaR and much more:

"It is still time for you to play "defense", although we did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up (it did...). Although some like it "beta" or more appropriately being "short gamma" such as the "value" proposal embedded in Contingent Convertibles aka CoCos (now making the headlines), we prefer to be "long gamma" but we ramble again..." - source Macronomics, February 2016

When you buy CoCos, you are effectively the "insurer", bear that in mind. Banks are benefiting from your generosity given you are providing the "crash protection" insurance and to do so they entice investors by offering higher coupons. There is no free lunch there...

Credit wise, we have been advising for a while to play the "quality" game rather than the "beta" game for investors willing to get "carried away and play the lower capital structure part of European banks credit. It comes to us as no surprise from reading Deutsche Bank's note that indeed senior unsecured bonds have had the best performance across the bank capital structure:

"Figure 32 and Figure 33 summarise relative spread performance across the bank debt capital structure. 

Compared to a year ago, bank EUR bond benchmark spreads are wider at all levels of seniority but their changes differ meaningfully:

• Covered bonds: 9bp wider (at 54bp now)

• Senior unsecured bonds: 1bp wider (at 108bp)

• Tier 2 bonds: 47bp wider (at 244bp)

• AT1 bonds: 292bp wider (at 870bp)

While this compares unfavourably with corporate non-financial senior bonds (16bp tighter at 94bp), senior unsecured bonds have had the best performance across the bank capital structure (including equity as shown before). Banks have been able to obtain term funding at relatively stable levels but their capital instruments have sold off meaningfully in spread terms due to broader concerns about compressed profitability and also potential solvency in weaker parts of the banking system.

On the one hand, regulation has brought explicit bail-in risk to bank creditors. On the other, regulatory policy over the last few years has ensured that banks have effectively been run for creditors. We have seen continued build-up of capital, de-risking of balance sheets and strengthening of liquidity profiles, all of that being bank credit positive. While we have shown that some banks are under obvious asset quality and capital pressures, major European banks have maintained reasonably strong credit profiles and this is why their credit has been relatively insulated from the equity turmoil." - source Deutsche Bank

Of course, this should not come as a surprise in the on-going "Japanification" process of the credit markets with the ECB as of late joining the bond buying spree. There is no "Confusion" there for this process to happen because it has all to do with central banks meddling with risk premiums and asset prices. They are indeed the first culprits in asset prices manipulation. This was as well clearly illustrated in Deutsche Bank's report:

"Investors have a behavioural bias towards absolute return targets. Even as ever lower rates and quantitative easing inflate asset prices and expected future market returns necessarily fall, they are reluctant to fully adjust their targets to the new reality. They reach for yield, moving down the risk spectrum to hit their return targets in a low-yielding world.
They take on more duration and credit risk, squeezing risk premia on the way. In the case of some term premia, for instance, these can turn negative as hold to- maturity considerations are overshadowed by a hope for a short-term capital gain or at least avoidance of the negative carry of shorter-duration instruments. (Locally, there seems to be particular aversion to negative yields although the initial resistance has been broken even in corporate bonds) Many investors, such as insurers and pension funds, also seek yield in less liquid and/or structured products, the latter often with greater tail risks.
Reaching for yield is an inherent part of the portfolio substitution channel that transmits QE to the financial conditions in the wider economy. As direct central bank purchases of sovereign and corporate bonds removed some downside risk, at least for now, they naturally contributed to a further drop in required risk premia. Investors then reach for yield in riskier asset classes.
There is nothing wrong with the willingness to accept lower risk premia. However, reaching for yield has limits and there is a risk of a yield over-reach.
To an extent, central banks trade off monetary and credit easing for potentially less financial stability down the road. At some point, however distant, reversal of the reach-for-yield phenomenon (repricing of risk premia) might be quite abrupt and lead to a sharp tightening of financial conditions, with macroeconomic and financial-stability consequences. But that is a worry for another day.
The financial sector has been a collateral victim of this environment. As maturity transformers, banks are notable earners of term premia, liquidity premia and credit risk premia. Consequently, their diminishment has been a drag on bank profitability. Given the difficulty in passing negative rates on to depositors, the competitive nature of the (in parts overbanked) industry and soft demand for credit, European banks seem to have been unable to reprice loans to preserve their margins. Also, eurozone banks increasingly compete with markets in which the ECB has been buying non-bank corporate bonds, driving spreads down relative to banks’ own cost of market funding despite bank bonds’ better ratings. The 3-6-3 banking rule most certainly does not apply here. Given the state of the economy, demand for credit and potential capital constraints, the required increase in loan volumes to compensate for tighter margins seems unlikely to be reached soon.
Low rates and QE have also had benefits for banks, such as lifting the value of sovereign holdings and improving asset quality relative to the counterfactual (of no such policies). Also, the ECB’s TLTROs or BoE’s Funding for Lending have been designed to provide funding cost benefits to banks, which should be positive for earnings if not fully competed away. Overall, however, the extraordinary rate environment has been deeply damaging to the prospects for bank profitability and it might potentially be structural if the “secular stagnation” hypothesis turns out to be correct.

Figure 5 summarises the dramatic shift in the rate environment over the years, spelling rather dire prospects for the European economy.

Banking in low-growth, low-inflation and flat-curve environment is simply a challenge. Globally, flattening curves and rates falling towards or below zero at ever longer maturities have been a vote of ever lower confidence in the adequacy of current policies to restore inflation and growth.
While one could have a long metaphysical discussion about whether 30-year bond yields near or below zero reflect true economic risks or duration overreach, their levels are not driven purely by QE purchases. Swiss 30-year government bonds have a negative yield even if the SNB is not buying. Clearly, peripheral sovereign credit has been a great beneficiary of ECB QE.

