Credit - A Cadmean victory

"Thus it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory." - Sun Tzu

While Pyrrhic victory is of common use, in this week's title analogy and in reference to the humiliating agreement extracted last week-end from Prime Minister Tsipras, we decided to use the more obscure, yet similar reference Cadmean victory (Kadmeia Nike). It is a reference to a victory involving one's ruin. It refers to Cadmus (Greek Kadmos), the legendary founder and first king of Thebes in Boetia and the mythic bringer of script to Greece. On a side note he was also the brother of "Europa" who was abducted by Zeus but we ramble again...

Before we delve into more details of this week's credit conversation, which will deal with corporate leverage and vulnerability, we apologize dear readers, but, we would like to open a parenthesis on Europe and the significant evolution of the entire project following this "Cadmean victory".

When it comes to Greece, we reminded ourselves from our August 2012 ramblings from our conversation "The Unbearable Lightness of Credit". This important we think from our analytical point of view, particularly in the "light" of the events that took place in Europe against the "rule of the people" namely democracy.

Our August 2012 title was an analogy to Milan Kundera's masterpiece "The Unbearable Lightness of Being". This 1984 book explores the artistic and intellectual life of Czech society from the Prague Spring of 1968 to the invasion of Czechoslovakia by the Soviet Union and three other Warsaw Pact countries and its aftermath:

"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries". This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956.

"In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.

The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until; the "Sinatra Doctrine" came up with Mikhail Gorbachev.
"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia

"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 

Back in June 2012, in our conversation "Eastern Promises" we did write the following:

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."

Remember, it is still a game of survival of the fittest after all:
Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:
"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.

As far as Europe is concerned and given the growing rift between France and Germany surrounding the treatment of Greece and the possibility of a "Grexit", we are sticking to our view that in the end, Germany will eventually "defect" and we will move from a Brezhnev doctrine to a Sinatra doctrine.

Remember, there are "implicit guarantees" in the world and explicit guarantees. The German constitution is the most "explicit guarantee". The "willingness to repay" is an "implicit guarantee", this is the most important variable when assessing "credit risk" as aptly described by "Chan Akya" in Asia Times on the 13th of July in his post entitled "Demonizing the deadbeats":

"The first principle of credit is to look at an applying borrower’s willingness to repay. The second principle is to look at their ability to repay. Please read that again – this IS the order in which you gauge the creditworthiness of your borrower; not, as the various automated credit machines and CDO engines will have you believe, by looking at the latter principle i.e. ability as a guide to the first principle i.e. willingness. That simply doesn’t work, and is almost always responsible for more losses in credit than mistakes in assessing the second principle.

Too much about banking these days focuses on a borrower’s ability to repay – the value of any collateral they are willing to provide, their income and expense analysis; and use of proceeds from the loan – and too little emphasis is placed on the actual willingness of anyone to repay. That’s because the latter is a subjective analysis, and these days it is quite dangerous to perform subjective analysis of anyone because of the political ramifications." - Chan Akya, Asia Times, 13th of July 2015.

Spot on! Particularly in the light of IMF's recent reluctance in supporting further Greece, or put it simply when there is a heightened risk of "strategic defaults", or when the borrowers decides to walk out hence their nickname "walkaways" (which by the way was a major design flaw in the CDO engines). End of our parenthesis, time for our "credit conversation".

Synopsis:

• The credit channel clock is ticking faster, and not only for High Yield
• Appetite for "Credit" as an asset class is waning - a simple question of "supply" and "demand".
• The credit "mousetrap" has been set by central bankers, yet another "convexity" concern
• Final chart: US M&A Cycle and Equity volatility

• The credit channel clock is ticking faster, and not only for High Yield

While in our "Blue Monday" conversation we mused around the credit channel clock ticking faster for High Yield given the rise in leverage in Q1 jumping to 4.8x due to plunging EBITDAs while coverage levels dropped due mostly to the "Energy" sector where EBITDAs fell by a cool 130% YoY, erasing $13 billion in profits in the process, the clock is as well ticking faster in the Investment Grade space.

As a reminder here is how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Whereas the US is re-leveraging and balance sheets are weakening, the leverage at least in the European banking sector is falling.

The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters as per our previous conversation when it comes to High Yield.

To quote Bastiat, when it comes to leverage:

"That Which is Seen, and That Which is Not Seen" - Frédéric Bastiat

On the subject of corporate leverage we read with interest UBS Global Credit Comment from the 15th of July entitled "Corporate leverage: more than meets the eye":

"Corporate leverage: more than meets the eye

One of the key inputs into our HY default model is the level of US non-financial corporate leverage. This has proven to be a leading indicator of HY defaults 12 months forward, and along with other indicators, is currently forecasting defaults of 2.5% over the next 12 months. We believe this understates the risk, most notably to the energy sector as we have discussed. However, it also likely understates the risk of defaults in the ex-energy sector, due to the presence of large high quality firms with outsized earnings and little debt. We believe this is a cautionary tale for investors who are using aggregate data to assess the health of US corporates.

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We take a sample of net debt to trailing 12m EBITDA from just over 1,000 US domiciled S&P rated firms today from the BICS Level 1 universe. We then construct two versions of this leverage metric; a weighted version that accounts for firm size (divides the sum of total net debt by the sum of total EBITDA) and an un-weighted version (a simple average of firm net debt/EBITDA ratios). The differences in Figure 1 below are striking.

The leverage of the un-weighted index is growing considerably more than that of the weighted index, as high-quality firms (A-rated and above) help skew the latter down. This is another manifestation of “corporate inequality” as we wrote about recently, per differing cash levels across firms. The main takeaway here is that aggregate leverage metrics are likely to understate issuer leverage and issuer-weighted default rates going forward.
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When we isolate our series to just HY rated and BBB rated firms (those firms most sensitive to defaults and downgrades respectively), we can clearly see the deterioration in leverage across these segments. Here, there is no bias from the presence of larger firms; the increase in leverage is pervasive throughout (Figures 2 and 3). 

