Sunday, 11 August 2013

Credit - Alive and Kicking

"What you gonna do when things go wrong? 
What you gonna do when it all cracks up? 
What you gonna do when the Love burns down? 
What you gonna do when the flames go up? 
Who is gonna come and turn the tide? 
What's it gonna take to make a dream survive? 
Who's got the touch to calm the storm inside? 
Who's gonna save you? 
Alive and Kicking 
Stay until your love is, Alive and Kicking 
Stay until your love is, until your love is, Alive"
- Alive and Kicking - Simple Minds - 1985
Songwriters: Kerr, James / Macneil, Michael Joseph / Burchill, Charles

While enjoying the smoother driving commute to work courtesy of the summer lull, we listened to old classic 1985 "Alive and Kicking", from Scottish rock band Simple Minds, and some of the lyrics did struck a chord with the on-going central banks "kicking the can" game which has been increasing the correlation between asset classes and the levitation process. Therefore, in continuation to our previous use of musical references for our title analogy, we thought this week's title reflects our current interrogations on central banks abilities in dealing with the next burst of the asset bubble they have so aptly created thanks to their numerous and generous liquidity injections from the last couple of years.

In this week's conversation, we would like to focus our attention on the inherent "instability" which has been building up in all asset classes due to rising correlations, the consequences of negative real returns, and how to somewhat side-step negative convexity thanks to CDS. But, first, our usual market overview:

The volatility in the fixed income space has been receding during this on-going summer lull as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 75 bps level - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

A low volatility regime until May had benefitted the most carry trades such as Emerging Market Bonds as well as high carry Emerging Markets currencies. This was the direct consequence of negative interest rate of return on US Treasuries for the last couple of years due to "financial repression". Following the huge surge in volatility after the conflicting "tapering" signals sent out by the Fed that began in May, Emerging Market currencies should remain volatile and under pressure in the coming months as indicated by Bloomberg's "Chart of the Day" from the 5th of August displaying JP Morgan's Emerging Market Volatility Index:
"The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Volatility Index since Fed Chairman Ben S. Bernanke told Congress in May that policy makers may temper bond purchases that helped spur $3.9 trillion in capital flows to developing countries in the past four years. The gauge jumped to a one-year high of 11.8 percent June 21, before falling to 9.5 percent yesterday after the Fed said it will keep stimulus for now. The index’s 35 percent quarterly increase was the most since 2011.
Currencies in Brazil, India, South Africa, Turkey and Chile have fallen at least 7 percent since May 1 as higher Treasury yields lured investors away from emerging markets. Developing countries are paying for the Fed’s mixed signals and ministers from Chile to South Africa share India’s “unhappiness over the developments,” Indian Finance Minister Palaniappan Chidambaram said in an interview with the Times of India published July 31" - source Bloomberg.

A clear illustration of this surge in currency volatility can be seen in the depreciation of commodities linked currencies such as the Australian dollar and the Brazilian Real, which had been perfectly correlated since 2008 until the summer of 2011, which saw the start of some large unwinds from the Japanese levered "Uridashi" funds (also called "Double-Deckers") from their preferred speculative currency namely the Brazilian Real. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted for 46 percent of double-decker funds - graph source Bloomberg:
The Brazilian Real was one of the top "Double-Deckers" preferred currency play for its previous interesting carry. These funds represented 126 billion USD in asset in 2011:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

Following the violent surge of volatility in the fixed income space the recovery in Investment Grade credit indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG has been more muted in the US - source Bloomberg:
But as far as credit cash markets are concerned in the European space, European cash spreads are now within 5 bps of tights post the Great Financial Crisis, with the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds tighter by 6 bps so far in August as indicated in a recent note by CITI "The Reluctant rally" from the 9th of August:
"In aggregate, the € iBoxx index has now taken back more than 80% of the widening in May and June – in other words, we're just 5bp from the tightest level credit has seen since 2008.
We're big advocates of leaning against the wind in the current range-bound market environment and have been suggesting taking profits at the margin where spreads have tightened the most. But we remain long. Why not be more resolute and go underweight here at these tight valuations? Sure, the European and US macro data is supportive but, after all, there's plenty of uncertainty in store in the autumn: the impact of actual Fed tapering, US debt ceiling discussions, European politics after the German elections, the German constitutional court ruling on the OMT, FTT negotiations, bank repositioning on the back of the latest Basel guidance, periphery politics, Chinese data, Middle East tensions to name a few.
Some of these issues may yet come back to haunt us but, at the moment, we struggle to see the vulnerability in the European cash credit market even at these tight levels." - source CITI

As far as credit markets are concerned, they are no doubt, "Alive and Kicking". And we agree with CITI, as the Simple Minds (like ours) song goes:
"Stay until your love is, until your love is, Alive"
So stay in credit until your love is alive, but get close to the exit as we move towards a heightened risk of a fall during the Fall (Autumn that is...).