We review these market phenomena because they matter for the bank lending business as well, in addition to some of these bonds sitting directly in banks’ liquidity portfolios. In the corporate space, reaching for yield has been equally relentless. As we calculated recently, 3 over a third of AAs and As and nearly a quarter of BBBs, by amount outstanding, among non-financial corporate EUR bonds traded with negative ask yields.
Most recently, we have seen the first non-financial corporate (AA-rated Deutsche Bahn) issue a zero-coupon EUR bond with a yield of -0.006%. “Income” is disappearing from “fixed income”. These developments have pushed many bond investors down the credit quality spectrum but with BB yield at 3.06%, “high yield” is becoming a bit of a misnomer too, at least relative to its history.

All this weighs heavily on banks’ credit intermediation business. With interest rates on loans to households and firms on a multi-year downward trajectory, helped also by the ECB’s TLTROs, lending margins have been falling. Margins in our selected eurozone countries are mostly at 50-70% of their 2010 levels, with many worrying that the downward trend has more to go. Note that this
refers to new business only. There will be a further lagged response on the full loan book’s net interest margins (NIM) as it gets gradually repriced, eroding net interest income more.
In a negative-rate world with limited hopes for a change any time soon, NIM pressure is here to stay. Indeed, the collateral damage to bank stability and ultimately to economic growth from the negative-interest-rate policy has increasingly been seen as an impediment to more aggressive rate cuts by the ECB. At the same time, it has to be accepted that in a negative-rate world with much higher capital ratios than before the crisis, returns on bank equity below 10% might well be a fair compensation to shareholders. Current profitability measures cannot be compared to the “old days” of high interest rates and thin equity cushions.
To get on a higher earnings path, banks also have to continue to adjust their business models and cut costs. In banking systems with clear inefficiencies and overcapacity, especially as more European corporations raise funds via markets rather than banks, consolidation among smaller players and downsizing by some larger players may need to accelerate. There is a common interest in Europe in having a stable and adequately profitable banking system that promotes sustainable growth. That also requires overcoming some legacy challenges in pockets of potential instability." - source Deutsche Bank

Death by a thousand rates cuts and cost cutting, thanks to the stupidity of NIRP which is slowly but surely weighting on bank profitability and destroying NIM. At least from a credit investing perspective you have the ECB as your "buyer of last resort", avoiding in effect default risk to materialize for the time being but, just postponing the end result we think.

On a side note, we might be sounding yet again like a broken record but, for instance loan growth in Italy is constrained because Italian banks are "capital impaired" (to say it in a politically correct way...). Forget "bail-in" because if you do crush the retail crowd you can rest assured that Renzi's days will be over and that the whole European project would unravel with Italy threatening to leave the European project with a new majority such as the Five Star Movement. Even the leader of the populist movement is acutely aware of the risk "bail-in" would have on Italian savers.

The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

Also, back in our February conversation "The disappearance of MS München" we joked in around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016

Reading through Deutsche Bank report, indeed, the Atlas plan was doomed from inception:

"With the aforementioned gap between market and book valuation of NPLs, disposals have been slow as banks are reluctant to book losses given their capital positions. In February, to facilitate disposals, the government introduced a scheme of state guarantees (GACS) of IG-rated senior tranches of NPL ABS at a cost linked to a basket of equally-rated Italian corporate CDS. While this introduced a handy hedging service, from the very start it stood little chance of solving the actual problem. To comply with EU State-Aid rules, these guarantees had to be offered at “market prices”. If that is the case, then by definition no amount of tranching and hedging can overcome the fact that if the securitisation vehicles acquire NPLs above their market values, investors in the junior tranches are unlikely to see the expected returns meet their targets. In reality, the scheme does offer guarantees that might not be readily available in the market otherwise and their pricing may be seen as marginally attractive. It just is not a silver bullet and can only be part of a bigger solution.

With no private buyers forthcoming, it has been increasingly clear that a comprehensive solution will require government involvement. The government coordinated the set-up of the €4.25bn Atlante fund by mostly private investors, which has been available for backstop recapitalisations (up to 70%) and NPL purchases (at least 30%). Its size, however, has been inadequate for the size of the NPL problem in Italy and at this point some €1.75bn remains available after recapitalising Banca Popolare di Vicenza (€1.5bn) and Veneto Banca (€1bn). It does not look like Atlante could dispose of those equity stakes soon, at acceptable prices, to free up resources for further purchases.
There have been reports that efforts are under way to set up Atlante 2 (to be called Giasone) with additional €2-3bn, particularly aimed at addressing NPL concerns around the largest troubled bank Monte Paschi. Even if such efforts succeed, however, the size of these private funds would be insufficient for a comprehensive solution." - source Deutsche Bank

Of course, these solutions are as we said earlier, an exercise of dubious intellectual utility. We might even suggest Italian banking authorities name Atlante Fund "iteration n" simply Danaus or Danaids (also Danaides or Danaïdes) because in Greek mythology the Danaids were condemned to spend eternity carrying water in a sieve or perforated device. In the classical tradition, they come to represent the futility of a repetitive task that can never be completed such as setting up private funds to resolve Italian NPLs.

Nonetheless, the ECB's credit buying spree is still supportive of credit versus equities when it comes to the European banking sector as a whole.

