Macro and Credit - The Woozle effect

"When everyone is thinking the same, no one is thinking." - John Wooden, American basketball player and coach

Watching with interest more fake news such as more stories surrounding evidence by citations of Russian involvement in US elections and fake prices, leading to some violent market gyrations as in Bitcoin, given our last musing around the thematic of hoaxes, we decided that for this week's title analogy, we would stick with the theme. The Woozle effect, also known as evidence by citation, or a woozle, occurs when frequent citation of previous publications that lack evidence misleads individuals, groups and the public into thinking or believing there is evidence, and nonfacts become urban myths and factoids. More importantly, "The Woozle effect" describes a pattern of bias seen within social sciences and which is identified as leading to multiple errors in individual and public perception, academia, policy making and government and markets as well (herd mentality). A woozle is also a claim made about research which is not supported by original findings. Given the creation of woozles is often linked to the changing of language from qualified ("it may", "it might", "it could") to absolute form ("it is"), we found interesting that the "Trumpflation story" has suddenly morphed from "it may" to "it is". To some extent, the Woozle effect is yet another example of confirmation bias we think. People tend to interpret ambiguous evidence as supporting their existing position. A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work re-interpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way. Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts but, also in financial markets. As we have often indicated in our past musings, our contrarian stance comes from our behavioral psychologist approach given we would rather focus on the process of the woozles rather than their content. In our last musing, for instance we indicated we had turned slightly more positive on gold and gold miners alike. We must confess we have been adding in late December.

In this week's conversation we would like to discuss our contrarian stance surrounding "Mack the Knife" aka King Dollar + positive real US interest rates and why we think that eventually "Trumpflation" could morph into "DeflaTrump", meaning a lower dollar thanks to that 30s model we discussed as of late,  namely that populism and discontent means we are potentially facing a global trade war with the rise of protectionism.

Synopsis:

• Macro and Credit - All the promises we've been given...
• Final chart - The central bank "put" has been weakening

• Macro and Credit - All the promises we've been given...

From a Woozle effect perspective, we find it very interesting how easy weighing up the costs of being wrong leads to overconfidence.

We might sound a bit philosophical in these early days of 2017 but, we do share Jim Chanos and Steen Jakobsen, that we are going to see some tectonic shifts.

These shifts will have some significant consequences in terms of allocations rest assured. You might be wondering why we have entitled our bullet point this way? Well as goes the lyrics for an Electro House song we like "All the promises we've been given", government and central bankers have been very good at promising:

"All the promises we’ve been given
All the fires that we’ve feedin’
All the lies that we’ve been livin’ in
Wouldn’t it be nice if we
Could leave behind the mess we’re in
Could dig beneath these old troubles return
To find something amazing" - The Presets - Promises

This is somewhat the "Trumpflation" story playing out. Unfortunately, we cannot leave the mess we are in thanks to so many years of lax policies, lies and fires which our central bankers have been feeding. But, there is more to it. and at this juncture, we would like to remind ourselves with our November 2013 conversation entitled "Squaring the Circle" in which we tackled the paramount issue between "explicit guarantees" and "implicit guarantees":

"We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference." - source Macronomics, November 2013

And this is the great swindle politicians have been pulling selling entitlements based on "implicit" guarantees rather than "explicit" ones. Let us explain, the developed world is awashed in unfunded liabilities, therefore "it may" has for so many people clinging to their pension benefits has become "it is". The woozle effect in that case is that many think that what is in reality clearly "unfunded" is "funded". It isn't. 

While everyone is focusing on the asset side of the "Trumpflation" story (lower corporate taxes, cash repatriation, etc.), no one has really been focusing on the liability side, which could have some important implications. What has been weighting so much on bond prices since the US election has been once again the Japanese investors crowd. Again what we indicated back in 2016 in our conversation "Eternal Sunshine of the Spotless Mind", still holds in 2017, namely that you want to track what these investors are doing flow wise:

"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"- source Macronomics July 2016

On this subject we read with interest Bank of America Merrill Lynch's Japan and FX Watch notes from the 12th of January entitled "Japanese investors sell foreign bonds after US election":

"Surplus structure keeps yen in check

Japan's Ministry of Finance today released the November international balance of payments and a preliminary portfolio investment report for December. Japan’s current account stood at a ¥1.8tn surplus in November to match the recent trend (Chart 3).

We are seeing a gradual recovery in Japan’s real exports, which seems in line with the positive cyclical trend in global manufacturing. Oil imports have stabilized, but remain low. Outward direct investments exhibit structural strength, but the yen’s significant depreciation since the summer suggests “tactical” large-scale purchases of foreign companies (eg, Softbank buying ARM) are probably behind us for the time being (Chart 4).

The BoJ’s yield curve control has widened the yield gap between foreign and yen rates, which should support Japan’s thick income surplus. Overall, the surplus structure marginally stabilizes the yen’s move especially as Japanese investors first reacted to the US election by selling foreign bonds (Chart 2).

Trump shock led to foreign bond sale

In December, Japanese banks and lifers sold ¥1.48tn of foreign bonds, the biggest sale since June 2015 amid the Bunds tantrum. This is in line with our view given the rise in volatility in the US and the likely loss from the move in rates after the election. Details are yet to be reported, but we would assume this is a continuation of November where most of the sales happened in the US rather than Europe (Table 1).

Given our core view in the US remains bearish duration while the BoJ’s monetary policy helps keep JGB yields relatively low, this likely leads to some repatriation of Japanese money to the JGB market, which explains the rise in JGB purchases at both banks and lifers in November.

Pensions rebalance into bonds, out of equity

In Oct-Dec, trust accounts–represented by pension accounts–sold domestic and foreign equities and bought JGB and foreign bonds (JGB data up to November) (Chart 6).

In our view, the GPIF portfolio is close enough to its target that large moves in financial markets would lead to rebalancing activities where appreciating assets are sold and depreciating assets are bought, reducing market volatility at margin.

Flows may keep USD/JPY basis from widening for now

Meanwhile, foreign investors net-sold ¥123bn of JGBs in December. This most likely resulted from quarterly redemption of JGBs as a data from the JSDA, which excludes redemptions, shows foreign investors were net purchasers for a 29th straight month in November. We argued that tightening in USD/JPY basis spread is unlikely to become a trend, but a combination of cautious Japanese investors in foreign bond investment (and some repatriation into JGBs) and demand from foreign investors for JGBs will keep the USDJPY basis off the high seen in November for a while." - source Bank of America Merrill Lynch

So, from a "flow" perspective, no matter what the latest woozle is, namely the "great rotation" from bonds to equities pushed forward by many pundits, when it comes to Japan, not only the voracious foreign bid from Japanese investors has tempered it's pace, but if indeed, Japanese are more cautious about their foreign allocations, then indeed this will put some additional upward pressure on sovereign bond yields we think.

