Tuesday, 21 November 2017

Macro and Credit - Stress concentration

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

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

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


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

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

One thing for sure we came close to some nasty widening recently in Europe with credit options expiry for Itraxx Crossover as indicated by DataGrapple in their blog post from the 15th of November entitled "When Technicals Drive The Market":
"Today was a pretty choppy session on credit indices, especially in Europe. The morning was really weak as the earning call of ASTIM (Astaldi) went down very poorly with investors. That name was indicated 15pts wider during the first exchanges, and it put pressure on the whole iTraxx Crossover complex. The index seemed then on its way to breach 260 and was dangerously close to the 262.5bps level, an important strike for options that were maturing today. Indeed, market makers were net sellers of options struck at that level and had to buy protection to hedge themselves, adding to the market momentum. But the widening stalled during the morning – sellers of protection eventually surfaced, enticed by the extra 30bps that were on offer compared with the tightest levels reached this month – and in the afternoon it became obvious that the (in)famous 262.5bps would not be breached, forcing option market makers to sell the protection they had bought earlier in the day. So much so, that iTraxx Crossover closed almost unchanged to conclude a very technical session" - source DataGrapple.
So yes we came close to "stress concentration" at least in the European High Yield synthetic space. Though we must confide that we agree with some investment pundits, that, there are indeed cracks showing up in the credit narrative. Some High Yield issuers are already showing some signs that things could indeed turn nasty fast should there be a clear change in the central banking narrative. This could either come from renewed inflationary pressures as we previously discussed or from an exogenous geopolitical factors and there are plenty to think about in these days and ages.  

We pointed out in our last musing that thanks to dispersion, long/short strategies from active managers would be more and more of interest. Clearly the rise in dispersion is not only a sign of the lateness of the credit cycle but as well signs that they are indeed cracks in this long credit narrative. Another indication of "stress concentration was as well highlighted by DataGrapple on the 8th of November on their post entitled "Towards More Stressed Bases?":
"The credit market has been weak over the last few sessions. Credit indices certainly needed to take a breather after their impressive march tighter, but the move was mainly driven by the behaviour of the risk premia of single entities. We have seen a few outsized moves among index constituents, and the biggest were moves wider. The above grapple has many bright red boxes - a red box means the corresponding name has widened over the last 5 trading sessions and the brighter the bigger was the move -, and they represent as many casualties among the corporate population. In the US, the retailers are once again on the move, together with car rental companies and many others that disappointed when they reported earnings. All in all, credit default swaps referencing single entities have widened faster than indices, especially in the iTraxx Crossover and CDX High Yield universe. The basis of CDX HY – the difference between an index quoted value and its theoretical value - is at the widest it has been in a while, and the basis of iTraxx Crossover is now almost flat, while it has been chronically positive - the index protection was more expensive or wider than single name protection - throughout the summer."  - source DataGrapple
In terms of issuer coming into the spotlight, recent equities woes and CDS spread widening surrounding French issuer Altice are of interest when it comes to discussing "stress concentration" on a wider scale for High Yield as an asset class. For the last two years we have been discussing with our good cross-asset friend and occasional contributor about the French issuer Altice. Credit investors tend to look at the credit metrics, ratios at a specific time and so on. Yet, we think they forget about the bigger picture, namely the dynamics within the Telco/Media sector. 

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

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

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

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

The background
Since results, there has been a spike in the CDS of Altice - take a look at the chart below for the CDs on Altice LUX. HY analysts say this is a result of credit analysts looking at the equity performance, assuming there must be wrong, and then selling the credit…
Clearly this is something to be concerned about, but to put Altice in the context of some other, albeit smaller, HY issuers - Vallourec, a steel company Exane covers, has had negative EBITDA for the past 3 years and is trading HY credit at 6%!

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

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

The final debt pool is at Altice Corporate Financing. 
 Figure 2 - Altice Group Debt structure as at 3Q17

Refinancing risk

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

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

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

The EUR5.1bn of liquidity Altice has available (from net cash and revolving facilities) covers all maturities out to 2020 and it still has EUR1bn of liquidity at hand.
 Figure 3 - Altice Group Maturity Profile

Recent refinancing efforts supportive

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

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

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

What about the US debt?

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

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

Optimum notes
Senior Notes Acq. - LLC 10.125% 2023 = 112.9 
Senior Notes Acq. - LLC 10.125% 2025 = 120.5 
Senior Notes - LLC 8.625% 2019 = 106.6 
Senior Notes - LLC 6.750% 2021 = 108.4 
Senior Notes - LLC 5.250% 2021 = 97.4 
Senior Notes Corp - LLC 7.750% 2018 = 102.0 
Senior Notes Corp - LLC 8.000% 2020 = 109.2 
Senior Notes Corp - LLC 5.875% 2022 = 100.2 
Figure 5 - Altice USA (Suddenlink + Optimum) net debt/EBITDA progression 

- source Altice

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

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

Variability of interest

So Altice said that a 5pp increase in Libor and Euribor would increase Group interest (pro-forma run rate of EUR3bn) by EUR300m - i.e. a 1pp increase = EUR60m. Which isn't that sensitive at all. See below for variable debt I've sourced from the individual Altice debt silos.
Figure 6 - Altice variable rate debt

- source Altice


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

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

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

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

Overall, maintenance covenant is less flexible than incurrence - Altice has incurrence, which should allay fears also. 
As a reminder, based on our current estimates, there will be no ability to upstream out of Lux until post 2021 - see Lux net debt/EBITDA chart below.
So what's all the fuss about with Altice and debt?
Well, beyond the obvious (i.e. it has a lot of it), the main concern is technical. If the market gets nervous about HY debt, the market for HY is not liquid enough for 'shorts', so a credit trader will look at the largest issuers and most liquid equities, and then short the more equity.