Moving on to our next "Confusion" point, we believe Japan, once more will have to play catch up to the tune of the ECB and stealth devaluation from China in order to revive "animal spirits", namely its stock market through yet another round of "unconventional" measures.

• Macro and Credit  - Japan looking for a "helicopter stall"

With Friday’s Bank of Japan meeting, every pundit is expecting "shock and awe" once more to induce yet another weakening bout of the yen as well as a rally in the Nikkei. In our last missive we indicated that re-initiating a short position on the Japanese yen could be of interest. While initially our timing was poor and faced an initial set back, we still believe Bank of Japan will again come to the rescue of its massive ETF equity exposure on its own local index.

What we find of interest in the discussions surrounding "helicopter money" and Japan is the analogy that can be made with Mario Draghi much discussed "bumblebee" reference in his 2012 speech that led to his "whatever it takes moment":

"And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing."- Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July 2012.

The issue with bumblebee according to 20th century folklore, the laws of aerodynamic prove that they should be incapable of flying:

"The calculations that purported to show that bumblebees cannot fly are based upon a simplified linear treatment of oscillating aerofoils. The method assumes small amplitude oscillations without flow separation. This ignores the effect of dynamic stall (an airflow separation inducing a large vortex above the wing), which briefly produces several times the lift of the aerofoil in regular flight. More sophisticated aerodynamic analysis shows the bumblebee can fly because its wings encounter dynamic stall in every oscillation cycle" - source wikipedia

 When it comes to "helicopter money" and vortex stall and Japan, we touched on this very subject in our May 2014 conversation "The Vortex Ring":

"In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust).
For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

"To get into vortex ring, three factors must all be present:

• There must be little or no airspeed.

• There must be a rate of descent.

• There must be power applied.

Note that all three of these must be going on at the same time." - source Macronomics, May 2014

We also argued at the time:

"It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets." - source Macronomics, May 2014

Given the relative dismal results induced by QQE on the Japanese results, we expect more of the same from Japan as posited by our friend Michael Lebowitz from 720 Global in his latest missive called Kyōki (Insanity):

"Eventually, due to the mountain of money going directly in to the economy, inflation will emerge. However, the greater likelihood is not that inflation emerges, but that it actually explodes resulting in a complete annihilation of the currency and the Japanese economy. In hypothetical terms as described here, the outcome would be devastating. Unlike prior methods of QE which can be halted and even reversed, helicopter money demands ever increasing amounts to achieve the desired growth and inflation. Once started, it will be very difficult to stop as economic activity would stumble." - source Michael Lebowitz, 720 Global

This is exactly what will eventually happen to the Japanese "bumblebee", under a Vortex ring state thanks to "helicopter money" a country can fall at an extremely high rate (deflationary bust).

We totally agree with our friend Michael Lebowitz about the dangers of "perpetual bonds", or bonds with no maturity date as well with is astute reference to the French money printing exercise ultimately leading to economic ruin and a leading factor fueling the French revolution. All of this is described by French economist Florin Aftalion in his 1987 book entitled "The French Revolution - An Economic Interpretation"

This is what we discussed in May 2016 in our conversation "When Doves Cry" when it comes to "assignat" and "helicopter money" leading to a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"):

"At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital." -  source Macronomics, May 2016

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point".

As we pointed out at the time and in relation to the ECB:

"To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB." - source Macronomics, May 2016

In similar fashion, the Japanese idea of "perpetual bond" is very close to the dreadful "assignat" and its dire consequences are well documented in Florin Aftalion's seminal book:

Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 

We also commented at the time in our May 2016 conversation:

"Of course as well as in Japan, doves have been crying given that they much vaunted currency depreciation scheme has been put in reverse as of late. But given the mounting evidence of a global slowdown, one would expect the Bank of Japan to return to the QQE game during the second part of this year. Now that the ECB is directly in competition of the likes of Mrs Watanabe, Japanese insurance companies, the GPIF and their pension funds, one would expect that the "fun" uphill, namely bond speculation, continues to run unabated, for the real economy, we are not too sure..." - source Macronomics, May 2016

But returning to "helicopter money", Japan and its much anticipated 28 trillion yen ($265 billion) fiscal package announced by Prime Minister Shinzo Abe, we have yet to see how the Bank of Japan is going to make good on Abe's promises. When it comes to Ben Bernanke idea of perpetual bond, this has been tried before in the form of the "assignat". If Japan issue a perpetual bond, to paraphrase du Pont de Nemours, Japan will have borrowed more!

On the issue of "perpetual bonds" we read with interest Nomura's Richard Koo's take in his latest note from the 26th of July entitled "Cost-benefit analysis of helicopter money":

"Four versions of helicopter money (3): government scrip and perpetual zero-coupon bonds

A third version of helicopter money involves government money printing or the replacement of the JGBs held by the BOJ with perpetual zero-coupon bonds.

The people proposing these policies hope that fiscal stimulus financed by government scrip or perpetual zero-coupon bonds, which are not viewed as government liabilities, will elicit spending from people who are currently saving because of concerns about the size of the fiscal deficit and the likelihood of future tax increases.

Economists refer to this reluctance to spend because of worries about future tax hikes as the Ricardian equivalence. If true, it implies that consumption will increase each time the government raises taxes since higher taxes mean lower deficit in the future. The fact that this phenomenon has never once been observed in the real world suggests it is nothing more than an empty theory.

Moreover, there are serious issues that must be confronted once the economy picks up and the liquidity supplied by the monetary authorities via government scrip or zero-coupon perpetuals must be drained from the system. Perpetual zero-coupon bonds are essentially worthless, which means the BOJ cannot sell them—no one in the private sector would be stupid enough to buy them.

