Sunday, 10 December 2017

Macro and Credit - Volition

"The true test of a leader is whether his followers will adhere to his cause from their own volition, enduring the most arduous hardships without being forced to do so, and remaining steadfast in the moments of greatest peril." - Xenophon

Looking at the dizzy heights being reached in equities with uninterrupted flows into US Investment Grade with yet another warning coming from the wise wizard from the BIS, namely Claudio Borio in the latest quarterly report, when it came to selecting our title analogy, we reminded ourselves of the term "Volition" from psychology given our fondness for behavioral economics. Volition or will is the cognitive process by which an individual decides on and commits to a particular course of action such as the normalization process undertaken by the Fed. It is defined as purposive striving and is one of the primary human psychological functions. Volition means the power to make your own choices or decisions. As an example of the classical concept of volition, comes from Eliezer Yudkowsky while discussing friendly AI development and "Coherent Extrapolated Volition" in 2004. The author came up with a simple thought experiment: imagine you’re facing two boxes, A and B. One of these boxes, and only one, has a diamond in it – box B. You are now asked to make a guess, whether to choose box A or B, and you chose to open box A. It was your decision to take box A, but your volition was to choose box B, since you wanted the diamond in the first place. Now imagine someone else – Fred – is faced with the same task and you want to help him in his decision by giving the box he chose, box A. Since you know where the diamond is, simply handling him the box isn’t helping. As such, you mentally extrapolate a volition for Fred, based on a version of him that knows where the diamond is, and imagine he actually wants box B. In developing friendly AI, one acting for our best interests, we would have to take care that it would have implemented, from the beginning. The question one might rightly ask is relating to the volition of the Fed, is it really for our best interests? One might wonder.

In this week's conversation, we would like to look at the volition of the Fed in its normalization process and the potential upcoming impacts in 2018 should the Fed, once again be behind the increasing flattish curve.

  • Macro and Credit - When the going gets tough
  • Final chart -  The Fed can't escape Newtonian gravity

  • Macro and Credit - When the going gets tough
Back in April 2017 in our conversation "Narrative paradigm" we argued that when it comes to credit market the only easy day was yesterday. Given the significant role of beta thanks to cheap credit and the "carry play" supported by low rates volatility, it becomes increasingly difficult for us to be supportive of at least the European beta play with the level touched by European High Yield. We also indicated recently that we were expecting a significant pick-up in M&A activity in 2018. This means that some investment grade issuers could experience some sucker punches in the form of blowing out credit spreads in 2018 hence the need of reaching out for your LBO screener à la 2007. A raft of M&A transactions in 2018 would clearly reinforce the view of the lateness in the credit cycle. In terms of change of narrative and in continuation of the "synchronicity" we mentioned in our previous post, the Fed's volition should not be taken lightly.

Also, regardless of the economic narrative put forward by many, including November payrolls rising by a seasonally adjusted 228K and beating expectations of 200K, leaving the unemployment rate in the US to 4.1%, rising wage pressure remains relatively absent. On top of that, surging consumer confidence and modest income growth should trigger much stronger loan demand in our "credit book". One could argue that the credit impulse in the US is tepid at best, no offense to the volition of the Fed. This is indicated by Wells Fargo in their Interest Weekly note from November 29th entitled "Mixed Credit Trends Among Businesses and Consumers":
"In the ninth year of the current economic expansion, credit standards point to a varied, but stable, outlook. Recent data suggest business lending demand has fallen, while consumer demand has seen modest gains.
Banks Optimistic (Yet Cautious) Approach to Lending
Banks continue to relax lending standards on business, commercial and industrial (C&I) loans and mortgages, as banks’ willingness to make loans has gained some stability. A slowdown in banks’ willingness to lend is customary with late cycle expansion. As seen in the below graph, banks’ willingness to extend credit follows a cycle-like trend.

At the start of an economic expansion, banks appear very willing to extend credit. But as the cycle matures, they become less willing to extend credit, and, in turn, tighten their standards in a cautionary nature.
Banks have reported increased competition from other bank and nonbank lenders, which in part, has led to the easing of standards. Continued loosening of lending standards of C&I and mortgage loans points to sustained confidence in the current state of the expansion. However, banks continue to tighten standards on credit card and auto loans, which may signal some caution in the consumer sector as the economic cycle ages.
Slowly Growing Consumer Demand for Loans
With an unemployment rate of just 4.1 percent, and in an environment of modest income growth and surging consumer confidence, theory would suggest robust loan demand. Loan demand, however, remains muted, pointing to a change in consumer sentiment towards debt. Credit card demand has remained unchanged, while we have seen a recent uptick in auto loan demand (below graph).

The rise in demand for auto loans is likely attributable to rebound effects in auto-sales due to damage from the recent hurricanes in Texas and Florida. Consumer demand for mortgage loans has slowed, which is expected to reverse as existing home sales edge higher off a recent slowdown.
Without an increase in income growth, loan demand should continue to increase modestly. Our forecast calls for an uptick in disposable personal income in Q2 2018, due to the effects of the proposed tax reform, followed by a slowdown in disposable personal income growth through the last year of our forecast (2019). Such slowing in income growth suggests consumers may increasingly turn to borrowing to fund their consumption habits in the future.
Demand for business loans remains weak, yet increased strength in business investment suggests that firms have turned to other sources of funding to fuel capital spending (below graph).

