Macro and Credit - Stress concentration

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

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

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

Synopsis:

• Macro and Credit - Cracks in the credit narrative 
• Final charts -  Oh My God! They Killed Volatility and brought instability...

• Macro and Credit - Cracks in the credit narrative 

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

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

One thing for sure we came close to some nasty widening recently in Europe with credit options expiry for Itraxx Crossover as indicated by DataGrapple in their blog post from the 15th of November entitled "When Technicals Drive The Market":

"Today was a pretty choppy session on credit indices, especially in Europe. The morning was really weak as the earning call of ASTIM (Astaldi) went down very poorly with investors. That name was indicated 15pts wider during the first exchanges, and it put pressure on the whole iTraxx Crossover complex. The index seemed then on its way to breach 260 and was dangerously close to the 262.5bps level, an important strike for options that were maturing today. Indeed, market makers were net sellers of options struck at that level and had to buy protection to hedge themselves, adding to the market momentum. But the widening stalled during the morning – sellers of protection eventually surfaced, enticed by the extra 30bps that were on offer compared with the tightest levels reached this month – and in the afternoon it became obvious that the (in)famous 262.5bps would not be breached, forcing option market makers to sell the protection they had bought earlier in the day. So much so, that iTraxx Crossover closed almost unchanged to conclude a very technical session" - source DataGrapple.

So yes we came close to "stress concentration" at least in the European High Yield synthetic space. Though we must confide that we agree with some investment pundits, that, there are indeed cracks showing up in the credit narrative. Some High Yield issuers are already showing some signs that things could indeed turn nasty fast should there be a clear change in the central banking narrative. This could either come from renewed inflationary pressures as we previously discussed or from an exogenous geopolitical factors and there are plenty to think about in these days and ages.  

We pointed out in our last musing that thanks to dispersion, long/short strategies from active managers would be more and more of interest. Clearly the rise in dispersion is not only a sign of the lateness of the credit cycle but as well signs that they are indeed cracks in this long credit narrative. Another indication of "stress concentration was as well highlighted by DataGrapple on the 8th of November on their post entitled "Towards More Stressed Bases?":

"The credit market has been weak over the last few sessions. Credit indices certainly needed to take a breather after their impressive march tighter, but the move was mainly driven by the behaviour of the risk premia of single entities. We have seen a few outsized moves among index constituents, and the biggest were moves wider. The above grapple has many bright red boxes - a red box means the corresponding name has widened over the last 5 trading sessions and the brighter the bigger was the move -, and they represent as many casualties among the corporate population. In the US, the retailers are once again on the move, together with car rental companies and many others that disappointed when they reported earnings. All in all, credit default swaps referencing single entities have widened faster than indices, especially in the iTraxx Crossover and CDX High Yield universe. The basis of CDX HY – the difference between an index quoted value and its theoretical value - is at the widest it has been in a while, and the basis of iTraxx Crossover is now almost flat, while it has been chronically positive - the index protection was more expensive or wider than single name protection - throughout the summer."  - source DataGrapple

In terms of issuer coming into the spotlight, recent equities woes and CDS spread widening surrounding French issuer Altice are of interest when it comes to discussing "stress concentration" on a wider scale for High Yield as an asset class. For the last two years we have been discussing with our good cross-asset friend and occasional contributor about the French issuer Altice. Credit investors tend to look at the credit metrics, ratios at a specific time and so on. Yet, we think they forget about the bigger picture, namely the dynamics within the Telco/Media sector. 

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

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

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

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

"Altice - Devil is in the debt

The background
Since results, there has been a spike in the CDS of Altice - take a look at the chart below for the CDs on Altice LUX. HY analysts say this is a result of credit analysts looking at the equity performance, assuming there must be wrong, and then selling the credit…

Clearly this is something to be concerned about, but to put Altice in the context of some other, albeit smaller, HY issuers - Vallourec, a steel company Exane covers, has had negative EBITDA for the past 3 years and is trading HY credit at 6%!

Altice debt position

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

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

The final debt pool is at Altice Corporate Financing. 

 Figure 2 - Altice Group Debt structure as at 3Q17

Refinancing risk

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

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

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

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

 Figure 3 - Altice Group Maturity Profile

Recent refinancing efforts supportive

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

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

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

What about the US debt?

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

- source Altice

How does one assess the refinancing risk at Altice US, given the recent concerns in US HY?