That means the only way to mop up the excess reserves created via the issue of perpetual zero-coupon bonds is for the BOJ to ask the MOF to issue equivalent amounts of coupon-bearing bonds.

The same would be true when trying to mop up reserves created by government scrip. Once this scrip starts circulating, it becomes part of the monetary base, and draining it from the system will require the government to absorb it by issuing bonds. And in the case of both perpetuals and government scrip, the government that issued the bonds cannot spend the proceeds. If the government spends them, the liquidity that had been mopped up will flow back into the economy again.

Those recommending the issuance of government scrip or perpetual zero-coupon bonds say that one advantage of this approach is that it does not lead to an expansion of government liabilities (upon issuance). However, they will become massive government liabilities when the economy eventually recovers and they must be mopped up.

Helicopter money proponents silent on issue of mopping up reserves

In other words, the biggest issue with helicopter money—as with quantitative easing—is the question of how to drain these funds from the system. It becomes clear just how problematic both policies are when the difficulty of draining reserves is taken into account.

Yet in all the discussion about helicopter money and quantitative easing in Japan and elsewhere, almost no one has touched on the massive costs involved in mopping up the excess reserves created under these policies. Everyone emphasizes the benefits of these policies when introduced while ignoring that those benefits are small indeed when we examine the costs and benefits over the policy’s lifetime.

As one example of this bias, Waseda University professor Masazumi Wakatabe argued in a Nikkei column titled “Easy Economics” that helicopter money is preferable to quantitative easing inasmuch as it enables the government to undertake fiscal stimulus without increasing its liabilities.

I suspect that the helicopter money envisioned by Mr. Wakatabe involves the issuance of government scrip or direct central bank underwriting of perpetual zero-coupon bonds. However, he makes no mention whatsoever of how the liquidity created via these methods will be drained from the system once private-sector demand for loans recovers.

Helicopter money offers no benefits whatsoever over policy’s lifetime

As described above, the only way to mop up liquidity that has been created using these methods is for the government to issue bonds and not spend the proceeds. I think this would be more difficult from both a legal and practical perspective than winding down quantitative easing, which in itself is no easy task.

Moreover, the amount of government debt that must ultimately be acquired by the private sector is no different from a case in which the government had issued bonds to fund fiscal stimulus from the outset.

In short, whether fiscal stimulus is funded with government scrip and zero-coupon bonds or with the ordinary issue of government debt, the size of the government’s liabilities will be the same in the end. Helicopter money offers no benefits whatsoever when viewed over the lifetime of the policy, including the eventual need to mop up liquidity." - source Nomura

In similar fashion to "assignat" perpetual bonds are essentially worthless and there is indeed a heightened risk that Japan will face significant consequences to the value of its currency and eventually trigger a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"), hence our long term very short view on the Japanese yen (our target might even scare you...).

Of course these are longer term risks that will eventually play out, closer to home and short term wise, there is growing dividend risk in Europe going forward.

• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

 While European banks are slowly but surely dying thanks to NIRP and with Japan increasingly looking for its "helicopter stall", no "Confusion" there, in Europe what we think is of interest for our final chart is the growing gap between European Dividend Yield (DY) versus European Earnings Yield (EY). As indicated in the below graphs from Deutsche Bank Equity strategy note entitled "A new hope?" from the 25th of July , we agree with them that, going forward, given the level attained by the European payout ratio (55%), there is growing dividend risk going forward so "Mind the Gap":

"The European dividend yield (DY) is at a 20-year high relative to the corporate bond yield, suggesting equities have yet to catch up with the recent performance of corporate bonds. However, unlike the DY, the relative European earnings yield (EY) remains firmly within its four-year range, suggesting equities are not clearly cheap relative to corporate bonds. The real issue here is that the DY is high relative to the EY, which means that the payout ratio is elevated, pointing to downside risks for dividends." - source Deutsche Bank

As far as we are concerned, "hope" is never a good strategy. We cannot resist but to chuckle again and remember a comment we read in the past from a credit desk:

"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

So, yes indeed, mind the gap between DY versus EY, watch Japan and fade the sell-side pundits telling you that European banks are "cheap" from a valuation perspective (that's what many told you at the beginning of the year...). Like we posited before, the problems facing Europe and Japan are driven by a demographic not the financial cycle.

 As we concluded our April conversation "Shrugging Atlas":

"The very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

The game is moving towards capital preservation we think...

"Confusion of goals and perfection of means seems, in my opinion, to characterize our age." - Albert Einstein

Stay tuned! 

Credit - Liebig's law of the minimum

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed." - Mahatma Gandhi

Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through, but, when it comes to our chosen analogy, we decided this week to leave out the "explosive" references and steer towards a principle developed in agricultural science by Carl Sprengel (1828) and later popularized by Justus von Liebig.  The Liebig's law of the minimum states that growth is controlled not by the total amount of resources available, but by the scarcest resource (limiting factor). For us, this important factor is "capital", particularly in the light of ZIRP and repetitive QEs hence this week's title analogy. 

Liebig's law of the minimum concept was originally applied to plant or crop growth, where it was found that increasing the amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth). Only by increasing the amount of the limiting nutrient (the one most scarce in relation to "need") was the growth of a plant or crop improved (preventing mis-allocation of "capital"). This principle can be summed up in the aphorism, "The availability of the most abundant nutrient in the soil is only as good as the availability of the least abundant nutrient in the soil." Or, to put it more plainly, "A chain is only as strong as its weakest link."