For the time being, the dollar woozle is still working its way, being the largest consensus trade around for many pundits, also for the likes of Deutsche Bank from their FX Blueprint note entitled "King Kong Dollar" from the 12th of January:

"King Kong Dollar

The most prominent theme in our 2017 FX blueprint is that a Trump presidency changes everything. The US economy is the 800-pound gorilla in the room – policy shifts are too important to not matter for global FX. Our overall assessment is that Trump will be highly supportive of the dollar. Whether this mostly happens against the low-yielding EUR and JPY or EM FX will depend on the policy mix that is delivered: greater emphasis on growth and the euro and yen will suffer most; greater trade protectionism and EM, particularly Asia, will bear the burden. Either way, the broad trade-weighted dollar should strengthen, with a Trump administration coming at a convenient time for our medium-term bullish view. First, the greenback has finally entered the ranks of a G10 FX top-3 high-yielder, an important driver of dollar appreciation in the past. Second, a rally that is front-loaded to the beginning of a Trump presidency fits in nicely with the mature stage of a typical 7-10 year dollar up-cycle.
It is tempting to only talk about President-elect Trump, but currency drivers run beyond the US. From Brexit to European elections and China’s ongoing battle with outflows, politics and de-globalization stand out as the broader FX drivers of 2017. In most instances, particularly in Europe, idiosyncratic stories provide further support to a bullish dollar view. In other cases, local drivers allow for useful diversification against dollar longs, with ZAR, RUB and IDR standing out in particular. 2017 promises to be another exciting year for FX.

Looking for the dollar catalysts

We see Trump’s Fed appointments and corporate tax reform as the most important drivers of the dollar in 2017. Four out of seven board nominations are due this year, including Yellen’s replacement. These are likely to lean hawkish and entirely reshape the Fed. Corporate tax reform may well mean lower rates, but far more important would be an imposition of a “border tax” –potentially the biggest shift in global trade since Bretton Woods and leading to a big US competitiveness gain. Beyond America’s shores, idiosyncratic drivers point to a stronger dollar against both the JPY and EUR. In the Eurozone, negative surprises in either the French or potential Italian election open up existential risks. Even if all goes well, the beginning of ECB taper could accelerate record portfolio outflows: wider spreads (and redenomination risk) and more volatility in bunds should further lower demand for European assets. Japan stands out for the opposite reasons: political stability will allow the BoJ to continue targeting JGB yields unhindered, further increasing policy divergence with the US. We expect EUR/USD to break parity and USD/JPY to approach its all time-highs this year.

It’s all about Trump’s tax policy

While most attention is focused on US fiscal stimulus, we think corporate tax reform stands out as the biggest positive driver of the dollar in 2017. Lower tax rates, border adjustments and a tax holiday on unrepatriated earnings all matter. Border adjustments would impose a 15-20% tax on all US imports while exempting export income from taxation. The policy would amount to a 15% backdoor competitiveness gain for the US economy. A mechanical application of trade elasticities would imply that the US basic balance would go back to the highs seen at the start of the
century (chart 1).

A tax holiday and shift to a territorial system of taxation would allow more than $1 trillion of dollar liquidity and $200bn of annual future earnings to be brought back to the US. Most of this cash is already in USD: but the withdrawal of offshore liquidity will maintain widening pressure on cross-currency basis pushing offshore dollar yields higher. Corporates are likely to use the liquidity for buybacks and dividend hikes which together with corporate tax cuts would encourage equity inflows and further support the dollar. With foreigners not having invested in US equities for the last five years, there is plenty of potential for foreign buying of the S&P (chart 2).

- source Deutsche Bank

Like any woozle, while the above narrative is enticing, we are not buying it. Equities pundits like to focus on the asset side, such as the impact of corporate tax rate mentioned above, we credit pundits tend to focus on the liability side which means that rather than focusing on the corporate tax relief effect we would rather side with our friend Michael Lebowitz from 720 Global from his latest note "Hoover's folly" from the 11th of January and focus on Global Trade risk, Hoover's style:

"Ramifications and Investment Advice

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.
If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.
From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. 

Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016

This makes perfect sense and as we indicated earlier on, we have become more positive on gold / gold miners in late December for that very reason. As we pointed out in our November conversation "From Utopia to Dystopia and back" the trade attitude of the next US administration is the biggest unknown, and the biggest risk we think. In this previous conversation we showed in our final chart that gold could indeed shine after the Fed and guess what it has:

"Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again." - source Macronomics, November 2016

So if indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar. This is a point put forward by Nomura in their FX Insight note from the 5th of January entitled "The weak dollar revolution could be tweeted":

"Weak dollar policy is a natural extension of protectionist policies

Clearly, the one area of trade policy that has been so far little discussed is FX policy. In a detailed interview on 30 November 2016, soon-to-be Treasury Secretary Steve Mnuchin evaded a pointed question on whether he supports a strong dollar. Instead, he responded:

“I think we’re really going to be focused on economic growth and creating jobs and that’s really going to be the priority.” (CNBC, 30 November 2016).

FX policy cannot be ignored in trade policy. A weak currency can be effective in giving domestic industries an advantage over foreign industries. Indeed, this has generally been the policy of emerging Asia economies from China to Thailand. Their substantial growth in FX reserves since the Asia crisis in 1997 is testament to a concerted policy to curb strength in their currencies. For Donald Trump, at a fundamental level, any appreciation of the dollar would offset some if not all of any import tariffs introduced.

As for the practicalities of introducing a weak dollar policy, the Plaza Accord of 1985 under a Republican administration is the last such example. However, it was coordinated with key trade partners and monetary policy was moving in a supportive direction. Replicating such an Accord would be a gargantuan task. The other precedent of sorts is the Nixon shock – again under a Republican administration. This was a unilateral move and involved both a currency devaluation and the imposition of import tariffs.

However, the better reference points may actually be emerging markets. They have pursued weak currency policies without coordination and often at odds with domestic monetary policy. Admittedly, the presence of capital controls makes it easier to separate FX and monetary policy (thereby overcoming the so-called Triffin dilemma).