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

Optimum notes
Senior Notes Acq. - LLC 10.125% 2023 = 112.9 
Senior Notes Acq. - LLC 10.125% 2025 = 120.5 
Senior Notes - LLC 8.625% 2019 = 106.6 
Senior Notes - LLC 6.750% 2021 = 108.4 
Senior Notes - LLC 5.250% 2021 = 97.4 
Senior Notes Corp - LLC 7.750% 2018 = 102.0 
Senior Notes Corp - LLC 8.000% 2020 = 109.2 
Senior Notes Corp - LLC 5.875% 2022 = 100.2 

Figure 5 - Altice USA (Suddenlink + Optimum) net debt/EBITDA progression 

- source Altice

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

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

Variability of interest

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

Figure 6 - Altice variable rate debt

- source Altice

'Funnies' in the Altice debt

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

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

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

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

Overall, maintenance covenant is less flexible than incurrence - Altice has incurrence, which should allay fears also. 

As a reminder, based on our current estimates, there will be no ability to upstream out of Lux until post 2021 - see Lux net debt/EBITDA chart below.

So what's all the fuss about with Altice and debt?

Well, beyond the obvious (i.e. it has a lot of it), the main concern is technical. If the market gets nervous about HY debt, the market for HY is not liquid enough for 'shorts', so a credit trader will look at the largest issuers and most liquid equities, and then short the more equity.

That is why in November/December 2015 that both Altice and Valeant Pharma really suffered. So, we must absolutely keep a look out for increasing nervousness in the HY markets, because that could be a trigger for increasing short activity in Altice." - source Exane

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

We do think that the "micro" pictures seems to indicate in some instances that we are starting to see cracks in the credit narrative with credit investors becoming more discerning hence the rise in dispersion. But, from a "stress concentration" perspective we can easily take some cues from the synthetic CDS markets as pointed out by DataGrapple from their 17th of November blog entitled "That Means Stress":

"This week marked the return of volatility in the credit market, at least on a micro point of view. Indices had their up and downs but the moves were always contained. Peak to trough variations of 15bps – and we have to look at intraday prints to get a double-digit number as daily closes always seem to attract contravariant investors who bring daily moves in check – at best qualify for tempest in a teacup. The real action took place at the single names level, especially in the European high- yield universe. A few corporates have consistently been the focal point of the credit market. ASTIM (Astaldi), ALTICE, SFR, BOPRLN (Boporan) experienced roller coaster rides and they are all closing the week at their recent widest levels. Investors have real concerns about them, and there was a genuine appetite for protection on these names during both the up and downs of the market as a whole. So much so that for the first time in while, the basis of iTraxx Crossover (ITXEX), the index to which they all belong, stayed negative – ie the quoted risk premium of ITXEX was tighter than the sum of the risk premia of its constituents – throughout the whole period. It is what you would expect when ITXEX tightens - indices tend to react faster than single names -, but it is quite unusual when it widens. It is a sign of genuine stress." - source DataGrapple

A positive basis is normal in credit markets. A negative basis is rarely seen. We will be watching closely the evolution of the basis in the months ahead. It is essential on the credit market to follow the basis as the indicator of the liquidity but also as an opportunity of arbitrage. Here is below an illustration of a very negative basis which narrowed back towards more reasonable levels during Q1 2015:

- source DataGrapple

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

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

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

- source Bloomberg

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

- source Bloomberg

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

It would be difficult for us to argue that some parts of credit are very expensive from a valuation perspective, but then again we did indicate in various conversations that we would hit 11 on the credit amplifier in true Spinal Tap fashion. This is due to $11 trillion worth of negative yielding bonds not to mention the recent 3 year French Veolia negative yielding issue just launched. As we put it simply recently, the unabated bid for US Investment Grade is due to TINA (There Is No Alternative), particularly when most of the support for US credit markets is "Made in Japan". For those of you who like to worry while some others prefer to "carry on" in true credit fashion, we would like to point out to Société Générale's Market Wrap-up note from the 20th of November entitled "The credit valuation chart that worries us most":

"Market thoughts

Corporate bonds are typically valued in one of three ways: the yield, the spread to benchmark, and the asset swap levels. On all three bases, global credit currently looks expensive. Chart 1 shows the current yield of a global credit index, made up of the iTraxx USD-denominated, euro-denominated and sterling-denominated IG and HY indices (weighted by the notional amount of the debt).

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

At the start of November, spreads were below the lowest levels seen in mid-2014. They have since bounced slightly above this point but remain very close to multi-year lows.