In similar fashion, if we take biotechnology itself being totally dependent on external sources of natural capital, capitalism and CAPEX expenditures also depend on efficient market allocation of "capital". Obviously QEs and ZIRP, to that extent do not help whatsoever the process, on the contrary the distortions have been immense hence our Liebig's law of minimum analogy.

Also when it comes to our analogy and the "law of a minimum", we think investors should more and more focus on the return of "capital" as a "minimum" rather than focusing on the return of "capital" as a "maximum". Yes, there has been a strong rebound in inflows in recent weeks particularly in High Yield ETFs, but, looking at our much discussed "CCC credit canary" bucket and the dip in new issuance for the latter, it is a harbinger of trouble ahead we think, hence our recent call for moving higher in the ratings spectrum. If we would like to tweak slightly the previous aphorism we would state the following: "The credit cycle is only as strong as its weakest link, namely the CCC credit canary". 

While there has been a positive momentum in credit and equities alike, leading to strong inflows, with "bad news" on the macro side with weaker China GDP growth, leading to somewhat "good news", at least on the credit side, we think that financial system vulnerabilities have risen, thanks to the commodity down cycle in conjunction with the sharp depreciation of currencies in Emerging Markets (EM), particularly for commodity exporters such as Brazil. These developments have clear implications for foreign-denominated debt particularly for the corporate ones as discussed recently. There is a heightened risk for EM and DM banking systems alike for significant loan defaults and banking system losses in 2016.

In this week's conversation, we will look again at the consequences positive correlations have had on idiosyncratic risks and why in the current tightening mood, you should this time around avoid getting "carried away", meaning stretching for yield and risk given the lateness in the credit cycle.

Synopsis:

• Positive correlations means idiosyncratic risks are rising
• More on the credit cycle turning - don't get "carried away"
• Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 

• Positive correlations means idiosyncratic risks are rising

While in August we voiced our growing concerns on the rise in positive correlations and the instability it was generating in our short conversation "Positive correlations and large Standard Deviation moves", the recent significant price movements we have witnessed on numerous occasions, indicates clearly to us that this instability is leading to sudden bursts of volatility and large standard deviations move. We would not call that a "new normal" environment but, we think it is akin to the "law of minimum" in a ZIRP central banks induced world. 

This rise in idiosyncratic risks has been confirmed by Bank of America Merrill Lynch in their latest Credit Derivatives Strategist note from the 14th of October entitled "Refocusing on the big picture":

"The rise of idiosyncratic risksThe EM driven volatility is here to stay. Names with significant sales exposure to EM have borne the brunt during the recent sell-off. Additionally the consequent commodity price sell-off has triggered an increasing pressure on metals and miners. But on top of the global growth headwinds, we have also seen a significant rise of pure idiosyncratic risk recently both in high-grade and high-yield market. Multiple single name stories have been popping around. The VW story is casting a shadow on the autos and auto parts sector. Abengoa has also been on the fore over the past couple of months. Matalan recently saw their bonds down ~10pts.
Our Plunging bonds index is reflecting exactly that; the rise of idiosyncratic risks. Note that the number of bonds that dropped more than 10pts in a month spiked to the highest level in September.

However, the performance in the month of September was not that catastrophic across the board. After all not many European companies are either exposed to EM or have been affected by the VW story.
A way to illustrate the diverging performance across high-grade cash sectors is by tracking the standard deviation of their excess returns. In chart 3 we present the standard deviation of monthly excess returns for a number of non-financial sectors over time.

We find that the level of dispersion in September has been the highest since the 2008/09 global financial crisis, and far worse than the one experienced during the European sovereign crisis in H2-2011.

Note that while autos and industrials were the ones that dropped by c.4%, the rest of the market was down by ~1% on average (chart 4). These two sectors represent only ~10% of the entire high-grade market.

Record low financing costs…default risks should be contained…Default rates have historically been highly correlated to companies’ financing costs. We find that the loan interest rate cost is a good leading indicator of default rates (in the following 12 months, chart 5). 

With the ECB likely to expand/extend QE beyond September 2016, financing costs are likely to remain low for longer. Should this trend continue the currently low financing costs should support low default rates suppressing systematic default risks. 

The recent EM-driven weakness has driven spreads significantly wider, decoupling from lower loan rate costs for European companies (chart 6).

This provides more attractive levels to selectively add risk in credit instruments that have a cushion to first losses. 

Fundamentals improving…no re-leveraging despite enticing financing rates

Inflation and financing costs have been ticking down over the past couple of years. Corporate fundamentals are clearly improving. Over the past six quarters, leverage has fallen due to an improvement not only in earnings, but also thanks to lower debt overhang. Chart 7 shows that European corporates have not embraced more leverage (more in our dedicated HY fundamentals note), despite enticing record low financing costs."

- source Bank of America Merrill Lynch

We agree with Bank of America's take when it comes to European valuation being relatively more attractive compared to the US thanks to lower overall "leverage". This what we argued in our conversation "The overconfidence effect", US "releveraging" has been fast and furious which is not yet the case in European credit (far less "leverage" and "buybacks").

But, we cannot agree with Bank America Merrill Lynch's use of loan interest rate cost as a good leading indicator of default rates. This is misleading we think in this credit cycle. This time, it's different!

Why so?

In September 2014 in our short note "US High Yield issuance and debt outstanding" we indicated the following:

"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far.
Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans"

- source Macronomics, September 2014, graph Morgan Stanley, March 2013.