Now, the leverage metrics we present are likely biased to the upside in the current period relative to history due to survivorship bias and the fact that our sample is skewed more toward HY than in the overall credit universe. However, the point remains that leverage metrics are worse than what appears at first glance. Hence the focus on profits as we enter into Q2 earnings season. As we discussed last week, profit growth at US firms has been anemic recently. Historically when profits have been weak, debt growth has accelerated, and spreads/defaults have come under pressure in future months. This is a fairly consistent relationship we find back to the 1950s. Thus, we need to see a pick-up in earnings soon (driven by top-line revenue growth ideally) to slow down this releveraging cycle among lower-quality credits." - source UBS

Same goes with equities, end of the day, earnings needs to justify already lofty valuations we think.

So, yes indeed, when it comes to corporate leverage, given the amount of skew in the aggregate data, leverage has been rising much faster in this "overmedicated" credit cycle.

As a reminder from our conversation "Blue Monday":

What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:

"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube

Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. 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. As per our last conversation, "convexity" had a bigger impact than the taper tantrum in June on the asset class:

"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.

While in our last conversation we indicated that Investment Grade credit had an unpleasant June with IG spreads widening by 21 bps as a series of events unfolded, in the US, Investment Grade, the belly of the credit curve, namely BBBs wasn't spared either as indicated in Morgan Stanley's Credit Companion note from the 10th of July entitled "Sizing up cyclical risk" which also explains the fast releveraging in the credit space leading of course to the materialization of "convexity" risk, both in terms of duration exposure as well as rating bucket exposure:

"The Tale Since the Tights: We hit the tights of this cycle in June of 2014 at 96bp for US IG. A combination of M&A and share-repurchase fueled re-leveraging along with opportunistic issuance ahead of Fed hikes, Grexit risks and China-related growth concerns have taken us about 50 bp wider over the past year, to levels not seen since the taper tantrum of 2013. We are nearly 30 bp wider over just the past 4 months.

It Feels Like Cyclical Risk: Even though issuance has been concentrated in Financials, Healthcare and TMT (the latter two to support buybacks and M&A), underperformance has been the starkest in cyclical sectors including Basics and Energy (-4.2% and -5.6% excess returns) as well as BBBs (-3.2%). Financials have been a safe haven in a cycle that is beginning to resemble the late 1990s quite vividly:

BBBs Were Really a Trap: BBBs have significantly underperformed over the past year, down 3.2% vs. just 1.9% for As. While the Energy sector (which has an outsized representation in BBBs) is certainly a reason for this underperformance, other late cycle factors such as weakening fundamentals, elevated M&A and buybacks, and increased downgrades also play a role.

Beta and Volatility: BBB beta has been declining in recent weeks and is substantially off of its LTM highs, while the single-A sector beta has been rising more than valuations would suggest. Surprisingly, BBBs are also the least volatile sector among the three and rewards investors well from a spread to vol perspective. However, we continue to be cautious on BBBs, and believe investors are better off getting their beta from sectors (Financials, Basics and Consumer), and the curve (the long-end) rather than credit quality alone." - source Morgan Stanley

On that note we would disagree with Morgan Stanley in terms of "positioning" (more in our second bullet point) given the heightened risk of interest rate volatility linked to dwindling liquidity and believe that investor should stick more stable front-end minimum single A credit, which have appeared to have been more resilient in the on-going market gyrations. 

To paraphrase Admiral Ackbar from Star Wars, BBBs are a indeed "convexity trap" set up by the Fed's "Death Star", and could lead to a "Cadmean victory" for the "Beta" chasers out there, but we ramble again...

 Why "Beta" matters now more in H2? This brings us to our second point of "supply" versus "demand".

• Appetite for "Credit" as an asset class is waning - a simple question of "supply" and "demand".

As noted above for leveraged and carry players, namely the "Beta" crowd, interest rate volatility matters, particularly when market gyrations in conjunctions with "flows" in the asset class are now representing serious headwinds for credit as an asset class. On that subject we side with Societe Generale's positioning from their Fixed Income Portfolio strategy note from the 25th of June entitled "Rates to beat credit":

"Credit
We expect credit markets to move wider over the second half, as demand falls but the supply of bonds remains high. We recommend investors overweight the US vs Europe and emerging markets, buy single A and single B credits against BBs and BBBs, and reduce maturity from the 5-7yr bucket to the 1-3y bucket in order to reduce credit duration.

 Beta: Now it matters for all the wrong reasons                                                      

In the March 2015 Fixed Income Portfolio Strategy we argued that credit beta was likely to rise in the second quarter, and support high beta markets (like emerging market corporates and the US) relative to low beta markets like Europe. EM corporates did indeed outperform Europe, but markets diverged, with Europe going wider and EM markets tightening, then stabilizing.

We expect beta to be critical for portfolios in H2 – but instead of being a positive, as we expected in Q2, it now looks likely to be a negative. We expect global credit spreads to go wider in H2 for three reasons.

Capital could now flow out of credit. Low bond yields have been a boon to corporate bonds, since investors who target a certain yield level (like insurance companies or pension funds) have had to move down the credit curve in order to achieve these yields. The rise in bond yields over the end of Q2 has not completely offset this need. Graph 1 shows our shortfall model, which measures the gap between the returns that European insurers need to achieve and the yields being offered by government bonds. We still measure the shortfall at around 120bp.

However, the demand for credit from yield-based investors could be more than offset in coming months by reduced demand from investors who measure performance against an index. These investors’ demand could be reduced because they face capital outflows, with their clients deciding that credit is now a less attractive asset class.

How could this come about? After all, the yield in credit has risen in recent months, due to the rise in underlying government bond yields. But the problem is not the reward – it’s the risk. Graph 2 shows the information ratio of the credit yield, which we define here as the average yield over a quarter, divided by the standard deviation in yields over that same quarter.

The volatility of yields has risen back to levels last seen in Q2 2013, but average yields are lower – so the information ratio, or the appeal of credit as an asset class, has fallen. This means assets could come out of credit, and demand might wane.