Spreads to benchmarks are the most important yardstick of value for investors who chose between corporate and sovereign bonds (such as insurance companies, multi-product fixed income investors, or private investors choosing where to allocate their fixed income investments). Banks who swap corporate bonds look at credit on an asset-swap basis, as we do in Chart 3.

Once again, the spread on this basis is tight – slightly below the trough levels of 2014.

There is a fourth way of valuing credit, used by investors who are comparing corporate bonds to governments. This is the spread to benchmarks as a percentage of yield, which we show in Chart 4 above. Once again, the numbers do not look good. The rise in yields and fall in spreads has driven the global ratio of spreads to yields from a peak of 2.1 in the summer of 2016 down to less than 1 now, broadly in line with the 2014 summer tights.

So credit is expensive more or less any way you look at it. The data that worries us the most, however, is shown in Chart 5, i.e., the one-year break-evens on global credit. The falls in duration and spreads have conspired to push the break-even well below the trough levels of 2014.

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

- source Société Générale

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

- source Pitchbook

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


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

• Final charts -  Oh My God! They Killed Volatility and brought instability...

Back in July 2017 in our conversation "The Rebound effect", we argued the following:

"One could easily opine that the biggest effect from overmedication from our "Generous Gamblers" aka our central bankers, has been the disappearance of volatility thanks to financial repression. As our tongue in cheek bullet point reference to the old South Park catch phrase, one might wonder if this low volatility regime will end, now that the narrative has been more hawkish somewhat as per our recent conversation "The Trail of the Hawk".

In similar fashion to Le Chiffre, aka Mario Draghi from the ECB, Janet Yellen has as well steered towards "Credit mumbo jumbo", which has had a much vaunted "Rebound effect", at least for US equities. Yet Janet Yellen's "rich" valuation word has been totally ignored by the leveraged and carry crowd, particularly in European High Yield seeing as well not only record issuance numbers but also loose covenants and record tight credit spreads." - source Macronomics, July 2017

Some of us have been mesmerized by the low volatility regime which has been slowly killing the "macro" hedge funds returns in recent years. The low volatility regime has not only been a VIX or a MOVE index story. It has also been the case in various asset classes as indicated by Bank of America Merrill Lynch in their presentation from the 6th of November entitled "Why volatility and alpha have disappeared" where they show that low volatility is not merely a US equity phenomenon:

"Low volatility is not merely a US equity phenomenon; has been pervasive across asset classes and globally in 2017 apart from FX

Since 2014 markets across asset classes have also set multidecade records for instability

The physics of a depressed volatility and alpha-starved market; Low conviction, crowding and high fragility ~ not “fake news”

- source Bank of America Merrill Lynch

While we recently mused that gamma hedges in credit were cheap, while credit remains an attractive carry trade in this long in the tooth credit Goldilocks scenario, it's not only in the VIX that there has been systematic selling of volatility for income. The game has also been played in the credit world. In the current environment, Credit payers and Gold calls screen as best value tail hedges. We agree with Bank of America Merrill Lynch, record gold/real rates correl creates value in owning gold or gold miners upside to hedge political and geopolitical uncertainty which by the way is rising by the day. We reminded ourselves to what Janet Yellen at the Fed said in September 2016:

  "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016

If asset values aren't out of line with historical norms volatility certainly is from a "stress concentration" perspective, no wonder she decided not to stick around too long at the Fed, but we ramble again...

"The seed of revolution is repression." - Woodrow Wilson

Stay tuned!

Macro and Credit - The Trail of the Hawk

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato

Watching with interest the change in the narrative from our "Generous Gamblers" aka central bankers, leading to some rise in sovereign yields, when it came to selecting our title analogy, we reacquainted ourselves with Nobel Prize-winning novel 1915 "The Trail of the Hawk" by Sinclair Lewis. He was the first American writer to win the prestigious award. It is the fictional story of the life of Carl "Hawk" Ericson, from rural Minnesota. He begins his amazing career as a stunt pilot in the early years of aviation. As his friends and colleagues meet tragic ends, he realizes there must be a better way to use his life. His path is highly non-linear; he tries an assortment of opportunities (ZIRP, QE, NIRP). Fearing the mortal dangers of flying, maybe like Icarus who flew too close to the sun, at some point the hero Carl "Hawk" Ericson decides to retire to avoid the fate of his friends and colleagues. In similar fashion, it seems to us that our "liquidity" providers of recent years have decided to "retire" as of late, hence the recent small turmoil seen in the Government bond markets. 

In this week's conversation, we would like to look at other signs that the credit cycle is indeed in its last inning with the return of Jumbo leveraged deals and other cautious signs.