Europe is an on-going story of "deleveraging" when it comes to its banking sector. Banks are not making that many new loans, particularly in peripheral countries because weaker banks are still capital constrained! If you think banks have completed their deleveraging, then watch German banks and in particular Deutsche Bank. More pain to come, more assets to be offloaded, more jobs to be cut.

Using again our Liebig's law of the minimum analogy, the limiting nutrient (the one most scarce in relation to "need") for European banks is "capital". 

As a reminder credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and their "core capital " has been artificially boosted by Deferred Tax Assets (DTAs). DTAs are like "Aspartame", an artificial, non-saccharide sweetener used as a sugar substitute in some foods and beverages but, when it comes to European banks by no means it can be considered true "capital". DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios. This is significant!

With loans you have covenants as an alert system, even less so in the US with the return of Cov-Lite loans,  and with bonds, not that much covenants, hence the significant increase in "idiosyncratic risk".

Furthermore, we agree with our Rcube friends recent take on "bonds" being now a more serious indicators than "loans":

"We have been highlighting for months now that the combination of redemption and rising cash levels would be equal to a serious tightening of bank’s lending standards. This is because the share of corporate financing now achieved through capital markets has massively increased over the last 10 years. Bond funds have taken over loan officers as the main credit providers to corporations around the world. Only watching banks’ lending standards to evaluate the health of credit flows is a serious mistake in this cycle. In the US alone, the ratio of bond issuance vs. loans is 5 to 1. For risky assets to drop, negative sentiment is a prerequisite condition. It is now the case." - source Rcube

While we might be sounding like a broken record but, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger, even for European Issuers, regardless of their EM exposure, or not.

This brings us to our second point namely that in a context of deteriorating "credit metrics" for High Yield issuers (and no it isn't only bound to the "Energy" sector...), we think that investors should focus on return of "capital" rather than return on "capital" because  increasing amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth) so far, although we keep hearing from the "snake-oil" pundits that's the "recovery" is just around the corner:

US Labor force: For the first time since May 1990 the Ratio Not in Labor Force / Civilian Labor Force has topped 60%:

- source Macronomics

• More on the credit cycle turning - don't get "carried away"

Whereas cheap credit has enabled some "extend" and "pretend" game, one of the major consequences has been to allow the extension of the "Maturity wall" to a later stage as illustrated by Bank of America Merrill Lynch in the below graph displaying the maturity profile for US High Yield bonds and Leveraged Loans:

- source Bank of America Merrill Lynch

In similar fashion, for some distress issuers in Europe, the game has been extended to "overtime" but in no way has altered the necessity for some form of "restructuring" as illustrated recently by the situation of Norske Skogindustrier ASA, a Norwegian pulp and paper company based in Oslo as reported by DataGrapple on the 16th of October:

"So NSINO (Norske Skogindustrier ASA) eventually paid their 2015 bonds. The company has apparently decided to buy some time in order to find a suitable solution to manage their considerable debt pile. Their next maturity falls in May 2016, but once these junior bonds will have been paid, there will be very little cash to redeem other maturities. It is therefore no surprise that holders of longer dated bonds are mulling restructuring plans. A group of investors holding NSINO’s 290mln euros of senior bonds due 2019 allegedly met with the company to discuss a possible debt for equity swap. Holders of junior bonds due 2017 approached management with an alternative plan that included extending their claims until after 2019. The company is conveniently in blackout period ahead of its results on October 22nd. They should expect a grilling then regarding their intentions. But in the meantime, as their willingness to kick the can down the road was evidenced by the payment made yesterday, investors have steepened the risk premium curve of NSINO on the short end. The 1 year CDS closed today at 29pts upfront, 10pts lower than 2 days ago." - source DataGrapple

Of course, in similar fashion, the "lunatics" running the "central bank" asylums have also played the "buying some time" game to say the least. They seem to be oblivious to Liebig's law of the minimum but we are ranting again.

We think it is high time investors start thinking about "playing" defense", this means going higher into the "ratings" spectrum. As goes our second point, do not get "carried" away, meaning stop "selling "beta" for "alpha" (though we do know that the first source of "alpha" are fees to quote one of our Hedge Fund manager friend...) because the cycle is running out of steam. 

On that note, we could not agree more with Bank of America Merrill Lynch's High Yield Wire note  from the 19th of October entitled "Fool me once, shame on you, fool me twice…":

"All credit cycles come to an end. This one’s no different.We’ve said for a while now that the benefits of low rates have long been sapped from the market, and we are in no rush to change our tune on the back of a two week rally. As we look at the fundamentals of the market, our strategic view on high yield remains crystal clear: the market is in its 7th or 8th inning and still needs to cheapen substantially before valuations become attractive. With the risk for 100s of billions of investment grade downgrades, our view that defaults will soon be increasing, and that Fed stimulus is no longer a tailwind to the market, our expectations are for wider spreads in 2016. This is not to say we expect a massive default wave next year, but do wonder whether the lack of liquidity and general direction of the market creates an attractive entry point anytime soon. 