That is why in November/December 2015 that both Altice and Valeant Pharma really suffered. So, we must absolutely keep a look out for increasing nervousness in the HY markets, because that could be a trigger for increasing short activity in Altice." - source Exane
In similar fashion for those who remember, the credit pressures faced by Deutsche Bank and their Contingent Capital notes (CoCos) in recent times, given high beta such as CoCos and High Yield are not "liquid" enough, "stress concentration" triggers additional pressure on equities in that case. This is the reason why increased nervousness in illiquid high yield markets leads to additional pressure/sell-off on the underlying equities. Also, the acute reduction in investment banks inventories since the Great Financial Crisis (GFC) acts as an accelerator in the move and add to the growing underlying instability in credit markets we think. From a micro level, as shown above, sure credit metrics matter from an issuer risk profile perspective, yet with disruption being so rapid these days we wonder if truly credit risk premia reflect the real level of risk. For some sectors in European High Yield we do not think it is warranted.

We do think that the "micro" pictures seems to indicate in some instances that we are starting to see cracks in the credit narrative with credit investors becoming more discerning hence the rise in dispersion. But, from a "stress concentration" perspective we can easily take some cues from the synthetic CDS markets as pointed out by DataGrapple from their 17th of November blog entitled "That Means Stress":
"This week marked the return of volatility in the credit market, at least on a micro point of view. Indices had their up and downs but the moves were always contained. Peak to trough variations of 15bps – and we have to look at intraday prints to get a double-digit number as daily closes always seem to attract contravariant investors who bring daily moves in check – at best qualify for tempest in a teacup. The real action took place at the single names level, especially in the European high- yield universe. A few corporates have consistently been the focal point of the credit market. ASTIM (Astaldi), ALTICE, SFR, BOPRLN (Boporan) experienced roller coaster rides and they are all closing the week at their recent widest levels. Investors have real concerns about them, and there was a genuine appetite for protection on these names during both the up and downs of the market as a whole. So much so that for the first time in while, the basis of iTraxx Crossover (ITXEX), the index to which they all belong, stayed negative – ie the quoted risk premium of ITXEX was tighter than the sum of the risk premia of its constituents – throughout the whole period. It is what you would expect when ITXEX tightens - indices tend to react faster than single names -, but it is quite unusual when it widens. It is a sign of genuine stress." - source DataGrapple
A positive basis is normal in credit markets. A negative basis is rarely seen. We will be watching closely the evolution of the basis in the months ahead. It is essential on the credit market to follow the basis as the indicator of the liquidity but also as an opportunity of arbitrage. Here is below an illustration of a very negative basis which narrowed back towards more reasonable levels during Q1 2015:

- source DataGrapple

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

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

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

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

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

It would be difficult for us to argue that some parts of credit are very expensive from a valuation perspective, but then again we did indicate in various conversations that we would hit 11 on the credit amplifier in true Spinal Tap fashion. This is due to $11 trillion worth of negative yielding bonds not to mention the recent 3 year French Veolia negative yielding issue just launched. As we put it simply recently, the unabated bid for US Investment Grade is due to TINA (There Is No Alternative), particularly when most of the support for US credit markets is "Made in Japan". For those of you who like to worry while some others prefer to "carry on" in true credit fashion, we would like to point out to Société Générale's Market Wrap-up note from the 20th of November entitled "The credit valuation chart that worries us most":
"Market thoughts
Corporate bonds are typically valued in one of three ways: the yield, the spread to benchmark, and the asset swap levels. On all three bases, global credit currently looks expensive. Chart 1 shows the current yield of a global credit index, made up of the iTraxx USD-denominated, euro-denominated and sterling-denominated IG and HY indices (weighted by the notional amount of the debt).

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

At the start of November, spreads were below the lowest levels seen in mid-2014. They have since bounced slightly above this point but remain very close to multi-year lows.
Spreads to benchmarks are the most important yardstick of value for investors who chose between corporate and sovereign bonds (such as insurance companies, multi-product fixed income investors, or private investors choosing where to allocate their fixed income investments). Banks who swap corporate bonds look at credit on an asset-swap basis, as we do in Chart 3.

Once again, the spread on this basis is tight – slightly below the trough levels of 2014.
There is a fourth way of valuing credit, used by investors who are comparing corporate bonds to governments. This is the spread to benchmarks as a percentage of yield, which we show in Chart 4 above. Once again, the numbers do not look good. The rise in yields and fall in spreads has driven the global ratio of spreads to yields from a peak of 2.1 in the summer of 2016 down to less than 1 now, broadly in line with the 2014 summer tights.
So credit is expensive more or less any way you look at it. The data that worries us the most, however, is shown in Chart 5, i.e., the one-year break-evens on global credit. The falls in duration and spreads have conspired to push the break-even well below the trough levels of 2014.

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

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

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


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


  • Final charts -  Oh My God! They Killed Volatility and brought instability...
Back in July 2017 in our conversation "The Rebound effect", we argued the following:
"One could easily opine that the biggest effect from overmedication from our "Generous Gamblers" aka our central bankers, has been the disappearance of volatility thanks to financial repression. As our tongue in cheek bullet point reference to the old South Park catch phrase, one might wonder if this low volatility regime will end, now that the narrative has been more hawkish somewhat as per our recent conversation "The Trail of the Hawk".
In similar fashion to Le Chiffre, aka Mario Draghi from the ECB, Janet Yellen has as well steered towards "Credit mumbo jumbo", which has had a much vaunted "Rebound effect", at least for US equities. Yet Janet Yellen's "rich" valuation word has been totally ignored by the leveraged and carry crowd, particularly in European High Yield seeing as well not only record issuance numbers but also loose covenants and record tight credit spreads." - source Macronomics, July 2017
Some of us have been mesmerized by the low volatility regime which has been slowly killing the "macro" hedge funds returns in recent years. The low volatility regime has not only been a VIX or a MOVE index story. It has also been the case in various asset classes as indicated by Bank of America Merrill Lynch in their presentation from the 6th of November entitled "Why volatility and alpha have disappeared" where they show that low volatility is not merely a US equity phenomenon:
"Low volatility is not merely a US equity phenomenon; has been pervasive across asset classes and globally in 2017 apart from FX
Since 2014 markets across asset classes have also set multidecade records for instability
The physics of a depressed volatility and alpha-starved market; Low conviction, crowding and high fragility ~ not “fake news”
- source Bank of America Merrill Lynch