Synopsis:

• Macro and Credit - Credit mumbo jumbo
• Final chart - Compensation costs and interest costs are not as in sync as they were in previous cycles.

• Macro and Credit - Credit mumbo jumbo

Whereas "mumbo jumbo" is a language or ritual causing or intended to cause confusion or bewilderment, the latest U-turn taken by the ECB following Le Chiffre's comment (aka Mario Draghi) ties up nicely with the definition which is confusing or meaningless language. The phrase is often used to express humorous criticism of middle-management and civil-service doublespeak (or central bankers):

"The current context where global uncertainties remain elevated, there are strong grounds for prudence in the adjustment of monetary policy parameters, even when accompanying the recovery. Any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure," - Mario Draghi

What could be a better definition of "Credit mumbo jumbo" after vice president of the ECB Vitor Costancio suggested market participants had read too much into Draghi’s comments, and that they should not be considered a hawkish shift in language we wonder? But, as we have seen, as of late, it's not only the Fed that is on "The Trail of the Hawk", it seems the Bank of England and others are on a similar pattern.

While we have indicated in our past musings our growing 2007 feeling, with tighter spreads, higher leverage, clearly the returns of significant large deals in the LBO (Leverage Buy-Out) space is a clear reminder of the lateness in the credit cycle. LBOs are definitely a sign and we agree with DataGrapple's recent blog post on this subject on the 29th of July entitled "Jumbo Leveraged Deals Are Back":

"Roughly a year ago, SPLS’s (Staples Inc) attempt to buy ODP (Office Depot Inc) for $6.3Bln was thwarted by antitrust regulators. A tough year ensued after its CEO stepped down, during which the company scrambled for a plan B, closing stores and seeking to recast itself as a source of business services. It looks as if these transformation efforts seduced Sycamore though. They announced yesterday night that they are ready to bid $6.9Bln to buy SPLS in what could be the largest LBO announced this year. Even though a deal had been rumoured for some time – it was reported in May that a takeover offer from Cerberus had been rejected because it was too low -, investors initially sent SPLS’s 5-year risk premium soaring 50bps wider at 350bps, as such deals inevitably mean more debt. But soon it transpired that Sycamore, in a similar move to what it did when it bought Jones Group in 2014 and split it in 4 different independent operating companies, could divide SPLS into three different entities: US retail, Canadian retail and corporate-supply business. It inevitably raised the question of where the debt will sit and which entity (or entities) CDS currently referencing SPLS will cover. The answer is not necessarily the most leveraged. The CDS gave up all its widening and more, to close 25bps tighter on the day at 272bps." - source DataGrapple

At the same time we hear that Apollo Global Management has raised $23.5 billion for the largest buyout fund ever.  Blackstone's fund raise of nearly $22 billion in 2007 was near the top of the previous bull market as a reminder. For us this is another sign of the lateness in this credit cycle and no this time it's not different rest assured.

This is what we wrote about the return of LBOs in 2013 in our post "For whom the Dell tolls":

"In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fueled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 
The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  Energy Future Holdings was loaded with 37.4 billion USD worth of obligations whereas Texas Competitive was saddled with 32.2 billion USD in debt, 700 million USD of which was due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 
KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp moved towards bankruptcy and restructuring 
Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council." - source Macronomics, 2013

As a reminder, during the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news.

There lies the crux of the current tactical issue, leverage has been creeping up in US investment Grade and High Yield is facing headwinds thanks to rising oil woes, which is triggering some fund outflows as of late, including the feeble ETF retail space. Now as a credit portfolio manager, you probably want to dust out your LBO screeners. Not only are central bankers with their mumbo jumbo lingo triggering heightened volatility in government yields, but there are indeed potential sucker punches awaiting credit investors with the return of the 2007 LBO trend. In relation to the US Investment Grade Outlook we read with interest Wells Fargo's take on the subject in their latest outlook note entitled "Hoping for Carry":

"U.S. Investment Grade (IG) corporate credit spreads are currently close to the tights of the year (112 bps) but remain within our expected target of +/-10 bps this year. A healthy rally at the beginning of the year has given way to a steady ‘lo-vol’ grind as credit spreads remained in an 8 bps range over the quarter. The benefit of last year's aggressive loosening of global monetary conditions has started to fade, while hope for a meaningful fiscal stimulus in the U.S. has been tempered as well. That said, credit fundamentals appear to have stabilized as corporate profitability has improved. Looking forward, we expect the current environment of ‘lo-vol’ carry to continue with few macro catalysts on the near-term horizon. However , the trajectory of spreads could become more choppy as the summer ends and monetary and fiscal policies return to center stage. Over the course of the year, we expect the YTD range to hold for credit spreads with IG +/- 10 bps and HY +/- 50 bps, but in the near term, the grind should continue . To position portfolios, we recommend credit investors stay fully invested to capture as much carry and residual spread compression as possible, but also strongly recommend moving up in quality where possible to minimize a big macro beta bet and instead focus on more micro trades to drive outperformance. To do so, we recommend remaining Market Weight in IG and prefer to focus on sector and curve strategy.