The success of their policies has often hinged on the scale of their interventions whether through direct currency intervention or sovereign wealth fund purchases of foreign assets. One study featuring 133 countries over the past 30 years found that such state-directed outflows were a significant positive driver of the current account (i.e. pushed it into surplus)9. An IMF study featuring 52 countries (13 advanced and 39 emerging) from 1996 to 2013 found that currency intervention had a larger and more significant impact on exchange rates than interest rate differentials10.

It should be noted that Japan, which has been the most active G7 intervener in currency markets, has typically engaged in sterilised intervention. That is, intervention that would not affect domestic money supply (and so not impact monetary policy). Studies have shown that Japanese intervention has at times been successful even though it was sterilised. Moreover, one study by former Deputy Vice Minister of Finance for International Affairs, Taktatoshi Ito, showed that FX intervention over the 1990s, which was predominantly uncoordinated with other countries, resulted in a profit of JPY9 trillion ($75 billion). This showed that the MoF was buying USD/JPY at the lows and selling at the highs11. Therefore, there could be nothing to stop the US engaging in FX intervention to weaken the dollar. " - source Nomura

It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier.

What appears to be clear to us is that the Woozle effect from a central banking perspective has been fading as shown below in our final chart.

• Final chart - The central bank "put" has been weakening

What has clear in recent months has been rising signs of the Woozle effect fading when it comes to central banks credibility. With rising populism, which in recent ways has been driven by central banking interventionism, there are growing indications that the cosy relationship between politicians and central bankers is getting tested. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 9th of January entitled "Yielding to populism" and displays how the central bank "put" has been weakening:

"Yielding to populism

We expect to return frequently to the theme of “populism” as 2017’s big narrative. For credit investors, populism doesn’t have to be all bad news. As our US credit strategy colleagues have highlighted, potential Republican tax reform could be very beneficial for some parts of the US market. In Europe, though, we worry that populism will manifest itself in two bearish ways this year: a weaker ECB “put” (read: weaker credit technicals), and rising political risk, which we believe is not reflected in European spreads.
Thus, while Euro corporate bonds have nudged tighter in the first week of 2017, with reach for yield behaviour still evident, we think Euro spreads stand to end the year wider. We look for the Euro high-grade market to finish the year 15bp-20bp wider than today’s levels, and for high-yield spreads to end 50bp wider (applying some tweaking to our Nov ’16 forecasts given the big high-yield tightening in December).

Draghi’s populist moment

In our view, Dec 8th 2016 should be seen as a game changing moment for Euro credit markets. We think the ECB yielded to another form of “populism” – namely pressure from a hawkish governing council to step away from the negative yield era, given undesirable side effects. So from April this year, ECB monthly QE buying will decline from €80bn to €60bn.

But we think that Draghi’s actions highlight a bigger story: namely that the central bank “put” (or influence on the market) is already showing signs of weakening. Chart 1 shows cumulative central bank asset purchases including EM FX reserves (which we think should be viewed as another form of QE buying). Note the peak in September last year, due to declining EM FX reserves (such as China). 

But in 2017, we know that the ECB is set to tone down its asset buying, and we also expect the BoE to stop buying gilts and corporate bonds once their respective targets have been reached (which we estimate to be in February ’17 and April ‘17, respectively). A weakening influence of central banks therefore means a weakening of the very strong technicals that have been asserting themselves on European fixed-income markets."

- source Bank of America Merrill Lynch

From a credit tightening perspective, we think you ought to monitor US Commercial Real Estate (CRE) because as reported by UBS in their latest US Credit Strategy Outlook for 2017, CRE nonperforming loans are likely to rise for the first time since 2010 and monthly CMBS deliquency rates were up 6 bp to 5.23% Y/Y in December. Bank loan officers have started to tighten lending standards since the first quarter 2016. US CRE is therefore something you want to keep a close eye on 2017. If the equity crowd are indeed the eternal optimist and suckers for the Woozle effect, the credit crowd is often the eternal pessimist, but then again, regardless of the narrative, as indicated above, in a world stifled by very high debt level, both duration risk and credit risk have been clearly extended meaning that price movements like we have seen in the Energy sector in 2016 are larger. When things will turn nasty at some point, recoveries this time around are going to be much lower, so forget the assumed recovery rate of 40% when you price your senior CDS but, that's a story for another day...or year...

"Every swindle is driven by a desire for easy money; it's the one thing the swindler and the swindled have in common." - Mitchell Zuckoff, American journalist

Stay tuned!

Macro and Credit - Tangerine Dream

"I don't know where I'm going from here, but I promise it won't be boring." - David Bowie

Looking at the continuing pressure on the Chinese currency, with Hong Kong's yuan interbank rates rising to record highs (overnight rate at 66.82%), and the on-going heightened volatility in various asset classes, we thought this week we needed a dual reference for our title analogy. "Tangerine Dream" is a symbol of false perception of reality, when the situation in the eyes of a person is seen very differently than it is in reality. "Tangerine Dream" is also a German electronic music group founded in 1967 by Edgar Froese who died one year ago, on the 20th of January. For eighties buff like ourselves, you might remember their seminal title "Love on a real train" from 1983 classic "Risky Business", a prominent feature of today's markets, because the movie covered the following themes materialism, loss of innocence, coming of age and capitalism. We could have gone for another musical analogy such as "Under pressure" featuring the maverick David Bowie, that just departed, but, that will be for another time.

When it comes to our "Tangerine Dream" title analogy and markets, if in a dream you are eating a tangerine, it is a sign that in reality the situation is much more complicated and serious than you could have imagined which the case is today. In this case, you should only blame your excessive credulity in relation to central bankers. Therefore it is necessary to percept the events with your own point of view, and not with someone else's (or your usual sell-side analyst); you need to learn how to think and reason independently (like we do) and forget about the "herd mentality" that prevails often in overcrowded positions and markets. Given peak tangerine season lasts from autumn to spring, there is indeed plenty of opportunities for you to eat "tangerines" or dream you are eating "tangerines", but we ramble again...

In this week's conversation, we will look at some of the implications of the troubles in China from a creditor's perspective, given we think many pundits are having a "Tangerine Dream" when it comes to assessing the Asian corporate bankruptcy regimes. We will also look at why size matters in the credit markets and how to mitigate "liquidity" issues from an issuance perspective.