While we recently mused that gamma hedges in credit were cheap, while credit remains an attractive carry trade in this long in the tooth credit Goldilocks scenario, it's not only in the VIX that there has been systematic selling of volatility for income. The game has also been played in the credit world. In the current environment, Credit payers and Gold calls screen as best value tail hedges. We agree with Bank of America Merrill Lynch, record gold/real rates correl creates value in owning gold or gold miners upside to hedge political and geopolitical uncertainty which by the way is rising by the day. We reminded ourselves to what Janet Yellen at the Fed said in September 2016:
  "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
If asset values aren't out of line with historical norms volatility certainly is from a "stress concentration" perspective, no wonder she decided not to stick around too long at the Fed, but we ramble again...

"The seed of revolution is repression." - Woodrow Wilson
Stay tuned!

Friday, 10 November 2017

Macro and Credit - Paraprosdokian

"He was at his best when the going was good." - Alistair Cooke on the Duke of Windsor

Watching with interest the continuation of the "carry play" thanks to low rates volatility, with equities making new record highs while credit continues to tighten on the back of favorable financial conditions as displayed in the latest quarterly Fed Senior Loan Officer Opinion survey (SLOOs), when it came to selecting our title analogy, we reminder ourselves of a figure of speech called "Paraprosdokian". A "Paraprosdokian" is a figure of speech in which the latter part of a sentence or phrase is surprising or unexpected in a way that causes the reader or listener to reframe or reinterpret the first part. It is frequently used by comedians or satirists, and even central bankers, as it enables a humorous or dramatic effect, producing somewhat an anticlimax. "Paraprosdokian" comes from the Greek "παρά", meaning "against" and "προσδοκία", meaning "expectation". The continuation of the most hated bull market in history is somewhat an illustration of "Paraprosdokian" we think. We could rephrase slightly our above "Paraprosdokian" quote by saying that markets are at their best when confidence is at the highest. Another interesting illustration is as follows:
"Always borrow money from a pessimist. He won't expect it back."
As well one could argue that our dear central bankers, when it comes to fulfulling their inflation mandates have been apt users of some form of Paraprosdokian such as this one:
"To be sure of hitting the target, shoot first and call whatever you hit the target."
Or more recently this one:
"In the year since the global financial crisis ended, our economy has made substantial progress to full recovery. By many measures, we’re close to full employment, and inflation has gradually moved up toward our target," Jerome Powell, new head of the Fed.
Today many pundits, including the Fed’s policy makers, are divided about how close the economy is to full employment. There is a well a continuation of a "Paraprosdokian" effect with the Phillips curve cult members behaving against expectations. Given the many potshots we have taken this year against the Phillips Curve cult members, on a side note, we will simply refer to the latest post from David Goldman in Asia Times entitled "You canna fool me – there ain’t-a no Phillipy-Curve":
"Structural factors — demographics, technology, and the organization of retail distribution — turn out to be more influential than demand management. Quantitative easing has been neither a success nor a failure. It’s been largely irrelevant." - David Goldman, Asia Times
We hope that once again, we have put to rest for the time being the Norwegian Blue parrot aka the Phillips curve but we ramble again...

In this week's conversation, we would like to look again at the critical support provided by foreign investors to US corporate credit as well and why we favor equities over credit in this ongoing melt-up.


Synopsis:
  • Macro - One should favor Equities over Credit in true Paraprosdokian fashion
  • Credit - Foreign flows are critical for US corporate credit
  • Final charts - A hawkish Fed doesn't necessarily means a strong USD

  • Macro - One should favor Equities over Credit in true Paraprosdokian fashion
Sure many pundits will point out that valuations are stretched and it's getting late in the game. Of course it is. But, as per our previous musing, when it comes to valuation, we will go towards the 11 level on the valuation amplifier in true Spinal Tap fashion even for credit as we move into the "euphoria" phase with the additional melt-up in asset prices overall:
- source Bank of America Merrill Lynch - Month to Date until end of October 2017

We remain "short term Keynesian" but long-term wise we confess to have a more "Austrian" stance. If we would use a "Paraprosdokian" construction to define ourselves we would opine that we don't belong to a specified economic school of thoughts, but that we are "Wicksellian". 

The most recent quarterly Fed Senior Loan Officer and Opinion Survey (SLOOs) points towards loose financial conditions though credit standards for consumer loans continued to tighten amid steady demand. Loan standards have overall remained unchanged on net for commercial real estate (CRE) except for multifamily loans, which saw 22.2% of tightening according to the report. Also, banks reported weaker demand across a range of CRE loan types while net percentages of banks reported easing standards on most residential mortgage loan types as demand weakened. As we posited in recent conversations, we continue to monitor very closely US consumer credit. On that subject we noticed in the latest report that a net 9% of Senior Loan Officers said they tightened standards on credit cards, and 9.8% said they tightened standards on auto loans. It isn't yet a cause for concern but another sign that we are moving in the last inning of the credit cycle. For Commercial Industrial loans (C&I), more aggressive competition from other bank or nonbank lenders was by far the most emphasized reason for easing in this report. Another sign comes from the relentless flattening of the US yield curve with 10s and 2s touching 68 bps. 