Spread compensation not enough for what matters: ReturnsAs we have been traveling across the US and Europe the last 6 weeks we have heard two arguments why investors may find value in high yield. First, there is a lack of alternatives. Second, with the recent widening, spread compensates you for the default expectations priced into the market. We don’t agree with either. Investors need to demand return, not yield. A 7% coupon does not yield a 7% return and with the potential for low average returns for some time, we think alternatives do in fact exist. Additionally, traditional measures of spread compensation are flawed in our view, and need to be seen in the context of alternatives and default risk over the life of a portfolio." - source Bank of America Merrill Lynch

When it comes to Liebig's law of the minimum and "return" of capital, we also agree with Bank of America Merrill Lynch's take on the need for looking for "quality" rather than yield:

" All credit cycles come to an end. This one’s no different.
Over the last couple of years, the market has frequently been fooled by assuming a new old world where bad news is bad news and good news is good news, only to be whipsawed by risk on sentiment where fundamentals matter less than easy monetary policy. At the risk of being fooled again, we say the tide has turned, and low rates and pushed out hike expectations matter less in a world where sentiment has shifted, fundamentals are poor, and investors are not being compensated for default and
liquidity risk.
It is interesting how so few disagree with us that fundamental metrics in HY are quite poor and unlikely to take a turn for the better any time soon and yet so few agree with our thesis that this is highly problematic. The effectiveness of central bank policy in boosting asset prices over the last few years has created a blind spot when it comes to fundamentals. This is apparent when the only counter to our argument is “where else will the money go?”
The steadfast belief that low rates and the central bank put will continue to mean a reach for yield, never mind it’s quality, seems absurd and contrary to evidence. It’s been six years since the recession; we’ve had numerous rate cuts and quantitative easing programs the world over, we’ve seen all-time high stock prices and we’ve witnessed all-time low bond yields, and yet neither the market, nor it seems the economy is allowing the Fed to hike rates. As Thanos wrote recently, we should have known something was wrong when bad news was greeted more cheerfully than good news.
Ok, so what has changed now you say; if central banks continue to remain so accommodative, why not more of the same? Because the last six years have also borne witness to the fastest growth in corporate debt that we’ve ever seen and re-leveraging to a scale comparable to the worst moments in HY’s history.  

This has occurred in conjunction with mediocre revenue growth, disappointing capex spending and earnings burnished by buybacks and acquisitions. And just as credit quality started a turn for the worse, risk aversion has set in quite firmly within the market. The flight from Energy and the reluctance to step back in even at today’s highly distressed levels amongst investors has been stark, as they anticipate many HY E&Ps to raise priority debt ahead of existing bondholders and potentially file for bankruptcy. Even the erstwhile “safer” places to hide may not make the cut going forward. We have already seen some unraveling in the traditionally defensive pharma market with stock and bond prices of drug makers taking sizable hits on the prospects of drug price caps. Lately, the risk aversion has spread to mainstream hospitals too- case in point HCA equity down 23% since August 4th.

In the same vein BBs, which have outperformed Bs and CCCs all year (BBs -0.93%, Bs -2.67%, CCC -7.14% YTD), face headwinds from falling angels once rating agencies begin downgrades ahead of the default cycle. In the past two migration cycles, an average of 10% of the starting IG universe was downgraded to HY over the course of the cycle (Chart 3). 

This translates to as much as $300bn worth of par value in cumulative downgrades over the next 3 years if the rating agencies begin to shift their expectations in 2016. Should history repeat itself, these downgrades will expand the current BB universe by a whopping 63% and the overall size of the high yield index by nearly 25%.
Of course, existing BBs today will also suffer attrition by way of downgrades to Bs, and Bs to CCCs, but the overall indigestion to the market could prove massive. We hear so much about the potential for outflows, but very little about the potential for new paper through downgrades. The latter dwarfs the former.

Finally, the re-pricing in the primary market as issuers bow to investor demands is just another reminder of waning risk appetite. Never before has access for CCC issuers, even non-commodity ones, been so poor post crisis. The proportion of low quality issuers accessing the market on an annual basis has now dipped below 20%, a far cry from the 50% at the top of the cycle. It doesn’t take much to see what this means for the survivability of low quality issuers going forward. In fact the previous times we were at these levels and heading in the wrong direction was in 1989, 1999, and 2008, right at the heels of default waves (Chart 5). 

Of particular interest is that once CCC issuance (as a percentage of all existing triple C issuers) falls below 20%, the default rate tends to spike north of 10% within a year and a half on average. In the late 1980s/early 1990s, the time to double digit defaults was 20 months, in the late 1990s/early 2000s it was 22 months and in 2008 and 2009, it was just 14 months. Assuming a similar pattern today, one would expect the current risk aversion to lead to a significant pickup in defaults sometime in mid-late 2017, consistent with our previously published estimates. 

The idea that once again bad news is good news and good news is bad news has no merit in our view, especially in the context of all the late stage indicators we are seeing. We’ve said for a while now that the benefits of low rates have long been sapped from the market, and are in no rush to change our tune on the back of a two week rally. In fact, we would argue that we have witnessed nothing but a dead-cat-bounce in HY, and a price action which has little if anything to do with the expectation for rates or improved fundamentals, and everything to do with ETF buying and short covering. The $2bn+ that flowed into ETFs in the week ended Oct 9th was the highest on record for HY ETFs (Chart 6). 

This was the same period over which the HY index staged a dramatic 70bps of spread tightening, but has since given back some gains. In contrast, actively managed retail funds saw a meagre inflow of $140mn over the same period.
Note that the market was pricing an impossibly low probability for a hike before September’s meeting and that the market sold off all summer despite treasury yields falling. In fact, after Yellen’s press conference, where she discussed the lack of inflation and weak global growth as the main reasons for keeping zero interest rate policy, the market sold-off. Yet, we are meant to believe that when the same concerns were expressed in the minutes, everyone had changed their mind that these issues were now a good thing? We don’t buy it.