Synopsis:

• The "Tangerine Dream" in the Asian corporate bankruptcy regimes"
• Credit - Want to mitigate liquidity issues? Size matters
• Final chart - As in the US the distressed ratio in European High Yield is also rising

• The "Tangerine Dream" in the Asian corporate bankruptcy regimes"

Many pundits have been "speculating" whereas we have "Small Trouble in Big China" or "Big Trouble in Little China" (yet another 80s movie reference...) as we move from the Year of the Sheep towards the Year of the Fire Monkey. According to Chinese Five Elements Horoscopes, the "Monkey" Chinese sign contains Metal and Water and Metal is connected to gold (no surprise therefore to see a comeback of the precious metal as of late). "Water" is connected to wisdom and danger. Therefore, according to Chinese beliefs, we will deal with more financial events in the year of the Monkey. The Monkey is a smart, naughty, wily and vigilant animal. And, according again on the Chinese Zodiac forecast for 2016, if you want to have "good returns" for your money investment, then you need to "outsmart" the Monkey. Also, according to the same prediction, "Metal" is also connected to "Wind". That implies the status of events will be changing very quickly, hence the clear return, of "volatility" and plenty of "risk reversal" opportunities as we posited recently in our musings.

But, if indeed we are bound for "Big Trouble in Little China", then from a creditor's perspective it is highly relevant to assess the prospects for default and recovery value when the worst could be happening. 

It is, therefore paramount we think, that, "Tangerine Dreamers" focus on the bankruptcy regimes governing specific countries rather than rely on a false perception of reality. From a default and recovery value perspective, we read with interest Bank of America Merrill Lynch's Asian Strategy note from their 8th of January entitled "Default and recovery: What are the prospects when the worst happens?":

"What is the historical recovery experience for bond defaults?

We analyzed default and recovery data for 117 bond default cases by 105 issuers between 1997 and 2015 across ten countries. Of the 117 bond recovery cases assessed, 63 were straight bond defaults and 54 were convertible bond defaults. There is not a huge difference in terms of recoveries for the two bond types although country mixes differ. The results show an average recovery rate of 36%. Looking at unsecured recoveries from 2009, at a recovery rate of 43% Asia compares favorably versus recoveries from other regions including the US. This may come as a surprise considering 74% of our data comes from defaulted companies in China, India and Indonesia where legal systems are not considered particularly creditor friendly.

What factors impact recovery rates?

There are many factors which can influence the level of recovery that investors will get in a default scenario. Seniority and security are the two most important factors. On a macro level, low recoveries tend to be correlated with wide credit high yield spreads, higher default levels and when GDP growth and stock market returns are low.

The type of event precipitating default will also strongly impact recoveries. Other factors which we believe are relevant in Asia include complexity of group structure, management willingness to work with creditors and differences across legal jurisdictions. For more on the legal frameworks pertaining to insolvency, bankruptcy and restructuring please refer to our Primer: Asian corporate bankruptcy regimes.

What were some of our findings?

(1) There is a nice correlation between high yield spreads and recovery levels, (2) recoveries have been quite high despite slowing growth which is most likely due to the strong appetite for risk and yield. Recoveries could fall from the above 50% average levels over the last two years to around 30% based on growth today, (3) recoveries for distressed exchange/tenders are much higher than for missed payment and bankruptcy/liquidation situations. The Winsway bondholder who tendered in 2013 received 16% more than those who held to default, (4) secured bonds recovered less than unsecured bonds contrary to convention as bonds were actually unsecured in structure or secured on few hard assets so it pays to read the fine print, and (5) by industry, real estate provided the highest average recoveries and financials/basic industry the lowest.

We take a closer look at results in China, India and Indonesia
China: The average recovery rate is surprisingly high at 39% considering bonds are structurally subordinated to on-shore creditors putting them on par with equity. We believe this is because three quarters of the data comes from defaults in 2009 or later. In a broader downturn, recoveries are unlikely to be as high. India: We were very surprised to find that average recovery level was 40%. We surmise that the lack of trading liquidity for CBs (all data was based on CBs) led to imperfect pricing post default. Taking data based on latest/last prices (where available) the average recovery falls to 22% which is more in line with expectations. Indonesia: Has one of the lowest average recovery rates in the region at 28%. While there are a variety of factors we could point to, the key factor appears to be the weak legal system for dealing with bankruptcies, insolvency and restructuring." - source Bank of America Merrill Lynch

From a US credit perspective, as we have argued back in June 2015 in our conversation "Eternal Return", the "de-equitisation" process thanks to buybacks is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think. When corporate balance sheet leverage rises, default probability increases down the line. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers.

As we reported in our last conversation, half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%) while oil prices continue to fall. While this dispersion doesn’t bode well for US HY, default and distress ratios are increasing, even outside commodities. When it comes to assessing recovery levels, spreads do correlate as indicated by Bank of America Merrill Lynch's note:

"Spreads correlate well with recovery levels

While it intuitively makes sense that higher default rates would depress recoveries (too much distressed debt can overwhelm the capacity of distressed debt buyers to absorb the supply which negatively impacts prices), the relationship between recovery rates and default levels does not look particularly strong for Asia. This we believe is due (1) the size of the Asian high yield bond market was small in the late 1990s/early 2000s and; (2) we use convertible bond data for our recovery analysis which does not get included in the default rates (based on defaults in our bond index) impacting the results.

We find that high yield spreads provide a better relationship with recovery rates as spreads provide a good indication of risk appetite. We note the recovery level was low in 2006 which should not generally be the case given the tight spreads (and risk appetite strong). We chalk this up to the small sample size as two recovery points is hardly statistically significant. More telling is the lack of defaults during this period in general. Recovery rates have been quite strong over the last couple of years - not surprising given the overall market liquidity conditions.

Recoveries high despite slower growth and lower earnings

Recovery levels should correlate with economic growth and corporate earnings. We find that over the last few years recoveries have been quite high despite slowing growth. This is most likely due to the strong appetite for risk and yield.

However what this suggests is that recoveries could fall from the above 50% average levels over the last two years to around 30% based on growth today and lower if growth slows further."

 - source Bank of America Merrill Lynch

Where we disagree with Bank of America Merrill Lynch's take is that during last downturn the central banks "put" via QEs quickly came to the rescue which avoided a "distressed" glut and accelerated the recovery in prices, which led to a faster price recovery for many issuers in the process. The significant rise of "distressed" bonds in the US and the rising trend in Europe could weight in the next downturn on "recovery" values rest assured.

In similar fashion we played the "central bank put" game in European credit during 2011 in October when we bought BPCE 12.5% Tier 1 bonds at 94.5 cash price before the December LTROs from the ECB that "saved the day" for the increasing dollar liquidity crisis building up (liquidity crisis always lead to financial crisis...). The "ECB put" for financials enabled us to see our bond price surge by a cool 41% until we sold them this Monday at a cash price of 133, while enjoying some decent coupons in the process. 