If markets are at their best when confidence is at the highest, and given we belief that we are continuing into a melt-up phase akin to "euphoria", then it would make sense from an allocation perspective to favor equities over credit from a "beta" play perspective. In that regards, we read with interest Morgan Stanley's Cross-Asset Dispatches from the 3rd of November entitled "Why We Prefer Equities Over Credit":
"We are underweight credit vs. equities, given bigger late-cycle challenges in the former and relatively worse bottom-up exposure of credit indices vs. the S&P 500.
Top-down, equities typically outperform late in a cycle: While equity investors typically benefit from late-cycle dynamics like increased M&A and rising corporate confidence, credit investors are more exposed to the deterioration in balance sheet quality that often comes from these 'animal spirits', with capped upside, by definition. Historically, credit tends to underperform first into a cycle turn; this time around, CCC spreads have already begun widening, which may be the better leading indicator.

Bottom-up differences are underappreciated: The S&P has a higher proportion of companies with better fundamental metrics and better growth prospects relative to the credit indices. On the other hand, credit markets are more exposed to sectors with long-term operational challenges, particularly HY, with just under 30% of par (ex-energy) experiencing negative revenue growth over the past five years. Nearly a quarter of the S&P 500 market cap falls into tech. IG is most exposed to financials while HY is most overweight commodities, consumer discretionary and telecom.
Investment implications: We find that credit investors are not compensated appropriately for late-cycle risks. We like positioning for equity outperformance by going long SPX versus CDX HY (1:2 ratio) or by selling ATM puts in the SPX to buy 2x ATM puts in CDX HY, given the elevated ratio between equity vol and credit vol. The risk to both trades is equity underperformance versus credit. In addition, in credit, we prefer up-in-quality exposure, whereas in equities we prefer more cyclically geared sectors."  - source Morgan Stanley
Where we agree with Morgan Stanley is relating to the high beta part of the US High Yield market namely our CCC credit canary, which recently has indeed displayed some weakness as per the below Bank of America Merrill Lynch chart displaying US CCCs vs Bs:
- source Bank of America Merrill Lynch

Are cracks already showing in the credit markets? We believe we are seeing some cracks starting to show up particularly with increased dispersion in the credit markets universe. The higher the dispersion, the higher can be the performance of a long/short strategy. We won't delve too much into the subject of the attractiveness of long/short equities strategies, but during the 2008 melt-down, higher dispersion between stocks ensured a significant performance of these strategies overall (not the stuff a perma-bear would highlight...).


From a technical perspective credit should continue to grind tighter, given the global search for yields runs unabated thanks to a growing slice of negative yielding bonds as displayed in the below chart from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

With financial repression still running hot on the back of repressed/suppressed rates volatility, while credit players "carry on" from a beta perspective, in the ongoing "goldilocks" environment perspective we would rather allocate more to equities for the time being particularly in Europe where the risk reward on Europe High Yield with yields below 2% is not enticing to say the least. Morgan Stanley in their very interesting note make the following points:
"Why we prefer equities over credit
Since the start of the year, risk-adjusted total returns of the S&P 500 have outperformed the Bloomberg IG corporate excess returns index by ~5%. This is in line with one of our key calls from our year-ahead outlook. And we think that this relative outperformance can continue.
Our asset allocation preference is driven both by top-down and bottom-up considerations. From a top-down perspective, we find that the current stage in the business cycle is a larger boon for equities as opposed to credit simply due to the nature of the asset classes themselves. In addition, credit troughs tend to lead S&P 500 peaks historically. Various valuation and fundamental trends are also currently more favorable for equities than for credit.
Our preference also makes sense bottom up, a fact that we think is less appreciated by investors: owning the IG and HY indices creates exposure to sectors with inferior growth, ratings and leverage profiles relative to the S&P 500.
Investment implications: In credit, we prefer up-in-quality exposure, whereas in equities we prefer more cyclically geared sectors. We also recommend going long one unit of S&P 500 versus two units of CDX HY (adjusted for the beta differences between the indices), a trade we think could work in a bullish and bearish scenario, though less so if markets move sideways. For a more gradual divergence in credit and equities, we also like selling at-the-money S&P 500 put options and buying (2x) CDX HY puts, given the historically high ratio between equity and credit implied volatility.
Top down
1) Business cycle expansion is better for equities than for credit: Our Morgan Stanley proprietary business cycle indicator points to a US cycle in the expansion phase (Exhibit 3).


Strong macro readings within our model, particularly in employment and consumer  confidence, have driven recent strength in our cycle indicator's reading. This is the eighth year of expansion, one of the longest on record.
An expansion by its nature is more beneficial for equity than credit returns: During late-cycle expansions, increased demand helps to fuel capacity tightness, leading to a temporary accrual of economic rents to equity holders. While equity investors are able to earn the uncapped residual profits as that growth takes place, credit investors are more exposed to the deterioration in balance sheet quality that often comes from these rising 'animal spirits', with capped upside, by definition. Given the asymmetric risk/reward especially at tight spread levels, it is no surprise that credit has historically underperformed in this stage of the cycle.

2) Credit troughs tend to lead S&P 500 peaks: Towards the end of the cycle, credit and equity performance tends to diverge, with credit typically selling off in advance of equities. The asymmetric risk/reward profile of credit tends to make it more sensitive to weaker balance sheet quality and rising risks late in a cycle (see Bonding with Stocks, June 1, 2015). Since 1929, a trough in BBB credit spreads led a S&P 500 peak in 11 instances of 16 bear markets (a hit rate of almost 70%), with credit troughs leading S&P peaks by a median ~7 months (see The Credit Bear Market Almanac, February 19, 2016). Admittedly, prior to the 1990s, credit markets were much smaller in size and very different from today, so we hesitate to draw strong conclusions based on credit cycles far back in time. Looking specifically at the two most recent examples (2000 and 2007), credit spreads started widening in anticipation of a recession about 8-9 months before stocks ultimately peaked (Exhibit 5 and Exhibit 6).