It is a similar story for European Government Bonds yields as indicated in the below graph with German 10 year yields staying between the 1.60% / 1.70% level and French yields now around 2.26% flat from last week, with Italian and Spanish yield grinding tighter - source Bloomberg:

Moving on to the subject of rising correlations and the buildup in "instability", we agree with Martin Hutchinson's recent article "Forced Correlations" published in Asia Times:
"In 2009-10, ultra-low interest rates forced up commodity prices themselves, but since then new sources of supply have been forced onto the market, causing a reversal of the commodities bubble. In energy, fracking techniques caused a collapse of natural gas prices in 2011-12, but it's interesting to note that no such collapse has occurred in the oil market, presumably because the new supply sources are insufficient and have been offset by the artificially increased demand for automobiles in China and India especially. 

Interestingly, the rise in gold and silver prices caused by cheap money (if cash has a negative real return then gold and silver are ipso facto a good investment) has been suppressed over the last 18 months by the International Monetary Fund and the world's central banks, seeking to disguise the true effect of their monetary policies, but this effect may be wearing off. 

Finally, negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

Dollar index versus Gold - graph source Bloomberg:
While recently the dollar has been weakening so far against major currencies with a significant bounce from the Japanese yen and Australian dollar, should "risk-off" materialize during the Autumn, the dollar could significantly benefit yet again from a flight to safety.

The credit markets and equities are no exception to "rising forced correlations" as highlighted by CITI's recent note from the 9th August entitled "Forget the Great Rotation":
"Rotation – isn’t it obvious?
It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.
However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

"What you gonna do when things go wrong? 
What you gonna do when it all cracks up? 
What you gonna do when the Love burns down? 
What you gonna do when the flames go up? 
Who is gonna come and turn the tide? 
What's it gonna take to make a dream survive? 
Who's got the touch to calm the storm inside? 
Who's gonna save you?"
- Alive and Kicking - Simple Minds - 1985

But we are not there yet...

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

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.

This is particularly true for callable high yield bonds such as Windstream:
"We can again use Windstream to illustrate this dynamic. Figure 5 shows the duration (OAD) and yield to worst of the WIN 7.5s of 2022 from May 10 to August 7. As the bond sold off from May 10 to June 24 (yields rose), the duration increased as well, due to the negative convexity of the bond.
The increase in duration resulted in larger losses for the bond relative to an equivalent non-callable bond and CDS. In the subsequent rally, duration declined, resulting in a smaller gain relative to a non-callable bond and CDS. The negative convexity of the bond enhanced the downside during the sell-off and limited the upside during the most recent rally. Remarkably, even though nearly three months have passed, duration remains toward the high end of the range. The holder of the bond not only suffered a mark-to-market loss, but now has to contend with a higher duration investment that continues to suffer from negative convexity." source Barclays

The illustration of the downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages as illustrated by the Total Return performance on a callable High Yield bond suffering from negative convexity versus its CDS - graph source Barclays:
"CDS has outperformed the 2022s by more than 400bp in P&L terms (Figure 8) due to the rate exposure and duration extension of the bond." - source Barclays

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

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...

On a final note, counter-intuitively, rising yields should benefit US companies suffering from ZIRP due to rising  Pension Funding Gaps which have not been alleviated by a rise in the S&P 500.

As a reminder from our conversation "Cloud Nine":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

We agree with Bloomberg that rising stock prices have done little to bolster the finances of corporate pension funds this year - graph source Bloomberg:
"Rising stock prices may do relatively little to bolster the finances of corporate pension funds this year, according to Tobias M. Levkovich, Citigroup Inc.’s chief U.S. equity strategist.
As the CHART OF THE DAY shows, the percentage gap between pension assets and obligations for companies in the Standard &Poor’s 500 Index widened last year, when the stock-market gauge increased 13 percent. The S&P 500 rose another 19 percent this year through yesterday.
Assets were 23 percent less than projected payouts at the end of 2012, according to data from S&P Dow Jones Indices that Levkovich presented in an Aug. 2 report. The shortfall was the biggest since at least 1991.
“Overall pension pressures have not eased” even though the S&P 500 has more than doubled since March 2009, when the current bull market began, Levkovich wrote. “The stock market is crucial to the asset side of the pension story.” Managers contributed to the wider funding gap with their reluctance to put more money into equities, the New York-based strategist wrote. Stocks amounted to 48.6 percent of assets at S&P 500 funds last year, down from 50.5 percent in 2009.
Surging obligations also played a role, according to S&P Dow Jones’s data, published last week. Projected distributions increased 38 percent, to $1.99 trillion, between 2007 and 2012. Assets rose just 2 percent, to $1.53 trillion, as the period began with the worst bear market since the Great Depression." - source Bloomberg

So much for the "Great Rotation" story. Oh well...

"At times it is folly to hasten at other times, to delay. The wise do everything in its proper time." - Ovid

Stay tuned!

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