Fundamentals: IG companies continue to run historically high levels of leverage with Non-Financial debt/EBITDA of 3.0x. Q1 earnings came in well ahead of expectations, marking the best earnings season since 2011, and strong earnings growth is expected to continue over the balance of the year. However, while earnings are rising, debt is also rising at a rapid clip, particularly for the lower beta portions of the market. As a result, overall Non-Financial leverage remains unchanged as leverage ex-Energy is expected to converge toward Energy over the balance of the year.

Technicals: Demand for IG continues to be robust in H1 2017 with record inflows to IG mutual funds and ETFs, pushing up total assets in IG mutual funds to $2.0 trillion. IG bond issuance has similarly clocked a record pace in H1, but the slowdown in Q2 from Q1 has allowed spreads to continue to grind tighter. Foreign demand has been choppier this year as the cost to hedge USD fixed income positions remains high and the USD has started to weaken. Looking forward, we expect slightly less technical support in 2017 versus 2016 as monetary policy moves tighter and foreign flows decelerate.

Valuations: The current spread level of 112 bps is through our year-end spread target of 120 bps. With expectations of modest widening, but still positive excess returns, we believe chasing beta is a low-quality trade and recommend investors move up in quality to take advantage of currently compressed valuations. We favor curve flatteners at the long end as we expect rates to end the year above today’s levels, while we favor curve steepeners at the front end to take advantage of historically flat curves." -source Wells Fargo

We keep repeating this but in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. In our January 2014 conversation "Actus Tragicus" we indicated that the end of low interest rate volatility would end the "goldilocks" period for Investment Grade credit. We therefore think that rather than being focusing your volatility attention towards the VIX index, you should switch your attention towards the MOVE index we discussed in our previous conversation:

"Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)." - Macronomics, January 2014.

As noted above for leveraged and carry players, namely the "Beta" crowd, interest rate volatility matters, particularly the "Risk-parity crowd". From a positioning perspective in an environment impacted by dwindling liquidity and rising "convexity" risk from both a duration and credit quality perspective, we believe in a defensive position in H2 on US investment Grade, meaning lower duration exposure in credit as well as higher credit quality given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication". Investors have had no choice but to take on more credit risk hence and what we have called in the past a credit "mousetrap". Recently we indicated that tactically going for duration again particularly in credit has been paying off nicely (MDGA - Make Duration Great Again). This positioning has been vindicated as shown in the below chart from Wells Fargo US Investment Grade Outlook note showing that IG 10 years + has been outperforming:

- source Wells Fargo

Why the advice to continue playing defense in H2 and reduce duration? Not only inflows and new issues have been very significant but, as per the below Wells Fargo chart, duration risk is at all-time high:

- source Wells Fargo

So far, with the latest gyrations in sovereign spreads thanks to "The Trail of the Hawks" has been contained in the Investment Grade space, yet, with a potential return of Interest Rates volatility, one would be wise in the current context to dial down a bit his duration exposure we think. 

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk significantly as per the above Wells Fargo chart, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series. Durations have continued to extend thanks to lower coupons so to fully hedge out a market-based cash portfolio with 7.5 years of duration, you would require an extra 60% of protection to result in a CR01 neutral portfolio. This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if one wants to be "duration neutral" that is. So if indeed "The Trail of the Hawk" is the new mantra for our central bankers, not only you need to reassess your beta exposure credit wise, but, given the renewed pressure on High Yield outflows thanks to pressure on oil prices, you might as well need to rethink about "Gamma". On this subject we agree with DataGrapple post from the 28th of June entitled "Gamma or Theta?": 