However, we caveat that only two cycles' worth of data is far from a robust sample set.
To the extent that we are near the end of the cycle, we would expect credit markets to sell off in advance of equities. However, it is possible that the two markets may peak closer together (in time) compared to past cycles, given the strength of the 'yield seeking' flows into US credit. This year broad credit and equity indices have generally moved in the same direction, with total returns YTD of US equities at +17%, IG at +5% and HY at +7% (Exhibit 7).

But looking below the surface tells a more nuanced story. Lower-quality HY has outright diverged from equities (Exhibit 8), with the HY CCC index 103bp wider in spread since early March, as equities continue to make new highs.

The recent underperformance of CCCs makes intuitive sense, as credits most exposed to actual fundamental risks (as opposed to daily inflows and outflows) can show heightened sensitivity to rising risks near the end of a cycle (see A Tail of Dispersion, September 15, 2017). We saw a similar underperformance of CCC spreads in 1999 before an outright credit bear market began in 2000. In our view, this widening of CCC spreads could be how the late-cycle credit/equity divergence plays out this time around, and is something that investors should watch closely. Should cracks continue to emerge as we expect, we would expect the divergence in lower-quality credit to continue, a reason why we have recommended BBs over CCCs for most of the year.
3) Valuations: On the equities side, our equity strategists' preferred measure of equity risk premium (forward earnings yield minus the 10Y UST) still suggests that the S&P 500 is undervalued. With S&P 500 P/12M forward earnings trading at 18x versus our target of 19x, we still see equity upside. In contrast, a simple credit valuation metric that we like to track (credit spreads adjusted for leverage) is near 20-year tights, implying very poor long-term risk/reward.
4) Fundamentals: Company fundamentals ultimately drive both equities and credit. However, we would point out that credit and equity investors prioritize metrics differently. For example, leverage is an important consideration for both, especially  given equity holders' residual claims on a company. However, given that credit has capped upside and potentially large losses in the event of defaults/downgrades, corporate leverage is likely a more important indicator to a credit investor. Corporate earnings are also obviously important for both, as profit growth gives companies the ability to lower leverage and service debt. However, the uncapped potential of equities suggests that strong earnings growth may matter more for equity investors, but these benefits will not accrue to the same extent for credit investors and are therefore less relevant. To this point, we find that US earnings and leverage trends look very different: in the US, corporate earnings have been strong this year, with significant upside surprises. In contrast, leverage for our credit universes has remained elevated, sitting at or near the highest level in decades, as debt growth keeps pace with this robust earnings growth (especially for IG).
5) Fund flows: IG credit in particular has seen massive fund inflows in 2017, whereas equities have seen very muted flows/outflows. And the demand story for US credit goes beyond retail flows, as central banks have incentivized many different types of fixed income investors to reach for yield for years in this cycle. While not outright bearish for credit in itself, the flows picture presents risks, given how much credit investors may be relying on the technicals to remain supportive. For example, given the substantial support provided to credit markets as the Fed expanded its balance sheet in this cycle, we see scope for a weaker supply/demand picture as the Fed begins shrinking its balance sheet (see US Fixed Income Strategy: Trading the Fed's Balance Sheet, May 10, 2017). Equity flows do not present this risk to the same extent and instead show that the market has not yet reached the excesses often seen near the very end of a cycle.
- source Morgan Stanley

We do agree with Morgan Stanley that the recent underperformance of CCCs makes intuitive sense, as these credits are most exposed to actual fundamental risks and also clearly shows heightened sensitivity to rising risks near the end of this very long cycle. The widening of the CCC credit canary and its spreads indicates indeed how the late-cycle credit/equity divergence is again playing out this time around. We do agree with Morgan Stanley, the CCC bucket should be watched closely by investors.

Also, in various musings of ours we have indicated that US credit investors should start rotating towards quality and favor style over substance, namely Investment Grade Credit versus High Yield. Since August, in terms of performances, US Investment Grade has been outperforming US High Yield on a vol adjusted basis. Even though US HY issuer weighted default rate continued to decline in October, to reach a nearly 2 year low of 3.33%, this is akin to looking in the rear view mirror we think. Credit availability is essential and a good predictor of upcoming defaults as far as we are concerned.

Another interesting part of Morgan Stanley's note relate to their overall "bearishness" on credit:
"Why we are bearish on credit
Our cautious view on credit is based on three key points: 
First, the Fed has now started to tighten policy in an unprecedented way: We think that credit investors may have underestimated the tailwind from QE in this bull market, and they are similarly now underestimating the headwind from reverse QE – especially when that headwind is coming as the Fed is also hiking rates, and as global central banks will be slowly adding less liquidity as well. It is important to remember that central bank stimulus in this cycle has been massive in size, and has been hugely supportive of credit markets.