Supply remains very high: Yet, though demand for corporate bonds may wane, the supply of those bonds remains high. Three trends are playing a role here. The first is the long term but slow pattern of disintermediation, with corporations replacing bank loans by public bonds. This continues to simmer in the background. The second is the rise in leverage in the US caused by more M&A activity. Graph 3 shows the change in balance sheet leverage amongst US, European, and EM investment grade companies in percentage terms in 2014 (on the horizontal axis) and in Q1 2015 (on the vertical axis). US companies are clearly boosting their leverage.

European companies are however reducing leverage, as Graph 3 shows. However, this is not benefitting the euro-denominated bond markets because of the third trend – the fact that US issuers are increasingly looking to tap the euro-denominated market. In “What US jumbo issues mean for European indices,” our editorial in the June 5 credit weekly, we showed that the tilt towards Europe is taking place for both cyclical and structural reasons, and we expect it to continue until the percentage of US issuers in the euro-denominated indices returns to its 2008 peaks.

Exogenous worries are continuing: From a regional standpoint, exogenous pressures include political risk – and there is a lot of that about. Concerns about Greece are undermining peripheral credits (with a basket of peripheral CDS widening from 20bp above core spreads to 33bp, as Graph 4 shows). Spreads in central and eastern Europe corporate bonds are also coming under some pressure. Greece is not the only political risk, of course, with Russian corporate credits continuing to be affected by news on the Ukraine, and more recently Turkish corporate credits reacting to the latest elections.

The other issue is M&A. Above we have shown how US leverage has risen, but M&A is also increasing the volatility of individual spreads against one another. This has also boosted the volatility of credit portfolios." - source Société Générale

Indeed when it comes to supply and the "credit negative" impact of rising M&A leading to re-leveraging and weaker balance sheet going forward (bet for lower "recovery rates" in the next downturn...), a good illustration of the "supply" glut due to "overmedication" of liquidity courtesy of the generosity of our central bankers, M&A not only is illustration that the credit game is clearly in "overtime" in the current cycle but also that there is a risk of indigestion due to the significant increase in supply related to M&A in the Investment Grade space as indicated by Bank of America Merrill Lynch in their Situation Room note entitled "Supply weighs" from the 14th of July:

M&A pipeline
M&A funding has made a significant contribution to supply volumes so far this year (Figure 4), including large deals both this and last weeks. 

In Figure 3 below we list announced M&A transactions with potential funding needs in the USD high grade bond market. Please note that we exclude deals that have already been funded.

 - source Bank of America Merrill Lynch

A question of supply as rightly pointed out, but, most importantly a question of demand!

And as of late, from a "flow" perspective, demand for credit has indeed been waning as indicated by Bank of America Merrill Lynch in their "Follow the Flow" note from the 10th of July entitled "Credit down, equities up - fifth week in a row":

"Credit and equities on different paths
Outflows from high-grade credit funds intensified again. More than $1.3bn has left the asset class. This is the fourth outflow over the last five weeks. IG funds have lost $1.5bn on average every week. On the duration front, investors looked for “safety” in the front part of the curve. Short-term fund flows were in positive territory, while flows for both mid-term and the long-term funds were back to negative.
High yield funds followed the same trend, with $1bn of withdrawals from the asset class, making it the fifth week in a row and the eighth since May, where high yield fund flows were negative.
Elsewhere in fixed income space, government bonds were on their sixth week of outflows, however at a mere $77mn, well below the trend we saw recently. Since the bund sell-off, govies accumulated close to $11bn of outflows, over 10 out of 12 weeks of outflows. Money markets funds had a good week, with $24bn of inflows, but cumulative flows still remain down $28bn since the 22nd of April.

Investors might have retreated from FI markets, but not from equities. Equity funds flows in Europe kept moving upward with an additional $1.4bn of inflows; for the eighth week in a row. ETFs were the main source of inflows for the asset class, for another week. Note that over the past five weeks credit funds (high-grade and high yield combined) have seen continuous outflows, totaling $11.5bn, while equity fund flows have been on the positive territory, with more than $8bn of cumulative inflows." - source Bank of America Merrill Lynch

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. This brings us to our third point, namely that given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication", investors have no choice but to take on more credit risk hence our credit "mousetrap" reference.

• The credit "QE mousetrap" has been set by central bankers, yet another "convexity" concern

In our previous "Hooke's law" conversation, (when it comes to the law of "elasticity"), we argued:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates." - Macronomics, July 2012.

Of course the recent decision of the ECB to add at the beginning of the month 6 non-financial issuers to its list of eligible agency bonds (Ferrovie, Tema, Enel, Snam, Alta Velocidad and SNCF) is a clear indication of the intention of the ECB to push investors further up in the credit risk spectrum. On this subject, we read with attention Bank of America Merrill Lynch European Credit Strategist note from the 2nd of July 2015 entitled "The QEst for corporates":

"To be clear, the ECB have not announced a formal “Corporate Bond Purchase Programme”. The ECB have instead added some corporate bonds to their list of Eligible Securities under the Public Sector Purchase Programme. The new names are shown in the side table. High-grade credit issuers added are Ferrovie dello Stato Italiane, Terna, Enel, Snam, Alta Velocidad and SNCF. The first four are Italian issuers, Alta is Spanish and SNCF is French.
Why has the ECB done this? From an operational point of view the list of eligible agency securities was always subject to being amended. We don’t believe the ECB was struggling to buy Italian assets, in fact quite the opposite. Our rates team have highlighted that Italian net supply will be slightly positive in July (€1bn), while being very negative for the Eurozone overall (€105bn).
As our economists have pointed out, the ECB may be “tweaking” QE to show that they are ready to respond to any contagion that Greece may bring (note the ECB haven’t changed the overall size of monthly QE purchases). They may also want to signal that they are aware that a sustained rise in periphery yields will have negative implications for peripheral corporate funding costs. Enel 10yr bonds, for instance, have seen their yields rise over 1% since mid-April.
Nonetheless, with only 6 corporate bonds added to the list, the tweaks feel more symbolic to us at this stage rather than a material policy change." - source Bank of America Merrill Lynch

Yet another example of central banks meddling with another asset class which eventually led to "A Cadmean victory", namely ruin for those who will eventually seek out diminishing returns very high in the risk spectrum, advertising it as "Alpha" generation whereas it remains only a traditional "Beta" game being played à la 2006/2007 credit wise...