"In the morning, investors appeared to be reappraising the outlook for global borrowing costs and monetary policy in the wake of the comments from the usually dovish Mr Draghi. Global central bankers are coalescing around the message that the cost of money is headed higher. These concerns about tighter monetary conditions were compounded by remarks by Mrs Yellen yesterday that asset valuations look high by some measures, another global cyber-attack, an IMF cut to their US growth forecast. As a precautionary measure, iTraxx Main (ITXEB) was sent 1.5bps at 56.5bps, iTraxx Crossover was sent 6bps wider at 244bps, and all risky assets felt a bit shaky. That proved too much for the ECB to handle and they felt they had to say markets had misjudged Mr Draghi speech on stimulus. It certainly produced the desired effect, and risky assets went in reverse across the board. So, for the first time in a while, volatility has reared its head again, with investors able to capture a 4bps total variation on ITXEB today. The potential for tape-bombs to rock the market is now clear to everyone. That leaves options players conflicted between owning cheap gamma and having positive theta for the US holiday week-end coming up." - source DataGrapple

So if you think that on top of LBOs bombs falling in Investment Grade, you might fell prey of the hawks' latest mumbo jumbo, you might want to think about owning indeed cheap gamma. You might enjoy the low volatility regime providing you so far a "Goldilocks" scenario for credit, but should you want to play it safe through "Gamma" rather than being negative carry through a straight purchase of CDS indices, then you might want to look at credit options given they are still relatively cheap to own as displayed in the below table from Barclays CDS Index Options note from the 27th of June:

- source Barclays

As per the above, even in credit, spot volatility has been trending down, mist likely thanks to the relentless hunt for yields and Structured Credit players continuing to sell protection and hitting the bid of market-makers in the process as discussed recently.

As we have indicated in recent musings, there are many late credit cycle similarities to the 2007 period with credit spreads tightening, low volatility and renewed structured credit activity, with investors extending both credit risk and duration risk. There is as well on "The Trail of the Hawk", tighter monetary policy and a flatter yield curve typical of late economic expansion. Yet as per our final chart below, there is something different this time around, which is that compensation costs and interest costs are not in sync. 

• Final chart - Compensation costs and interest costs are not as in sync as they were in previous cycles.

As we concluded above, there is something puzzling in the current late credit cycle, namely that compensation costs and interest costs have been diverging, which remains an oddity. Our final chart comes from Société Générale American Themes note from the 29th of June entitled "US recession odds remain extremely low but concerns are growing". The chart displays the net margin expenses for US companies which in this current late cycle are not behaving like in previous cycles:

"One item different than previous cycles – Net interest margins remain low

We highlight the evolution of profit margins in a business cycle. Importantly, margins are getting squeezed due to labor compensation. We would be remiss not to point out the benign nature of net interest margins.

Net interest margins typically climb during the late phase of a business cycle. At present, we are not seeing that pattern. Low interest rates are restricting interest expenses despite heavy debt issuance.

Limited tightening from the Federal Reserve is keeping a lid on interest costs for US companies. If we are in the later stages of a business cycle, interest rate expenses are behaving in a different fashion than previous late-cycle periods. Conversely, the lack of interest expense pressures reduces the odds that the US economy is in a late cycle.

Tighter Fed monetary policy is a feature of many late economic expansions. In June, the Fed hiked rates for the fourth time in the current business cycle. The amount of tightening is low, the 10y Treasury yield is lower than it was when the Fed first hiked rates (December 2015), and credit spreads are mostly tighter. Do profit margins or interest costs matter more for the investment decision? The charts above offer some glimpse into a method of answering this question. Businesses seek profits and bear costs, such as interest expenses, to the point that margins justify the investment. The current period is unique in that compensation costs and interest costs are not as in sync as they were in previous cycles.

Debt stresses may be materializing despite restrained interest costs. Notably, we are seeing rising delinquencies in auto loans and rising charge-off rates for consumer credit. Further, the Fed’s Loan Officer Surveys show slowing credit demand and some instances of more restrictive credit. These debt features may be signs of stress not evident in issuance volumes or credit spreads." - source Société Générale

To paraphrase Bastiat, there is always what you see and what you don't see. Today the Treasury curve is the flattest it has been since March 2008. No doubt to us that the Treasury yield has had an historic accuracy. Additional rate hikes will increase the flattening on "The Trail of the Hawk". Also as we pointed out recently consumer credit recent weaknesses are a cause for concern and we are increasingly monitoring this space. If profit margins continue to shrink like they did through 1Q2017 to 12.5%, the lowest level since 2011, you could get your double whammy. The Trail of the Hawk might be tortuous but is nonetheless treacherous.

"To be interested in the changing seasons is a happier state of mind than to be hopelessly in love with spring." - George Santayana

Stay tuned!