On a side note, the implementation of the "Bail-in" process for financial bonds in Europe as of the 1st of January 2016 makes us much more wary of financials particularly in the light of the latest episode we commented recently on Novo Banco. While some care about the "carry", we decided to take profit as we do not want to get "carried away" given the weaker tone in credit as of late (yes, it is weaker in the US relative to Europe, cf Itraxx Main Europe 5 year vs CDX IG...).

But moving back to defaults and bankruptcy regimes in Asia in particular and "Tangerine Dreamers" alike, there are large differences in recovery values depending on countries as posited by Bank of America Merrill Lynch note:

"Country specific recoveries

In Chart 12 we look at the average recoveries by country and then compare them to data from the World Bank’s resolving insolvency report in Chart 13.

This is not an apples-to-apples comparison given the World Bank recoveries are based on secured loans but broadly we would expect higher recoveries from the more developed markets. This is not always the case based on the bond data. Recoveries in Singapore, HK and Malaysia are quite low relative to China, India and the Philippines where interestingly, the average recoveries from bonds are higher than the World Bank findings on secured loans. For the most part we can chalk this up to the small data set for a number of the countries on the bond side. Some of the data is based on defaults in the late 1990s/early 2000s which can also impact recoveries. We look more closely at the three biggest markets, China, India and Indonesia where we have the most data.


China
Shouldn’t recoveries be lower given structural subordination?
The average recovery rate for China is 39% which is surprisingly high considering that under China’s capital-account control regulations, funds from foreign creditors lent to an off-shore subsidiary are usually remitted to its on-shore parent in the form of an equity injection. Therefore, foreign creditors are structurally subordinated to on-shore creditors and are effectively on-par with equity.

We would attribute this to two things (1) 76% of the bond defaults in our China cohort have come from defaults in 2009 or later. The large amount of stimulus provided to the economy after the 2008 global financial crisis led to a strong rebound providing a better environment for restructuring and recovery and; (2) given the quick turnaround in economic growth we believe has led to a greater management willingness to work with creditors in order to ‘get on with business’.

What we do find is that there been quite a wide dispersion in recovery levels. In circumstances where there was some form of fraud involved, recovery for bonds has been negligible. There have also been a high number of distressed exchanges (which have all been since 2009) where recovery tends to be higher. On average though, if we exclude the fraud/distressed exchange situations, the average recovery is still quite high at 33%. However, as growth slows and defaults rise, particularly on-shore, we would expect recovery levels for off-shore investors to fall." - source Bank of America Merrill Lynch

So "Tangerine Dreamers", you have been warned, if you own Chinese off-shore bonds, as foreign creditors, you are structurally subordinated to on-shore creditors and are effectively on-par with equity hence your risk of false perception of reality when it comes to assuming the recovery value of your "off-shore" bond investment in China.

We also read with interest some interesting points made by Bank of America Merrill Lynch in their Asian Credit Strategy note from the 8th of January entitled "Asian corporate bankruptcy regimes":

"China is not a signatory to any significant international treaty relating to insolvency.

Apart from debt approval and registration requirements set by the State Administration of Foreign Exchange, there are currently no special procedures for foreign creditors. It is often more difficult for a foreign creditor to recover assets from a Chinese debtor due to the lack of recognition procedures. It is believed that treatment of creditors is based on whether they lent to onshore or offshore entities, not whether they were foreign or local lenders. To date, there are few bonds issued by Chinese companies offshore which have guarantees from the onshore operating subsidiary unless the company plans to utilize the funds off-shore due to the difficulty of obtaining approval from the Chinese authorities. Funds for use onshore can be injected as equity or in a shareholder loan format although the latter is less common. Funds injected as equity are effectively structurally subordinated to onshore borrowings and may not be party to any creditor agreements.

Hong Kong

Legal Infrastructure

Hong Kong’s insolvency framework is based on laws of England and Wales, contained within the Companies (Winding Up and Miscellaneous Provisions) Ordinance, Bankruptcy Ordinance, and the Companies (Winding-Up) Rules. Hong Kong does not have a dedicated bankruptcy court nor dedicated bankruptcy judges although it does have a companies judge who hears most corporate bankruptcy matters. The framework provides formal guidelines on bankruptcy processes other than rehabilitation, in which area Hong Kong has to date been unable to pass legislation.

Key risks

It is common to have large groups of banks (10-20) from different countries involved in a Hong Kong reorganization process and therefore reaching a consensus among creditors can be particularly difficult. Additionally, as Hong Kong does not have a statutory procedure for the rehabilitation of companies, there is little early recognition of financial difficulties on the part of companies. Further, despite the strong economic and trade relationship between China and Hong Kong, neither of them have devised a special procedure for effectively handling an onshore-offshore corporate insolvency situations. As there is no formal judicial recognition mechanism available to foreign creditors, foreign creditors who have received rulings in Hong Kong will have to initiate separate bankruptcy procedures according to China’s EBL." - source Bank of America Merrill Lynch

Should indeed we move towards a "Big Trouble in Little China" scenario, then, from a "restructuring" and "recovery" perspective, things could get interesting indeed, particularly for onshore-offshore insolvency situations when one takes into account that various Asian countries are not party to any international treaties for foreign insolvency procedures and they do not provide for the recognition of foreign insolvency proceedings. When it comes to "Asian recoveries" don't dream too much about "tangerines".

When it comes to "credit" and "liquidity", which has been a pet subject of ours and many others in the financial sphere, another way of "mitigating" liquidity issues, could be by selecting smaller issue size from a "contrarian" perspective as per our next bullet point.

• Credit - Want to mitigate liquidity issues? Size matters

As per our last conversation where we highlighted the rise of idiosyncratic risks thanks to central banks' "overmedication", the recent Novo Banco "bungee jump" drop in price to close an eventful 2015 was a reminder of the instability created by the rise of "positive correlations".

From a "contrarian" perspective, we read with interest Bank of America Merrill Lynch European Credit Strategist note from the 8th of January entitled "Go small, and go home":

"Welcome to the bear market

We believe so much monetary policy has become counterproductive for the IG credit market in Europe. “Yield fatigue” due to QE is the issue. And as a consequence, the functioning of the credit market is deteriorating.

The end of big inflows

The low yield environment has left the high-grade market more imbalanced between the “buyers” and “sellers” of credit risk. The “buyers” of credit risk – i.e. investors – are vacating the market. The “sellers” of credit risk – i.e. issuers – are coming in force. Nowhere is this first point more clear than in the flow data. Chart 4 shows that retail investors have withdrawn close to $30bn from European credit since June last year. 