When it comes to the "credit mousetrap", this can be ascertained from the diminishing sources of excess returns thanks to the "financial repression" played out by our "Generous Gamblers" in the central banking world. Like many pundits, we have long argued that financial crisis are always triggered by liquidity crisis and we do share our liquidity concerns with many such as Barclays which published on the 8th of July an interesting paper from their Interest Rates Research Team entitled "Declining liquidity in sovereign markets: Emerging fault lines":

"Most markets are simply providing diminishing sources for generating excess returns.
Central bank QE has directly contributed to this effect by depressing term premia. One can think of excess returns in being long fixed income instruments versus say T-bills as mainly coming from a) term premia, which is compensation for taking duration risk and b) spreads, which is compensation for taking credit risk. In Figure 12, we show how these two measures have evolved historically.

 For the former, we use a term structure model that estimates 10y term premia from the Treasury yield curve. For the latter, we use the Barclays Investment Grade Corporate OAS to Treasuries. As can be seen, historically, investors have been paid to take both duration and credit risk. During 1990-2006; the average term premia in US 10y yields was 1% and corporate spreads averaged 1.3%; currently by our measures, term premia is close to 0% in US 10 year bonds, and IG OAS is 1.4%. With no compensation for taking duration risk, investors are naturally being driven to take spread risk.

Therefore, it is not a surprise that there has been a tremendous increase in investor holdings of spread products directly or indirectly. Figure 13 shows that mutual funds’ holdings of corporate and foreign bonds have grown to $2.5trn, and now account for almost 50% of fixed income holdings of mutual funds (compared with 30-40% pre-crisis). 

To put this in perspective, corporate bonds account for roughly 24% of the Barclays US Aggregate index, only marginally higher than the average over the past few decades. Similarly, there has been a rapid increase in ETFs dedicated to corporate and foreign bonds.
Figure 14 shows that over the past ten years, such ETFs have gone from being non-existent to almost $225bn; their growth has been remarkable compared with growth of just $60bn in Treasury ETFs.

Therefore, it is not a surprise that there has been a tremendous increase in investor holdings of spread products directly or indirectly. Figure 13 shows that mutual funds’ holdings of corporate and foreign bonds have grown to $2.5trn, and now account for almost 50% of fixed income holdings of mutual funds (compared with 30-40% pre-crisis). To put this in perspective, corporate bonds account for roughly 24% of the Barclays US Aggregate index, only marginally higher than the average over the past few decades. Similarly, there has been a rapid increase in ETFs dedicated to corporate and foreign bonds. Figure 14 shows that over the past ten years, such ETFs have gone from being non-existent to almost $225bn; their growth has been remarkable compared with growth of just $60bn in Treasury ETFs.
There are a number of reasons why term premia are currently quite low. The global inflation backdrop is still markedly disinflationary, the risks to US growth are skewed to the downside, given the already-long business cycle, and sovereign bonds still represent a good hedge to a portfolio of risk assets. Figure 15 shows that the correlation between stock and bond returns has been negative through most of the post-crisis period and remains so.

Another key driver depressing term premia has been large-scale asset purchases by various central banks. To rephrase Fed Chair Bernanke, the Fed purchased Treasury and agency securities in QE with the intention of lowering yields on those securities, thereby forcing investors to rebalance their portfolio towards riskier assets. This, in turn, raised their prices and eased broader financial conditions. So depressing term premia via balance sheet expansion was stimulative by design, but a rapid unwind of risk premia also poses substantial risks. We have already seen this both in the US during the 2013 taper tantrum, and in the European markets in Q2’15 when Bund yields rose almost 100bp in two months.
In addition, concentration in the asset management industry has also increased. A higher concentration of assets increases the chances of a simultaneous unwind of “popular” trades. According to BIS, “total net bond holdings of the 20 largest asset managers alone increased by more than $4 trillion from 2008 to 2012, accounting for about 40% of their total net assets ($23.4 trillion). These managers accounted for more than 60% of the assets under management of the 300 largest firms in 2012, up from 50% in 2002.”As size and concentration are increasing for asset managers, dealers have been shrinking. Figure 16 shows that absolute broker/dealer holdings of fixed income securities have declined to ~2003 levels, and to multi-decade lows when measured relative to the size of the universe.

Hence, when these investors decide to unwind these concentrated trades, sovereign bond markets are unlikely to be immune to the repercussions given declining liquidity. Term premia are at historical lows, and given the backdrop of diminished market liquidity, any reassessment has the potential to create enormous market volatility. As term premia rise, one should expect “herding” to decline; but the ride is likely to be far from smooth." - source Barclays.

Therefore, central banks "overmedication" amount for us as "A Cadmean victory" and the end, rest assured, might indeed refer to a victory involving not one's ruin but, in our case many...

For the moment, as far as credit is concerns, the M&A wave is indicative of our late we are in the credit game which leads us to our final chart to close our conversation, namely that in the US, M&A has tend to lead the volatility cycle as we move clearly in the upper quadrant of the "Global Credit Channel Clock" from our good friend Cyril Castelli from Rcube Global Asset Management

• Final charts: US M&A Cycle and Equity volatility

 In our final charts courtesy of Rcube Global Asset Management, we would like to show that the US Financing Gap has been rising steadily which from a "forward" perspective" warrants monitoring as we indeed move further towards the upper quadrant of the "Global Credit Channel Clock":

"At the end of Q1, US non‐financial corporations needed to fund externally $761bln. They did so by mostly by issuing 440bln of corporate bonds, taking 110bln of loans and by tapping their internal funds (100bln). US corporations have sold 900bln of bonds so far this year.

Internal funds are also being used to fund M&A. The M&A cycle leads the volatility cycle by about 1.5 years.