We are not expecting a seamless process as central banks pull back in this largely untested way. At the very least, the volume of fixed income supply that needs to be absorbed by price-sensitive fixed income buyers is going to rise substantially in 2018. US credit will no longer be the only game in town. In our view, it is perfectly reasonable to assume the opposite of what happened when the Fed was expanding its balance sheet in this cycle (one-way flows into US credit) as the Fed begins shrinking its balance sheet, at least at the margin. And this means that the ‘liquidity buffer’ will no longer be there to the same extent, magnifying any negative catalyst that pops up along the way. In our view, it is not a coincidence that weaker-quality high yield credits are underperforming, as the shrinking of the Fed balance sheet is now being set in motion
Second, markets are late cycle: And while these late-cycle phases often coincide with the best returns in stocks, they usually do not coincide with the best returns in credit. In fact, this is when credit and equities often start moving in different directions, as discussed above. More specifically, we note that credit quality has weakened over the course of this cycle most ways we measure it. For example, corporate leverage is at levels rarely seen outside of recessionary environments while the average ratings of the IG credit index has fallen meaningfully. In addition, we think that ‘excesses’ are all over the place. For example, credit markets have doubled in size since 2007, given a  relentless reach for yield for the better part of the last decade, the percentage of LBOs levered over 6x is now at 2007 levels, covenant quality has never been weaker and low quality IG issuance (BBB rated) is up 31% y/y, to name a few. And as is always the case late in a cycle, the ‘stress points’ go underappreciated, until the cycle turns, and then all of a sudden the problems become obvious (i.e., how did I miss that?). We think that this time is no different. Lastly, as a result of the build-up in ‘excesses' over this nine-year bull market, problems are now starting to pop up, so far under the radar. For example, consumer delinquencies are rising slowly. Lending standards have tightened in places – i.e., autos, credit cards and CRE. And despite broadly tightening spreads, as mentioned above, the ‘tail’ in credit is growing. In our view, this is how it works – late-cycle 101. Problems pop up early on in the areas that experienced the most severe deterioration in fundamentals in the bull market. Investors initially treat those issues as one-off and ‘idiosyncratic’. They then spread out when credit conditions tighten more broadly.

Third, valuations are very rich in credit any way we slice the data, and in fact even richer than the headline indices suggest, when adjusting for the deterioration in quality of the markets over time. Very simply, in Exhibit 29 we show that IG spread per leverage is now lower than it was at the tights in 2007. Of course, valuations do not tell us much about where markets are going in the short term, but they do tell that long-term risk/reward in credit is very poor.
Our ultimate investment conclusions are as follows. For multi-asset investors looking to capture the upside in markets in the final phase of this cycle, look to asset classes with a less asymmetric risk/reward profile than credit, such as equities. For investors who only focus on credit markets, prioritize higher-quality, more liquid credits, even if that means giving up some yield, until markets compensate you to do otherwise.
Given all these considerations, we recommend a relative value equities versus credit trade. We prefer to go long one unit of S&P 500 (at 2570) versus short two units of HY CDX (at US$108.2/314bp) as we adjust for beta differentials (Exhibit 30). There are a number of considerations for our trade. We choose to use HY, given that many of the credit headwinds that we discussed are larger for high yield than for IG, both from a top-down and bottom-up perspective. HY tends to do worse than IG in expansions and has a larger concentration in smaller, highly levered and generally lower-quality companies. We also believe that current underperformance in CCCs will spread to the rest of the HY universe over time. And finally, we prefer CDX as opposed to cash instruments, given the liquidity advantage (although we would note that, in a bigger drawdown in credit with meaningful outflows, TRS may be a better hedge). Moreover, in this context, we prefer the S&P 500 for the equity leg (as opposed to the Russell 2000) as it is less sensitive to any tax-reform outcome, with more high-quality stocks, less exposure to sectors in decline and it has had smaller drawdowns. In our view, this trade should work well in either tail scenario. In the bull case, stocks have more upside than credit, even risk-adjusted. In the bear case, where markets worry about a cycle turn, credit markets have more downside on a risk-adjusted basis, at least initially, given current valuations and the tendency of credit spreads to trough before stocks peak.
The trade may work less well in a scenario where stocks move higher slowly and credit spreads grind wider over a long period of time: The S&P/CDX trade discussed above has a significant carry cost on the credit leg, with steep curves in the CDX market driving a 1Y carry + roll-down in CDX HY near 5%. To highlight this point, we look at the historical performance over 2H14. In short, credit spreads hit their tights in June 2014, before grinding wider into year-end, whereas stocks kept moving higher. Through 2H14, the CDX HY22 index price fell by US$2.3. However, after accounting for the coupon, the net P&L of shorting CDX HY was modestly negative over this period. At the same time, the S&P 500 returned ~5.3%. Even though the S&P 500 versus CDX HY trade did well, it did so mainly because of the equity index going up, whereas the credit short was hard to monetize, given the carry cost. In other words, if credit markets trade sideways or grind wider slowly, stocks would need to rise a fair amount based on earnings growth/multiple expansion to offset the carry cost on the 2x CDX HY leg.
One alternative way to position for a divergence is in the options market: In the options space, the downside 'tail' is already priced for our view: i.e., the put skew in credit is at the steepest historical level. Instead, we think that using close to ATM options works better. Given current levels of implied volatility, we think there is value in selling close to ATM puts in S&P 500 versus buying them (2x) in CDX HY. The implied volatility ratio between equities and credit has been inching higher this year and is currently close to 3x, much higher than the realized beta and realized volatility ratio of the two markets; in other words, the credit vol is cheap to the equity vol. For example, buying 50-delta puts in CDX HY to March costs 1.2% of notional, whereas 50-delta puts on the S&P 500 are roughly 2.7% of notional. On a beta-adjusted basis, this trade would pay investors an upfront of 0.3% of the equity options notional. The key risk to this trade is that equities underperform credit materially in a move lower.
- source Morgan Stanley

In our conversation "The Trail of the Hawk" back in July we indicated that cheap gamma could be found in credit options and that in Investment Grade there were relatively cheap to own. From our point of view, playing it through options is a cheaper alternative than the cost of carry involved by the credit leg in Morgan Stanley's recommendation. The reason for credit volatility being cheap to equity is simply because there are more sellers than buyers. CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool.  Secondly, implied volatility is low because realised volatility has remained persistently low. Selling of volatility in the credit options market has been motivated by the same global reach for yield driving flows into US credit,  and has helped compress implied volatility to new cycle lows. You get the picture.