The outflows have been relentless, and reflect far more than just a blip in preferences (previous outflows were much smaller around the Taper Tantrum and peripheral shocks). We believe we are seeing structural outflows from the asset class – driven by the realisation of a (very) low for longer yield backdrop.

At the same time, while the “sellers” of credit risk (i.e. issuers) continue to flock to Europe, the lack of inflows means that the new issue machine poses a greater strain on the market. Supply is being bought increasingly on switch, rather than with fresh cash. Thus high new issue premiums invariably reprice secondaries (as shown by the Daimler deal earlier this week).
This is a worry as January and February have historically each accounted for 10% of annual supply.

What if the credit market is not so deep?

With outflows and a tricky new issue machine, the consequence has been deteriorating credit market liquidity. Chart 5 shows that average bid-offer spreads in investment grade continue to rise. In fact the deterioration has been clear ever since the ECB first cut rates into negative territory. In all, we see a shallower credit market for 2016.

But what are the implications for other asset classes? For the equity market, a less healthy credit backdrop is likely to reduce some support for share price performance. However, our European equity strategist James Barty makes the key point that SX5E dividend yields of 3.7% still provide a strong tailwind for stocks.
What’s clear is that the “depth” of the credit market is past its best. Chart 6 shows that the average new issue size in European credit has been trending down for a number of years – but the decline was especially clear last year.

If debt funding capacity is lower in Europe, this could have a second order effect on equity sentiment. While this is unlikely to alter perceptions of debt-funded share buybacks in Europe (they are much less prevalent than in the US anyway), it may question the ability of European M&A to rise decisively this year. Chart 7 shows that US M&A (filtered by US companies acquiring), is past its previous peak. Yet, European M&A (filtered by European companies acquiring) is still way below the ‘07 highs.

When big isn’t so beautiful

To add fuel to the fire, ongoing idiosyncratic risk in credit is becoming troubling. Novo Banco bonds dropped 80pts in the final few days of 2015 (after senior debt was transferred to BES), Areva bonds have fallen 13 points this year on a rating downgrade (from BB- to B+) and Rallye spreads have also widened materially. This follows a 2015 when credit investors were greeted with the events of VW, Abengoa and the miners.

But we worry that idiosyncratic risk is starting to become a systemic risk for the credit market.

Why? Because “blow ups” are frequently happening to the larger credits in the market, and not to the small “overlooked” names (which has tended to be the perception of idiosyncratic risk in the past).

Nowhere is this more apparent than in the European HY market. In December, high-yield bonds widened close to 70bp, while investment-grade bonds widened by just 3bp – thus a massive relative underperformance of high-yield vs. investment-grade. Away from Novo, material widening in big credits – such as Portel – was detrimental to overall HY performance.

Chart 8 highlights the problem. The universe of European distressed bonds (issuers with bond prices below 85pts) is increasingly being made up of “large” names (i.e. credits with debt outstanding in excess of Eur 1bn). In fact, “large” names now account for 25% of the European distressed index.

Beating the event-risk blues: go small in ‘16

Avoiding the next idiosyncratic name in credit is, by definition, tricky. But a clear consequence of rising event risk in big issuers is that spreads of small issuers are starting to behave much more defensively. We see this trend continuing and expect spreads of “small” issuers to fare relatively better than spreads of “big” issuers this year.
As chart 9 shows, spreads of “small” names (defined as €1bn of debt outstanding and below) fared much better than spreads for “large” names in 2015. In fact, excess returns for “small” names in European HY were 6%, compared to just 0.3% for “large” names.

 - source Bank of America Merrill Lynch

This has, we think, profound implications for "Tangerine Dreamers" and we would like to make additional points that will alter somewhat your "perception of reality" (us breaking again the "fourth wall"). As per our conversation "The Cantillon Effects" from September 2013, if we take the art market as a proxy for the effect of QEs on asset prices and taking into account that art is removed from the capital structure, it is also worth pointing out that the higher returns of the art market also come with lower volatility. While the AMR Art 100 has an annual volatility rate of 12 percent from 1985 until 2012, the MSCI World Index had a volatility rate of 16 percent. Counterintuitively, this illiquid market is prone to less volatility. In the case of  European High Yield, counterintuitively, this "illiquidity" linked to the "size" of the issuer, as highlighted by Bank of America Merrill Lynch, is prone to less volatility and generates higher excess returns. To mitigate somewhat this "European High Yield" perception we would like to add that last few years in Europe, we have seen many "financials" particularly from peripheral countries migrating lower into the High Yield sector and indexes. Quod erat demonstrandum.

Interestingly enough, to add more thoughts to the concept of "liquidity" and "instability", we would like to point out the rising disconnect between European cash High Yield versus the Itraxx Crossover 5 year CDS index which is often used as a hedging tool. This disconnected is pointed out by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 13th of January entitled "The price of liquidity":

"Sell € iBoxx HY TRS, as a better hedge for HY portfolios
The Crossover CDS index has not been the perfect hedge for high-yield cash. December has been a month to forget for high-yield investors. The cash index (HE00) was almost 70bp wider, while Crossover was only 25bp wider. This was mainly on the back of name composition mismatch but also the differences of index weighting (equally for the CDS index, market value for the cash market).

This proves our point that high-yield cash investors need to stay close to home, and hedge with TRS. The € iBoxx HY TRS can insulate risks against wider spreads, with minimal tracking error (depending on benchmark)." - source Bank of America Merrill Lynch

This not a surprise to us.  Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

"Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays"

Given callable high yield notes are generally "negatively convex", and are a "dominant" risk feature in the high yield space,  in periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space. 

We concluded at the time our "Alive and Kicking" conversation as follows:

"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.

The decoupling between High Yield cash and the CDS market is also a reflection of CDS being positively convex versus cash high yield being negatively convex (due to callable features).

When it comes to surging defaults and the low recovery risk link to a potential "distressed debt glut" is something that needs to be taken into account by "Tangerine Dreamers" as per our final point.

• Final chart - As in the US the distressed ratio in European High Yield is also rising

While we pointed out earlier the difficulty in clearing a "distressed debt" glut without central banks support à la QE1, the recovery levels in the next downturn will be depending on the evolution of distressed ratios on a global basis, taking into account as well the various bankruptcy and restructuring laws available. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 8th of January entitled "Go small, and go home" and shows that the distressed ratio in European High Yield has risen from 8% to 12% since mid-November. For reference the distressed ratio in US High Yield is 25% currently due mostly to the "Energy" sector for now:

- source Bank of America Merrill Lynch

While spreads of small issuers are starting to behave much more defensively, should you want to hedge accordingly your High Yield exposure in Europe via the Itraxx Crossover 5 year CDS index, you might want to think of "overcompensating" your exposure, buying more protection in notional terms than your overall exposure...but, that's might be another "Tangerine Dream"...