We estimate that by year end the financing gap will have reached $1.1trn. Both M&A and buybacks are sharply rising, internal funds are being tapped, and investment ‐ although weak ‐ is also slowly increasing despite the oil crash. If GDP does not take off, US financing needs as % of GDP could soon reach 2007 levels.

The main difference between this cycle and the previous two is that the cost of capital is much cheaper. Interest rates and credit spreads were both higher when the business cycle reversed in 2000 and 2007 because the FED was raising interest rates and credit spreads had started pricing rising balance sheet leverage. By failing to act early, the FED has once again let leverage rise to levels that will pose systemic risks.

As shown in the below chart, banks will soon need to tighten their lending standards.

This will probably happen at the same time when the FED starts raising interest rates. We expect credit spreads to jump, and volatility to spike as a result. When valuations are as high as today, sentiment becomes the main factor driving risky asset classes. Once spreads widen and volatility increases, bullishness will drop; a bear market will follow." - source Rcube Global Asset Management

 It is going to be interesting to see if effectively the Fed has the "gumption" to raise rates later in 2015...

"Ignorance has always been the weapon of tyrants; enlightenment the salvation of the free." - Bill Richardson, American politician

Stay tuned!

Credit - Blue Monday

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks

Watching with interest the dizzying gyrations in various markets on Monday following the Greek referendum "shocker", which no doubt has put additional pressure on already "stressed" VaR models, we reminded ourselves for our chosen title of a double analogy this time around, a musical one. Given Blue Monday is often associated to the most depressing day of the year in January (typically the third monday of the month), for us it as well a reference to the single released in 1983 by British band New Order, later remixed in 1988 and 1995, the biggest-selling 12" single of all time.

As far as our analogy goes, it was interesting to note the indiscriminate "selling" that occurred on Monday, particularly at the open of the credit markets where at some point the CDS High Yield European risk gauge 5 year CDS index Itraxx Crossover was wider by around 50 bps, which was reminiscent in earnest of the moves we saw back during the supposedly "dull" summer of 2007, which was indeed much warmer than usual, fo us credit guys at the time.

From the starting lyrics and with the on-going Greek situation, we think that our chosen title is indeed more than appropriate again, this time around:

"How does it feel to treat me like you do?
When you've laid your hands upon me and told me who you are.
I thought I was mistaken, I thought I heard your words.
Tell me how do I feel. Tell me now, how do I feel.
Those who came before me lived through their vocations
from the past until completion, they'll turn away no more.
And still I find it so hard to say what I need to say." - Blue Monday, New Order 1983

Indeed, we could even have gone one title better and select yet another song from our beloved great New Wave group "New Order". We could have selected another of their seminal tracks "Confusion" and some of its lyrics when it comes to relating to the Greek situation:

"You cause me confusion, you told me you cared

He's calling these changes that last to the end

Ask me no questions, I'll tell you no lies

The past is your present, the future is mine

You just can't believe me

When I show you what you mean to me

You just can't believe me" -  Confusion, New Order, 1983

But we ramble again...

Again, rather than focusing solely on the "Blue Monday" effect on asset prices thanks to the continuation of the Greek tragedy, in this week's conversation we want to focus our attention on the deteriorating trend in credit and the recent moves in Inverstment Grade Credit particularly in Europe which somewhat have validated our recent take from our conversation "Eternal Return":

"As a reminder, 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 will be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!
So, should the volatility in the bond space continue in conjunction with a materialisation of a GREXIT, you could indeed face Poincaré's "recurrence theorem" and a vicious risk-reversal in illiquid secondary markets." - Macronomics, Eternal Return, 9th of June 2015

Synopsis:

• Convexity has no doubt started to "bite" credit, in particular Investment Grade Credit in Europe
• How to cheaply hedge a potential Greece related sell-off using credit
• The credit channel clock is ticking for High Yield
• Balanced funds getting "unbalanced"
• Final note: Cash holdings as a % of AUM is at the lowest since 2008

• Convexity has no doubt started to "bite" credit, in particular Investment Grade Credit in Europe

While we mused on the 9th of June on the convexity issues surrounding Investment Grade credit and in particular Europe and warned about its rising "unattractiveness", we were not surprised to read from a recent Bank of America Merrill Lynch note Euro Excess Returns from the 1st of July 2015 entitled "Worse than the Taper Tantrum" that indeed the convexity issue we discussed a month ago has started to "bite" returns in earnest:

Worse than the Taper Tantrum
Euro credit had an unpleasant June. IG spreads widened 21bp as a series of events unfolded. 

At the start of the month, the confusing ECB message on “volatility” caused 10yr bund yields to surge higher (after having already moved materially higher in April). Rate volatility surged and this instigated a strong risk off move across markets. Later in the month, the tensions in Greece added to market weakness and drove a strong bid for protection. Throw in concerns over US rate increases, and a perfect storm brewed last month.

Heightened outflows
On top of all of this, the poor total return performance of credit over the last few months has been the catalyst for retail outflows to start. Euro high-grade credit total returns in Q2 were -2.8%. This is the worst quarterly performance in our index history (since 1996). Retail investors have withdrawn $6.4bn from Euro IG credit over the last 3 weeks, which is a bigger dollar outflow than seen during the June 2013 Taper Tantrum (see below chart).

Tantrums: then vs. now
In terms of comparisons with the 2013 Tantrum, the side table shows total return comparisons, split by maturity.

What’s interesting is that this time around, front end total returns have not been too bad, and certainly a lot less severe than in 2013. The ECB’s pledge to do more QE if necessary has anchored front-end yields. Yet, at the longer-end of the curve, total returns this time have been more painful that in 2013. 7-10yr total returns in June 15 were -3.37% vs. -2.75% in June 2013.

Ugly XS returns
High-grade excess returns were -1% last month, the worst performance since May 2012 (just before the OMT was announced). High-yield excess returns were -1.4%, which feels a bit of an outperformance by high-yield. In fact, the superior spreads and improving growth outlook have been somewhat of a cushion for high-yield over the last month. Note that single-B excess returns were better than BB excess returns (-1.2% vs. -1.4%) last month.
In high-grade, no sector posted positive excess returns last month. Insurance was the worst, despite the paradox that higher yields benefit life insurers. Nonetheless, the sector’s excess returns were -2.1%. Media lost 1.2%, which in part reflected the strengthening of the Euro lately (and thus not good for dollar revenues of media companies). Utilities and telecoms suffered because of the prevalence of long-dated debt. The “least bad” performers last month were leisure, capital goods and financial services (see the tables on the next page).