Credit, no offense to some investor pundits, is a low-beta asset class. As such it is inherently short volatility and tail-risk. At low yields and tight spread levels like today, the case for credit rests in part on attractive risk-adjusted returns. You don't have attractive risk-adjusted return on European High Yield. Low levels of volatility boost "carry" trades and of course make funds' "Sharpe ratios" look better. But, volatility, like the default rate, is backward looking. It is much less stable than a fundamental measure like leverage for instance. As we indicated earlier on, wacth dispersion in US credit. Why? Because it is actually higher today than it was at the tights of the cycle in 2014, making long/short strategies more and more enticing we think.

When it comes to US credit, as per our below point, overseas investors represent a critical support.

  • Credit - Foreign flows are critical for US corporate credit
We pointed out in various musings of ours how critical foreign flows have been for US credit and in particular Japan. No doubt to us that "Bondzilla" the NIRP monster is "Made in Japan" and represents a very important support from a flow perspective to the asset class as a whole. As a reminder, back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla"was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player.

We also indicated in our previous post that Bondzilla is "is a critical support of US credit markets. As we posited in our conversation "The Butterfly effect", during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk.

On the subject of foreign flows, we read with interest Wells Fargo Credit Strategy note from the 6th of November entitled "Overseas investors - From Buy-Buy to Bye-Bye? Not yet":
"Foreign Flows Have Slowed but Remain Strong
Investors came into 2017 expecting the frenetic pace of foreign inflows from 2016 to continue strengthening. With two months left in the year, we feel fairly confident in projecting that foreign flows will, in fact, be lower YoY. U.S. Treasury TIC data for the first eight months of the year show a pronounced slowdown in the first few months followed by reversal over the summer (Exhibit 1), with the YTD total running 35% lower than the same period in 2016.

On the other hand, flows into predominantly domestic mutual funds and ETFs are on track for a record year, with YTD flows of $277 billion already 70% ahead of the prior full year record of $164 billion back in 2012.
While foreign flows have slowed overall, by all accounts, they have remained quite positive this year, with holdings custodianed abroad increasing by $255 billion through the end of July. While we caution investors not to read too much into the U.S. Treasury TIC dataset as it is fraught with potential inaccuracies, we can surmise a few broad conclusions relative to our prior analysis:
- Broad geographic distribution has remained relatively constant, with Europe representing 82% of holdings, Asia 16%, Australia and Latin America 1% each. As a region, Latam is growing the fastest (+19% YoY), likely a direct result of several of the larger regional economies bouncing back from recent recessions. Australia is just behind as its large pension system seeks to diversify into non-AUD assets.
- Looking at holdings by country (Exhibit 2) shows that holdings decreased for only three countries YoY: Saudi Arabia, Singapore and Denmark.

- Within Asia, Thailand and South Korea surpassed Taiwan as the fastest-growing holders of U.S. corporates. We attribute this to Formosa issuance sapping Taiwanese demand3, while demand accelerates from South Korea as its insurance industry undergoes a similar regulatory transformation to Taiwan’s. Thailand’s exponential growth is likely a direct function of the rapid growth of its central bank FX reserves. The same argument holds true for some of the other smaller countries with rapidly growing holdings, such as Kuwait and Israel.
- Within Europe, Italy and Finland appear to be buying at an accelerating pace, albeit from a low base, while Germany and France have purchased significantly more on an absolute basis.
Tying together the TIC data with a number of other sources, we estimate that overseas buyers currently make up approximately 39% of the U.S. corporate debt market, down 1% from our prior estimation as a result of the record growth witnessed in the mutual fund and ETF segment. Within the Domestic Institutional part, the fastest growth has come from private pensions (+2% versus our prior estimation), likely a result of the upcoming PBGC premium increases pushing companies to top off their pension contributions (as well as fears around the impact of potential tax reform to the deductibility of these contributions).
- source Wells Fargo

As we pointed out, in similar fashion to the 2004-2006 Fed rate hiking cycle, currency risk will be sacrificed in favor of credit risk. This means that, credit could technically tighten much further and touch the famous 11 level on the credit amplifier in true Spinal Tap fashion.

"There is no alternative," is often abbreviated "TINA,". It is a phrase that originated with the Victorian philosopher Herbert Spencer and became a slogan of British Prime Minister Margaret Thatcher in the 1980s. Today it is often used by investors to explain a less-than-ideal portfolio allocation, usually to stocks, since other asset classes offer even worse returns. One could as well characterize US credit as TINA as pointed out by Wells Fargo in their note:
"The Unspoken Truth: Overseas Buyers Have Little Choice but to Buy USD Credit
We have thus far shown that overseas investors are still better buyers of USD credit despite increasing risks to the trade and expensive valuations. This begs the question of why these investors continue flocking to the asset class rather than buying their respective domestic credit markets. In our view, the simple truth is that within the world of IG credit, overseas investors do not have much of a choice. While the market has long been speculating over the demise of the USD as the only global reserve currency, in the world of IG credit, current issuance trends couldn’t be more contrary (Exhibit 10).

In fact, the proportion of USD issuance within global IG credit has been steadily rising for nearly a decade and is now back above 50% for the first time since 2003. On the other hand, the two main competitors are fading: EUR issuance, which was even with USD in 2008 is running at just 19% market share YTD, while CNY issuance has collapsed to its lowest share in four years at 14% of issuance. The catalyst for the drop in CNY issuance this year is a global M&A binge by Chinese companies which is forcing them to fund almost exclusively in USD. The Chinese government appears to be encouraging this trend with its recent USD sovereign issue, which lowered USD funding costs for Chinese companies. Thus, in the world of IG, global investors have less and less of a choice but to buy USD bonds if they want exposure to corporate spread product.
HY is a different story. While the proportion of USD issuance remains high at 70% in 2017, it has been steadily falling, mostly in favor of the EUR (Exhibit 11).