"Who looks outside, dreams; who looks inside, awakes." - Carl Jung, Swiss psychologist

Stay tuned!

Credit - The Week That Changed The CDS World

"One must change one's tactics every ten years if one wishes to maintain one's superiority." - Napoleon Bonaparte 

Looking at the epic compression in recent weeks of the Itraxx CDS financial subordinated index versus the Itraxx Senior Financial CDS 5 year index, tied up to the recent ISDA proposals to include Bail-In Credit Event, we decided our reference this week ought to be a shorthand for describing surprising and uncharacteristic actions in similar fashion to Kissinger's 1971 secret trip to China. This secret trip laid the groundwork for the historic visit of Nixon to China that followed in 1972. 

Given the upcoming clean up of ISDA's 2003 Credit Derivatives Credit Event definitions which were in dire need of a brush up following the recent Dutch banks SNS subordinated debt saga, as per our Napoleon Bonaparte quote goes, arguably, one indeed must change tactics every ten years if ones wishes to maintains one's superiority. It could not be more truer than for the viability of the CDS market. What happened this week in the CDS world, with the proposed introduction of a new credit event for financial CDS in the case of a bail-in triggered by a government agency and the change in deliverability rules, made this week an important one from a credit perspective.

We already discussed the implications of the SNS case in our previous conversation "House of pain and House of cards":
"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."

So in this week's conversation we will look at the wider implications for the financial CDS market on the proposed ISDA Credit Events revamp on the 10 year anniversary of the ISDA 2003 Credit event definitions because the validity of the CDS market as a hedge had been put in jeopardy quite significantly by the SNS case. We will also look at debt disturbances and price-level disturbances, revisiting the wisdom of Irving Fisher in the process.

The CDS compression story in one chart - Itraxx Financial Senior index versus Itraxx Financial Subordinated 5 year index - source Bloomberg:

From the above chart one can see the severity and rapidity of the move in the subordinated financial CDS space.  

So is the move justified?

Here is BNP Paribas take on the move from their 23rd of May entitled  "ISDA Proposes Bail-in Credit Event:

"Is the Sub CDS move since last Friday justified?

Sub CDS has collapsed by more than 40bp since 16 May and the Sub/Sen ratio is now just below 1.4x, after having been at a mean of around 1.7x for a long time. The timing surprised us, as the new definitions are not finalised nor implemented yet. In addition, the market could have already reacted more than it did after the SNS news. Therefore, while we were proponents of the general Sub/Sen compression theme, we were surprised both in terms of timing and severity of the market move.

How do we explain the move then? The rapid compression of Sub vs. Sen over just a few trading sessions was probably due to the realisation that existing financial CDS contracts will over time be replaced by the new ones, making the old contracts less valuable from a long protection perspective. Thin market conditions due to European holidays may have exacerbated the move.

Other possible explanations of the significant move are the general bull market and search for yield, the gradual acceptance and pricing in of senior bail-in and the possibility of depositor preference over senior. Finally, investors may expect that, with the arrival of a new CDS contract, authorities would be less careful about legacy CDS (i.e. about making sure that there are deliverables, as the Irish authorities had ensured). That said, the change of definitions had been mentioned for a while and the implications clear, i.e. the new contracts should trade at a wider level. The old contracts can still be useful, especially as we believe that bail-in will trigger a restructuring event (as was the case with SNS), but the existence of sub deliverables is uncertain and therefore they are less valuable to a protection buyer than the new one. This information was previously available but the market reacted last Friday.

Can the magnitude of the move be justified by relative recovery expectations between senior and sub contracts? Chart 1 shows the implied Sub/Sen ratio (for the existing contracts) as a function of the senior expected recovery rate for different sub recovery rate assumptions. In most cases the sub recovery rate has been in the 0-20% range. At current market pricing, this corresponds to a senior recovery rate of 30-40%. This does not strike us as too low, especially when we consider that (i) the Moody’s average historical senior corporate recovery rate is around 38%; (ii) further developments towards resolution regimes and senior bail-in should increase the senior credit event probability relative to the sub probability; (iii) depositor preference, if forthcoming, would reduce the senior expected recovery rate; and (iv) the recent SNS event highlights a growing likelihood of events with a significantly higher sub recovery rate (for the existing contracts) than 0-20%." - source BNP Paribas.

We disagree with BNP Paribas on the implied recovery rate of 30-40%. It is not too low, it is not low enough at least on the "old contracts" because it relies on Moody's average historical senior recovery so this analysis is backward looking. The senior expected recovery rate due to the evolution of resolution regimes and senior bail-in implies lower recovery rates and wider spread levels in the new contract.

Why the new contracts should trade at a wider level you might rightly ask? 

We have touched on that subject previously in February 2013 in our conversation "Promissory Hope":

From EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 

bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

As we repeatedly pointed out, the importance of liquidity is paramount, particularly in the credit space, given the low level of inventories on dealers' book that can accommodate large selling movements. The lack of liquidity in the financial CDS space without a revamp of the 2003 ISDA Credit Events definitions would exacerbate potentially the movements in financial bonds. 

The liquidity in credit is already impacted by the poor liquidity in the secondary space, in this low yield, and yield hunting environment as described in a recent presentation made by Wells Fargo Credit Strategy team:

"Anecdotal evidence from our trading desk suggests the performance of secondary bonds is lagging that of new-issues. In addition, trading flows point toward more investors buying new-issues “on switch” rather than outright from cash. This is particularly true at the long end of the curve and for frequent borrowers." - source Wells Fargo

Since January the price action has been more volatile in the Investment Grade than in the US High Yield ETF space, which has mirrored much more the price action of equities, namely the S&P 500. Investment Grade is therefore a more volatility sensitive asset, whereas High Yield is a more default sensitive asset, as indicated in  by the price movement of the the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (AMEX: LQD) versus the US High Yield ETF HYG and the S&P 500- source Bloomberg:

Looking at the latest minutes from the FOMC and the discussions surrounding the Fed's QE stance and the possibility of a reduction in bond purchases in coming quarters provided an improvement in the employment data, it does make Investment Grade corporate bonds highly more volatile to interest movements in this "Japonification" of the credit markets courtesy of global ZIRP.