Year-to-date: equities way ahead of bonds now 

Year-to-date, Euro IG credit is down 1.4% in total return terms (83bp in excess return terms), Euro HY credit is up 2% in total return terms and Euro government debt is down 41bp in total returns. But stocks are eclipsing fixed-income now, even with the recent Greece related sell-off. The SX5E is up 11.5%, banks are up 15% and the Dax is up 14%.

If the Greece referendum returns a Yes vote at the weekend and tensions begin to ease, we think 2015 will begin to cement itself as the year of stocks over bonds (Table 2). 

- source Bank of America Merrill Lynch

No surprise there, we did warn about the end of the "goldilocks" period for Investment Grade credit in our conversation "Eternal Return":

"Should the volatility continue in the Government bond space, it will in the near term put upward pressure on credit spreads for both cash and synthetic indices such as the Itraxx Crossover (High Yield) 5 year CDS index taking the brunt of the widening stance we think as long as the GREXIT is "avoided".
Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process." - Macronomics, Eternal return, 9th of June 2015

We also indicated in our conversation that the Itraxx Main Europe 5 year CDS index was a good proxy "macro" hedge in case of Greek turmoils:

"Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process.
On a side note, the Itraxx Crossover 5 year CDS index, the "proxy" for High Yield, does includes two Greek companies, OTE and Hellenic Petroleum out of 75 entities within the Series 23 index which was implemented in March this year and rolls every 6 months. Also the US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to a potential GREXIT scenario playing out à la Poincaré..." - Macronomics, Eternal return, 9th of June 2015

iTraxx Europe is the benchmark investment grade CDS index in Europe and comprises CDS on 125 names. A new series begins to trade every six months (on 20 March and September). The current “on-therun” series is S23.

This brings us to the second point of our conversation,  namely how to benefit from "convexity" and on-going dislocation between equities and credit using credit as a good "macro" hedge for a potential "Grexit" in case of a new "Blue Monday" event.

• How to cheaply hedge a potential Greece related sell-off using credit

We pointed out on numerous occasions the importance of CDS indices for credit investors and "macro" players. CDS indices plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity.

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"

As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. 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:

"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..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment and also by the fact that some dealers have pulled out of CDS trading in the single name space, reducing even more the liquidity. Large market maker Deutsche Bank pulled out altogether from this business, due to the high cost of capital of this fixed income activity.

So how does one cheaply hedge a potential Greece related sell-off using credit you might rightly ask? On that very subject we read with interest Deutsche Bank Cross Market Insights note from the 2nd of July 2015 entitled "Funding protection with Credit":

"Euro STOXX 50 (SX5E) is about 8% rich vs. iTraxx Europe S23 five-year spread SX5E price reflects the positive impact of ECB QE and is ~4% above pre-QE levels in spite of recent Greece-related sell-off. In contrast, iTraxx Europe spread is 8bp higher than pre-QE levels. (Figure 1) 

The dislocation provides an opportunity to cheaply hedge a potential Greece related sell-off.
Trade: buy SX5E 3000 strike Dec-15 expiry put (notional 1x) funded by selling protection on the iTraxx Europe S23 five-year index (notional 2.4x).

• The gain in the iTraxx Europe position offsets the option premium in a benign environment.

• The trade provides potential upside in a sell-off in which the SX5E reverses its recent outperformance vs. iTraxx Europe; it also provides significant upside in historic sell-off scenarios.

• The trade is expected to have (small) positive P&L if markets rally between now and option expiry due to gain in the long risk iTraxx Europe position.

North American CDX.NA.IG also appears cheap vs. SX5E Investors looking for payout in USD can buy the put option above quantoed into USD, and sell protection on CDX.NA.IG.24 five-year index. 

Main risks
(1) Breakdown of the SX5E and CDS index relationships so that realised betas in a sell-off are materially lower than anticipated or credit experiences a sell-off while SX5E remains firm, (2) sell-off in equity implied vol, and (3) FX spot and vol fluctuations (for the USD trade). - source Deutsche Bank

Of course the story is one of rising convexity and on-going dislocation in the relationship between credit versus equities.

In their note, Deutsche Bank goes into more details on the on-going dislocations (linked for us, to the rise in "positive correlations" thanks to central banks "meddling"):

 "Euro STOXX 50 and iTraxx Europe prices dislocated
Uncertainty regarding Greece, ECB QE and core rates re-pricing have been the three major, and often conflicting, themes that have driven markets in 2015.
ECB QE, which should run until September 2016, is expected to provide long term support to risky assets (like equities, and credit spreads). The sharp move higher in core rates is seen as a more transient phenomenon with the most volatile periods likely behind us. Most market participants expect the Greek crisis to be contained and not lead to contagion like we saw in 2011. However, concern remains that material sell-offs can occur due to unexpected events in the saga, or due to policy missteps. 

Risk asset markets have not priced these factors in a consistent manner, especially in recent weeks. Figure 2 shows the evolution of the price of the Euro STOXX 50 (SX5E) equity index and the spread of the iTraxx Europe S23 CDS five-year index.

We also show equity and CDS index pricing at the time QE was announced. We see that the SX5E rallied 15% over its level at the time of QE announcement, and remains above that level in spite of the recent Greece-driven sell-off. iTraxx Europe S23, on the other hand, is now 8bp higher than before QE announcement. SX5E still remains buoyed by the QE effect, while iTraxx Europe seems to be discounting it.

Figure 3 and Figure 4 show the relationship in a different way. Figure 3 shows the beta of SX5E return to iTraxx Europe mark-to-market.