This highlights the fact that most HY issuers tend to be more coupon sensitive than spread sensitive, making the EUR market an attractive market for some non-Eurozone issuers.
On the other hand, IG issuers have become increasingly sophisticated in their ability to fund at the most advantageous spread on a currency-agnostic basis. As such, the key driver pushing non-U.S. issuers towards the USD market over the past few years has been the widening basis swaps between some currencies and the USD (Exhibit 12).

While the dynamic driving cross currency basis swaps is an entire topic unto itself, the short message is that currencies where central banks are more heavily skewing respective asset markets have the most negative basis swaps (i.e., JPY and EUR), a boon for issuers that fund in USD and swap the proceeds back to their home currency. Thus, in 2017 just 58% of USD issuance was from U.S. companies, down from 76% in 2008 (Exhibit 13), back when central banks were not intervening in their respective markets and therefore cross-currency basis swap costs were close to zero.

If the current issuance trends persist, the sensitivity of USD IG credit to economic factors outside the U.S. is set to markedly increase.
Not surprisingly, the Eurozone and Japan have been responsible for between 10-15% of USD issuance every year for the last nine years in a row (Exhibit 13). In the case of Japan, this is directly contributing to the dramatic shrinkage of its own corporate market, down 50% in size since 2010 before accounting for the ¥3.2 trillion of corporates owned by the BoJ (Exhibit 14).

The EUR corporate market has fared better, as the ECB has been less intrusive than the BoJ. More importantly, large cap U.S. issuers have begun to increasingly rely on the EUR market as “Reverse Yankees” now make up 19% of the market, second only to France in the EUR index.

Ironically, one could argue that these U.S. issuers have been crowded out of the domestic market by the tidal wave of overseas money and issuance that has flowed into USD credit. In other words, the unintended consequences of central bank QE are far-reaching and extend well beyond their respective shores. " - source Wells Fargo
From a flow perspective, the lion share of the allocation from foreign investors has been US Investment Grade credit when it comes to TINA. In the last four weeks, there have been big Investment Grade debt inflows of $25.1 billion. This represents the 46 straight weeks of Investment Grade bond fund inflows. That's where all the "fun" is going, uphill to the US Investment Grade bond market.

While our "Euphonists" are still playing loud aka our central bankers, some of the alcohol content of their credit punch bowl has been removed yet some investors pundits are still dancing while the music is playing and the credit mouse trap has been set up. Some players have started cashing in it seems. We already told you that you have been warned and that the tune of our central bankers have been changing.

This is as well the conclusion of Wells Fargo's note:
"Musical Chairs Means Central Bank Flows in 2018 Are Critical
The impact of central bank QE on global credit markets should not be underestimated. It has profoundly shifted the technicals that underlie global credit, pushing investors to take risks far away from their own shores in remote corners of the credit markets. But a new era is upon us as central banks attempt to extricate themselves from this grand experiment. In Exhibit 16 below, we show the magnitude of global QE flows over the past several years and attempt to project them forward into next year based on stated plans (Fed, ECB, BoE) and implied average pace (BoJ, SNB, PBOC).

In our view, the takeaway is quite stark: The peak in foreign flows into USD credit in 2016 was largely coincident with the peak in global QE purchases.
Looking forward, if global central banks are able to stick to current policy paths, there is a good chance that net QE flows approach zero by year-end 2018. This could have serious ramifications for the pace and sustainability of foreign flows into USD credit if overseas central banks manage to catch up to the Fed’s quantitative tightening policies and a USD bear market ensues. That said, so long as USD remains the currency of choice for a majority of issuers globally, overseas investors will likely have no choice but to remain involved to some extent in the USD corporate credit market." - source Wells Fargo
Sure the fun has been fabulous "uphill", in the bond market that is, and foreign investors have been as well properly intoxicated, but it was and still is a case of TINA we think.

For our final charts below, we still believe in additional weakness in the USD.

  • Final charts - A hawkish Fed doesn't necessarily means a strong USD
Our bearishness on the USD was the correct stance we adopted in early 2017 in opposition to the investor crowd thanks to our propensity to be contrarian at times. We still believe that even with a hawkish Fed in the making, it doesn't entail a stronger USD. Our final charts come from the same Wells Fargo reports shows that foreign investors are willing to take on more credit risk in the current low yield environment:
"A Hawkish Fed Does Not Necessarily Translate to a Strong USD
The behavior we outlined above (investors increasingly taking unhedged FX risk in U.S. corporates) is, in our view, a direct result of investor complacency with regard to the direction of the USD (as proxied by DXY, Exhibit 8). Post the significant rally around the first Fed rate hike in H2 2014, the USD has been relatively range bound. Foreign investors putting cash to work in a low-yield, tight spread environment on an unhedged basis are implicitly taking the view that they believe the USD will remain within this broad range (and therefore is likely to rally from current levels given DXY currently sits at the bottom of this range).
Investors espousing this view seem to be relying on the notion that a hawkish Fed, and therefore a rising rate environment, is almost certain to lead to further USD strength. Our FX strategy colleagues disagree with this thesis and believe we are in the early stages of a period of long-term U.S. dollar depreciation over several quarters and years.7 Moreover, investors should not assume that rising rates and a rising currency are highly correlated. In Exhibit 9, we shade in gray all periods since 1967 where the USD fell over at least one quarter, while at the same time UST five-year yields rose. While this pattern has not appeared much in the recent past (perhaps the reason for the prevailing misconception), it occurred in 22% of quarters since 1967, with most of those concentrated towards the latter end of prior economic cycles. In our view, the distinct possibility of a simultaneous bear market for both bonds and the USD (i.e., yields up, dollar down) is the single largest risk to overseas flows into U.S. credit."  -source Wells Fargo
Of course, there is a strong possibility that "balanced funds" will get "unbalanced" and that the traditional allocation will not work like a charm this time around in true Paraprosdokian fashion but we ramble again...

"To steal ideas from one person is plagiarism. To steal from many is research."
Stay tuned ! 

 
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