As hard as it is to accept that this glorious run for credit has come to an end, in our view it is time to acknowledge that valuations do not justify the risk-reward profile in HY, and no amount of QE or easy monetary policy is likely to change the story for an extended period of time. The market is in its 7th or 8th inning and without a substantial increase in earnings- a prospect that will require fiscal policy changes more than monetary stimulus, in our opinion- we think high yield will have a difficult time sustaining rallies. And to substantiate that view, we attempt to counter the most frequent arguments we’ve heard from those who disagree. 

Spread compensation not enough for what matters: ReturnsYield does not equal returnThis may be stating the obvious. But we find it necessary to say so anyway. The most vociferous argument for HY seems to rest on the fact that it indeed provides a high yield; more importantly a higher yield than Treasuries, high grade and perhaps even expected stock returns. But what good is a high coupon if enough price loss and defaults occur to wipe away any cash inflow? We would think investors would search for return, not yield, in which case, in our view compensation is not commensurate with the alternatives.
In late December last year, the yield on our HY index was over 7%, the highest it had been in over two and a half years. Just a few weeks back it was over 8% and year-todate returns stand at -0.6%. High yield or higher yield than recently observed did not by themselves preclude an even higher yield or negative returns. Why opt for 2-3% returns in HY with its volatility, defaults and liquidity challenges when HG paper yields 3.3%, has less volatility and virtually non-existent default risk?" - source Bank of America Merrill Lynch

Exactly!
Given the "holding" pattern of the Fed, we believe as well, that US Investment Grade has become somewhat attractive again. On that matter of "quality", we have read with interest Bank of America Merrill Lynch's Situation Room note from the 20th of October entitled "It’s what you don’t see that hurts you":

"Cash gets no credit
High quality industrial spreads are attractive relative to their lower quality HG counterparts. This is because currently single-A and BBB-rated industrials offer similar spread levels per turn of gross leverage (ex. energy, materials, utilities) – see Figure 1. 

This means that investors give A-rated industrials little credit for their superior liquidity positions, with higher quality industrials holding about twice as much cash on their balance sheets as BBBs (Figure 2). 

In other words, current valuations assign close to zero value to the much lower net leverage of high-quality companies compared to their lower rated peers. With corporate releveraging expected to slow we think credit market valuations should become more aligned with net than gross leverage. While a significant portion of corporate cash could be overseas, it would still be available and useful to repatriate - after a tax haircut - in situations of distress. 

The trend in gross leverage for both high quality and BBB-rated industrials has been similar, with the median leverage rising since 2012 (Figure 3). 

In contrast the higher cash balances actually pushed the net leverage down for single-A rated issuers, while net leverage increased for BBBs (Figure 4). 

In fact, about 40% of single-A issuer in our credit universe (ex. energy, materials, utilities) have negative net debt as of 2Q-2015." - source Bank of America Merrill Lynch

"Quality" indeed in Investment Grade credit is once more a "compelling" argument, we think, given the lateness in the "credit cycle".

While in September we would confide we have been adding on our US long duration exposure, it seems to us that in a "deflationary" enclined world, "quality" credit Investment Grade is still good value for your money, US High Yield doesn't appear to us like it and this bring us to the main reason we have also discussed in recent weeks is the rise in the cost of capital and global tightening financial conditions (think about our CCC Credit Canary and its issuance "issues"...).

This brings us to the final "inning" of this week's credit conversation, namely that in Liebig's law of the minimum, what matters in a D for Deflationary world more and more is the return of your capital, not the return on capital.

• Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 

While we recently boasted on the attractiveness of "deflation floors" for US Tips as compelling in a "D" world, there has been as well as of late, some evidence of the rise in the cost of capital hence a slowdown in buybacks and US corporates starting to become more defensive of their "balance sheet". We would like to point out David Goldman's comments which can be found on Reorient Group's website from their note from the 18th of October: 

"Part of the reason for lower per-share profits is the decline in equity buybacks. Factset reports, “Companies in the S&P 500 spent US$134.4 bn on share buybacks during the second quarter. This represented a 6.9% decline in spending from the first quarter. At the sector level, six out of eight sectors saw a sequential (quarter-over-quarter) decrease in share buybacks at the end of Q2 (excluding the Telecom and Utilities sectors, which have each averaged less than US$2 b in quarterly buybacks since 2005).” 

Buybacks, in turn, have declined because the cost of financing them has risen. The spread to Treasuries paid by medium-grade corporate borrowers rated Baa/BBB has risen by a full percentage point since July 2014.

In a zero-inflation and borderline deflationary environment, 5.4% interest on term debt is real money, and corporates are getting reluctant to lever their balance sheets in order to show higher per-share earnings. During the past five years, the 100 members of the S&P 500 with the highest proportion of share buybacks (the S&P 500 Buyback Index) outperformed the rest of the index by 20%.

Source: Bloomberg

During the July-September correction, though, the S&P Buyback Index underperformed, losing 4% against 1% for the S&P as a whole.
That’s an important signal that the quality of the carried asset ultimately is more important than the cost of carry. If earnings continue to deteriorate, carry trades will start to resemble the conclusion of the Stephen King film with the homophonous name. " - source Reorient Group - David Goldman - 1§th of October

While it isn't yet "Nightmare" on "Credit Street", it looks to us that while leverage matters, earnings matter even more when it comes to "default" risk as we posited back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, at the time we argued the following:

"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook" - Macronomics, November 2012

One thing for sure, don't get "carried" away, preserving "capital" sure is the law of the minimum...

"Words have no power to impress the mind without the exquisite horror of their reality." - Edgar Allan Poe