We see that the beta has steadily increased as risky asset markets have rallied over the past three years. This is to be expected. As markets rally, credit spreads get closer to their floor and so respond progressively less to bullish signals. Equities have no ceiling, and so can rise unabated. As a result, the equity-credit beta should rise over the course of a long rally. We see exactly that in Figure 3.

The beta links price changes between the two asset classes. Consequently, an increase in this beta in rising markets transforms into a convex relationship at the price level (Figure 4). The chart also shows that the iTraxx Europe S23 spread is too wide compared to SX5E, even after taking this convexity into account. In fact, the convex relationship shown in the chart implies that SX5E should be about 280pt (or ~8%) lower to price in line with its credit counterpart.

This observation is interesting but does not in itself mean that SX5E and iTraxx Europe S23 should re-price to fair levels over the next few weeks. However, it does give us confidence that SX5E will likely suffer more should markets selloff in the coming weeks – say due to unexpected events in Greece, or due to policy missteps (or miscommunication by policymakers), or if market participants begin to think that firewalls against contagion are inadequate.
Equity implied vol has already risen but not in a manner similar to what we saw in 2010-12 due to the formal mechanisms that have been constructed to minimize the danger of contagion. Given this background, investors see implied vol as already being quite high, and are considering strategies such as put spreads and ratios, and hybrid options to cheapen the cost of buying protection. Here, we utilise the richness of SX5E vs. iTraxx Europe to suggest a cheap hedging strategy." - source Deutsche Bank.

Of course, and always, regardless of the final melt up in asset prices, credit prices are indeed giving us clues for a stock market correction. And when it comes to credit and "Blue Monday", nothing last forever, particular when one takes into account the stellar performance of the asset class since 2009 and the fast rising leverage in the High Yield space, that warrants close monitoring we think which brings us to our the third point of our conversation.

• The credit channel clock is ticking for High Yield

As we posited in our May conversation "Cushing's syndrome", "overmedication" by central bankers have created an abnormally long credit cycle:

"What credit investors forget is that in a deflationary environment, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield. But, due to the "overmedication" thanks to our central bankers "market health" practitioners, the long credit cycle has indeed been extended into "overtime".
Investment Grade credit is a more interest rate volatility sensitive asset, High Yield is a more default sensitive asset. What warrant caution for both we think are, the risk of rising interest rates for the former as per our previous bullet point and the risk of rising default rates for the latter. For more on credit returns we suggest reading our March 2013 guest post from our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"

In terms of the credit channel clock ticking, the first quarter has recently shown that, indeed, when it comes to High Yield, it has been ticking much faster as indicated by Bank of America Merrill Lynch in their High Yield Credit Chartbook from the 2nd of July 2015 entitled "Stay tuned":

"June swoon
June came and brought with it setbacks for HY from all angles- geopolitical, fundamental and technical. Situation in the Eurozone deteriorated as a Greek deal proved elusive and trouble in Munis land brewed as Puerto Rico’s debt woes came to the fore once again. At the same time fundamentals in US HY continued on their negative trajectory with three more defaults pushing the US default rate to over 2% for the first time since 2013. These adverse changes prompted retail outflows, as we had envisioned and warned against, totaling $7bn in June. In what proved to be an unsurmountable climb for the asset class, HY spreads widened 50bps, and YTW jumped to 6.6%, most of the sell-off taking place in the last three days of the month alone as the cash cushion evaporated and pressure built up in the secondary to meet redemptions.
All asset classes we track declined; equity and rate volatility surged. Global equities took the worst hit in light of the negative news out of Europe, with EM equities returning -3.2% and SPX at -2.1%. EU HY took the next worst hit at -1.9%, while US HY returned -1.5%. Best performing asset classes, though still negative, were treasuries and mortgages. Within HY, belly of the curve outperformed the ends, as was also the case in IG. We have been recommending positioning in Bs, and believe the belly will continue to outperform in the 2H15. Stay tuned.

Tuning our HY earnings
HY market leverage increased dramatically in Q1 jumping 0.6 turns to 4.8x due to plunging EBITDAs, while coverage levels dropped. The main culprit being the Energy sector where EBITDAs declined by 130% YoY on an issuer-matched basis eroding $13bn in profits and sending leverages to new highs.

However, since most of these declines were a direct result of asset impairment charges, we found it necessary to tune HY earnings and strip out non-cash charges, in order to view the true trajectory of corporate health. In this month’s report, we introduce our Adjusted Leverage and Coverage metrics which we calculate using earnings adjusted forone-time items.
We find levels of leverage and coverage based on adjusted earnings to be markedly different compared to when using GAAP earnings. While headline HY leverage jumped from 4x to 4.7x over the last 2 quarters, adjusted leverage has increased only 0.3x from 3.5x to 3.8x. Similarly adjusted coverage shows a lesser decline (4.4x to 4.1x) vs 3.8x to 3.2x when using GAAP. Not only are the levels different but the pace of change of the two metrics has also diverged significantly since 2013.

This is because companies have consistently been reporting a net negative effect from on-time adjustments every quarter, amounting to 2%-4% of their cash earnings on an LTM basis. This disparity reached its peak in Q1, when a staggering 11% ($23bn) of LTM earnings were lost to non-cash charges. However, what hasn’t changed is that leverage is ticking up and has reached the unadjusted levels at the height of the last credit cycle. Adjusted coverage, while not as impacted mainly because of a conducive rates environment, too is heading in the wrong direction." - source Bank of America Merrill Lynch

What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:

"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube

Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. On that call we agree with Bank of America Merrill Lynch from their recent High Yield Wired note from the 29th of June entitled "Nothing last forever":

"HY market seems complacent about Greece risks
We have expressed concern over the last several weeks about the risk of the situation around Greece getting worse and the HY market’s reaction to such an event. In our view, most high yield investors seem complacent about events in Europe, instead concentrating on the low-yield, low-default environment as reason enough to continue to fund the asset class. In fact, many investors we have spoken with believe that Greece defaulting would be good for US high yield, as bunds collapse and treasury yields plummet towards 2% once again. We disagree; every time risk-free yields have fallen due to a flight to safety, HY has sold off meaningfully. In our view, this time will be no different. 