As per a recent Wells Fargo credit presentation, we agree with them in relation to the key risks for Q2 2013 given that:

"Lower coupons and longer maturities increase a portfolio’s duration/interest-rate sensitivity. The duration of the entire HG corporate bond market has extended 1.0 year to 7.0 years over the past five years. In maturities of greater than 10 years, duration has extended 2.0 years to 13.6. With the Fed signaling a potential shift in policy this year, long-duration corporate bond prices could be at risk of falling sharply and quickly." - source Wells Fargo Credit Strategy.

We are not surprised that the price of "stability" courtesy of massive liquidity injections from global central banks has come at a cost of increased "instability" as per Hyman Minsky's definition:

"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity." - source Wikipedia.

You might want to read again, Irving Fisher's book "The Debt-Deflation Theory of the Great Depression" published in 1933. Because in this book Irving Fisher dealt extensively with "business cycle theory".

For Irving Fisher, the two big bad actors in great booms and depressions are debt disturbances and price-level disturbances. We have both...but that's us ranting:

"Debt Starters

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was the prime cause leading to the over indebtedness of 1929." - Irving Fisher

Just a fact:

Investors borrowed $384.4 billion in April, a 1.3% gain from the previous month which was at $379.5 billion and conveniently the second highest in the history of the NYSE going back to 1959. The April surge was a 29% rise from the same month last year. The highest level was $381.4 billion recorded in July 2007.  We have an all-time record for margin debt and it exceeds the previous high mark. 

And what else did Irving Fisher wrote in his 1933 book?

"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debt tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts."

So no "speculation" going on, it is all going well...

As far as credit is concerned, the rapidity in the tightening movements in credit spreads is reminiscent of the warnings given in 1933 by the wise Irving Fisher. 

A recent note from Societe Generale on the 22nd of May is clearly indicative of the rapidity of how this time around the credit bubble is being blown by our "omnipotent" central bankers:

"When the music stops, we pause and then just add another chair. It's usually the slightest of breathers and the market isn't waiting too long before that relentless grind and lifting of paper resumes. Clips, blocks of paper and new issues are managing to get taken down without much fuss, and we're not seeing any contagion from the volatile stocks impacting the cash market. We're well poised here. Of course there's plenty of apprehension and it is understandable that we all need a little convincing that still adding risk at these levels is the right thing to do. It is. In the meantime, the low/high beta compression continues and was clearly evident from yesterday's deal from Plastic Omnium. The unrated - but implied non-IG - French borrower managed to raise €500m for seven years, paying just 3% for the privilege. Add in a premium for being unrated and one has to concede that the level is a funding coup for the borrower! For the broader market, the iBoxx cash index closed below B+133bp yesterday and will be lower again today after the tightening seen in today's session for corporate spreads. Even taking into account the massive February/March wobble (when the index widened 22bp), credit is tightening faster than even we - the most bullish of observers - would have expected. Hitting our original 2013 target of B+120bp is now a case of when not if, and we can only expect investor nervousness to rise even more as a result. As long as money continues to come into the asset class and supply remains at these (low) levels given the size of the demand, then the current tightening/compression dynamics will stay in place. Position for it." - source Societe Generale.

Moving back to the subject of the evolution ISDA Credit Events and the impact of expected changes recovery rates on financials, the impact of the new CDS contracts would make the CDS market in the financial space more relevant as per a note from Societe Generale from the 24th of May on the subject:
"Event: 
CDS protection may be more valuable should reported proposals for amending credit derivative definitions be accepted. The proposal is to amend credit derivative definitions for banks and comprises three main points. First, it adds a credit event to capture government enforced bail-in. Second, it expands the list of deliverables in the new credit event and keeps current deliverables available for old events, despite their potential loss-absorption ability in the future. And third, it improves successor provisions to keep CDS protection attached to the debt. Taken together, these may help to avoid a repeat of the CDS insurance failure of SNS while capturing the increased tool-kit available for governments to restructure banks out of bankruptcy. We do not expect these provisions to be retrospectively applied to existing contracts; however the amendments suggest much less value in outstanding sub contracts.
Assessment: 
ISDA’s proposed changes would make CDS protection more robust and, therefore, valuable. First, a new ‘hard’ credit event would capture government-enforced bail-in. This would be broadly defined as an action taken by government authorities that alters creditor rights under bank restructuring and resolution laws. By our understanding, this does not include the institution triggering Tier 2 contingent capital (CoCo) clauses, as this is an action undertaken by the entity itself, but it would capture Bankia-type events. If the new credit event trigger is a write-down, the event would not occur until the write-down is permanent or there is nonpayment under prior contract terms. A ‘hard’ event eliminates the maturity buckets of restructuring events. Second, deliverables in the new credit event auction may include the written-down or conversion/exchange proceeds. Again, this is Bankia-event type protection. In the event of complete write-off, à la SNS, par payment would be received by the protection buyer. In addition, deliverables under a current or new credit event could include Tier 2 or more senior securities with write-down provisions as mandated by legislation, provided they are not yet written down. This would enable most Lower Tier 2 debt to be deliverable even if it is loss absorbing Basel III-compliant via legislation. CoCos could be delivered in the new credit event provided they have not yet triggered. This captures many bail-in eventualities. Third, successor provisions would track the debt, enabling subordinated and senior CDS to succeed to different entities. This would keep CDS viable in a good bank/bad bank situation. Also, importantly, the new credit event could occur on subordinated CDS without triggering senior CDS. This may have implications for sub/snr trading levels once the new amendments are in place." - source Societe Generale

On a final note, the US equities market is increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally as indicated by Bloomberg's chart, great for CEOs and stock options and their shareholders but probably less so for the health of the balance sheet:

"Repurchases are becoming a bigger source of demand for U.S. stocks, and shares of the companies that carry them out may have an easier time beating benchmark indexes if history is any guide.
As the CHART OF THE DAY shows, the Nasdaq Buyback Achievers Index has more than tripled in the current bull market and has left the Standard & Poor’s 500 Index behind. The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months.
“Corporations have been aggressively buying back shares,” Jeffrey Kleintop, chief market strategist at LPL Financial Holdings Inc., wrote two days ago in a report. He added that the repurchases are largely designed “to boost earnings per share as revenue growth slows.” - source Bloomberg

"The public psychology of going into debt for gain passes through several more or less distinc phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible". - Irving Fisher.

At some point the Fed will have to normalize, probably not now, but the more they delay the adjustment, the more painful it is going to end up.

Stay tuned!