Issuance likely to increase over summer, as will HY spreads
After what has been a relatively slow June, we think issuance is likely to pick up this summer thanks to previously sidelined M&A transactions and more importantly, in anticipation of the Sep rate hike. The well-telegraphed nature of this hike and the absolute low level of current yields are likely to create a rush of deal volume.

Even outside of supply technicals, we have likely come close to a floor in spreads this year. Although it wouldn’t shock us to see OAS approach 430bp again, we think the trend will be higher. Investors are demanding a higher liquidity premium than in the past and with rates and geopolitical uncertainty on the rise and a backdrop of weak fundamentals, our anticipation is that we reach 500bp spreads before 400bp. 

Flows: US HY returns to inflows
US HY retail funds returned to inflows this week as optimism over Greece took hold in the earlier part of the week. US HY funds reported an inflow of +$790mn after posting two successive weeks of $2bn+ outflows. Non-US HY investors didn’t reflect the same level of optimism and pulled -$850mn from retail funds, putting the global total near zero. ETFs led the recovery within US HY with +$1.2bn of inflows. 

Issuance: moving along
DM high yield issuance was decent this week as 10 deals for a total of $5.5bn came to market. $4.5bn came from the US and $1.0bn came from Europe. Month-to-date, we have seen a total of $25.8bn come to market in June, while year-to-date we now stand at $215.6bn, about $10bn ahead of last year’s pace. Global loan issuance slowed down as $4.2bn was priced vs a strong $7.4 last week. Month-to-date, stand at $29.7bn while year-to-date we have seen a total of $141.5bn. Last year at this
time, we had already seen $233.2bn of new supply." - source Bank of America Merrill Lynch 

You can indeed expect additional "Blue Mondays" in the credit space, given we have been indeed moving into overtime in the credit cycle thanks to central banks' overmedication.

Also, as we mentioned earlier on in our conversation, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger.

In their High Yield note Bank of America Merrill Lynch confirms this risk to the downside for High Yield prices:

"Asymmetric credit returnsChart 4 shows that the relationship between spread levels and subsequent returns is negatively sloping. 

This isn’t all that surprising for seasoned credit investors. Over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months. More importantly, the average spread widening in those scenarios was about 11% (~48bp at current spread), while the average tightening was in the 7% (~29bp) range in the 44% of the time that the market rallied. So that’s not only a slightly higher likelihood of widening than tightening, but the scale of the sell-off is also likelier to be larger than the scale of any rally. " - source Bank of America Merrill Lynch

With positive correlations on the rise and convexity effects, we indeed do expect significant price movements over the coming months given the spillover from bonds volatility in the credit space. As we posited in our May conversation "Cushing's syndrome" expect as well lower liquidity particularly during the supposedly "summer lull":

"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.

This brings us to our fourth point in our credit note, namely that with the ongoing volatility in the bond space, VaR has finally taken its toll leading to significant outflows in government bond funds or when "balanced funds" are finally getting "unbalanced"

• Balanced funds getting "unbalanced"

As we indicated in our May conversation "Cushing's syndrome":

"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking"." - source Macronomics, May 2015

Indeed, this rise in bond volatility has led to significant outflows in government bond funds as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 3rd of July 2015 entitled "Not so safe assets":

" $3bn of government bond outflows
High grade credit flows moved back to positive during the last week, although only marginally ($65mn inflow). High yield on the other hand continued with the outflow trend at -$716mn, the fourth week of outflows in a row.
But the largest withdrawal was from government bond funds, where outflows were the highest ever last week at -$2.85bn.

The shock from the Greek referendum announcement pushed sovereign yields higher, adding more pressure to an already tense outlook. During the last five weeks, outflows from government bond funds have totalled $8.5bn. Money market funds also felt the heat of the Greek story: last week’s outflows were -$20bn, the highest this year.
The only significant inflow was recorded in equities, where inflows were $1.5bn, mainly from ETF funds. This brings the year-to-date inflow to $67bn, which is already the highest yearly inflow into European equity funds on record. " - source Bank of America Merrill Lynch

 This is indeed a materialization of the risk we discussed back in May when it comes to "Balanced funds":

"In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - source Macronomics, May 2015

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle.The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are indeed facing an uphill struggle in maintaining their stellar records in this environment. And if indeed, cash is currently king, particularly in US dollar terms in the ongoing "Blue Monday" markets, you will indeed have interest in our final note for this week's conversation.

• Final note: Cash holdings as a % of AUM is at the lowest since 2008

We read with great interest Citi's recent Globaliser Chartpack from the 29th of October. In terms of complacency, we find of great interest that the cash level in % of AUM dropped to 4.3%, which is indeed the lowest point since 2008, indicating that when it comes to equities, investors are indeed piling much more in equities, giving more ammunition to the "Great Rotation" crowd:

"Citi’s June poll: what do US investors think?

Our June poll results suggest the investment community seems fairly upbeat, with the current weighted average year-end S&P 500 objective of 2,177; 2015 earnings are expected to climb 4.5% on the Buy Side

‘The results of a late June poll suggest that investment community seems fairly upbeat’, declares US Strategist Tobias Levkovich, ‘and while investors have not shifted their expected year-end target for the S&P 500 much in the past two surveys, with a current weighted average objective of 2,177, more now anticipate a higher chance of a 20% rally vs a 20% pullback. The more striking result was the decline in cash holdings as a % of AUM. On average, the cash proportion dropped to 4.3%, the lowest figure we’ve seen since we began asking this specific question in 2008, indicating that money has been put to work, with 80% saying that they would allocate more funds to equities. Europe and Japan still lead the US as most favored equity markets for outperformance in 2015. Earnings are expected to climb 4.5% on the Buy Side for 2015, a tad below Citi’s 5.6% forecast, but still above the bottom-up and top-down Street consensus. Investors expect a Fed rate hike in 3Q15, underscoring a growing consensus around a September move’." - source CITI

Are investors suffering yet again from "Optimism bias"? We wonder...

"Hindsight bias makes surprises vanish." - Daniel Kahneman, psychologist

Stay tuned!