The loosening of lending standards, coupled with our positive outlook for business investment, should drive C&I loan demand higher in the near future. However, as the cycle continues to mature, we project equipment spending to slow, likely resulting in a reduction in business demand looking further ahead. The current credit climate insinuates stability within lending practices as growth continues in the ninth year of the current economic expansion."  - source Wells Fargo
While the Fed's volition is to continue with its hiking cycle, financial conditions remain loose and the lack of pressure on wages means that consumers are increasing their leverage through consumer loans in an environment where there is increased competition for business from other players. There are two ways we think the first part of 2018 could play out, "Goldilocks" or "Stagflation" with a sudden rise in inflation expectations that would provide support for a bond bear market narrative with rising interest rates volatility. This is of course without taking into account rising geopolitical risk aka the dreaded "exogenous" factors. We sidestepped various political "exogenous" risks in the first part of 2017 with various elections taking place in Europe in particular. It remains to be seen what will be the trigger of the return of volatility which has so badly wounded many large global macro funds in recent years thanks to its absence. As far as interest volatility is concerned it is at the lowest level in more than 20 years as displayed in the below Wells Fargo chart from their 2018 US Corporate Credit Outlook published on the first of December:
- source Wells Fargo

It won't last rest assured as it is getting late in the game we think and we are already seeing a "synchronized" change in the central banking narrative. Yet some "beta" players continue to be oblivious to the change in the central banking rhetoric. It doesn't mean that the "Goldilocks" environment won't last a little bit more in 2018 for credit, but, we think you should start thinking about playing "defense". This is why back in July we recommended to tactically going for duration again particularly in credit. This has been paying off nicely in 2017 (MDGA - Make Duration Great Again) as indicated by Bank of America Merrill Lynch Credit Market Strategist note from the 8th of December entitled "Year of Duration":
"Year of Duration
That 30-year corporate bonds, which we define in the following as 15+ years, have performed well in 2017 (+11.48% YtD) is no surprise. After all we expected “equity-like” 8-9% total returns in our 2017 outlook piece (see: 2017 US high grade outlook: Let’s do the twist 21 November 2016) on the back of a 27bps decline in 30-year corporate yields (actual: -48bps YtD, Figure 1).

However the surprise has been that credit spreads and Treasury yields were almost equally responsible for this decline in yields (25bps tightening in spreads and 30ps decline in 30-year Treasury yields as of yesterday, Figure 2).

This positive correlation between credit spreads and Treasury yields for such large moves is noteworthy and counterintuitive, but not unseen in the post-crisis years.
How did duration become king?
There are many reasons corporate yield curves are flattening so much including first and foremost that the Fed plans to hike rates actively in an environment of weak inflation data (Figure 3, Figure 4).

This was highlighted by today’s mixed jobs report for November where, although headline nonfarm payrolls were strong at +228k (vs. +195k consensus, Figure 5), average hourly earnings grew only 2.5% YoY (vs. 2.7% expected, Figure 5).

There are many other reasons for flattening yield curves including Treasury’s refunding announcement, where they committed to meet any increased issuance needs using shorter maturities (see: On funding and refunding), the ongoing shift in Europe out of cash and way out the curves (see: QE is dead, long live NIRP), macro risks, etc.
Re-iterate 10s/30s spread curve flatteners
Unusually - and a testament to extreme investor need for both yield and duration – we have seen the 10s/30s corporate spread curve (non-fin, commodities) flatten 8-9bps this year, despite the fact that the 10s/30s Treasury curve has flattened 22bps. More broadly this environment of both flattening Treasury and spread curves has been in place since spreads began tightening in early 2016 (Figure 7). However, the past six months has seen little flattening of the spread curve – but the lack of steepening is actually very impressive as the Treasury curve has flattened 27bps over the same period of time. Needless to say if the Treasury curve continues to bull flatten our recommended non-banks spread curve flattener will not work. We are probably even now reaching levels where further bull flattening actually leads to steeper spread curves. Our house view (see: Global Rates Year Ahead) remains that the Treasury curve is too flat and eventually will re-steepen, which should be very favorable for our spread curve flattener trade. The trade also works with higher interest rates as long as the curve does not flatten.
- source Bank of America Merrill Lynch

As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 10.53% return so far this year. For 2018, we continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. As well in another conversation of ours in June this year entitled "Goldilocks principle" we indicated:
"The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). " - source Macronomics, June 2017
Our call has been vindicated as well as our contrarian stance against the "bullish" dollar crowd. We continue to believe we will see further weakness ahead for the US dollar in 2018. If we do see additional pressure on the leverage play thanks to the carry trade due to central banking's volition, then one should expect a rise in the Japanese yen we think. As well we continue to see value in the long end of the US curve. Also while gold prices have been weaker recently, the recent pullback as for goldminers looks to us enticing, particularly in the light of a growing risk in "exogenous" factors. If credit options are cheap, gold/gold miners options are "cheaper" as well from a convexity reward perspective in 2018. When it comes to the bull run in credit spreads it has not yet ended and probably will last longer than many might expect, until we hit 11 that is on the "credit amplifier" in true Spinal Tap fashion. We do not see any value left (apart from playing the "dispersion" game with active credit management) in European High Yield at these levels. What is left is "carry" and clearly not enticing enough for us from a risk reward perspective in 2018. We would rather continue playing the US Investment Grade long duration play when it comes to credit allocation. What about US equities being priced to perfection and US High Yield? Given the strong correlations of both asset classes (close to 1 regardless of what some pundits would like to tell us), it is all a matter of "earnings" and they have been so far holding fairly well.

The big risk out there is, as we pointed out the return of the "Big Bad Wolf" aka inflation. This would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant repricing on the way. Inflation is our concern numero uno and this would we think be the trigger for higher volatility. This is as well the view of Deutsche Bank from their Asset Allocation note from the 4th of December entitled "What to make of volatility at 50-years lows":
"In our view the leading candidate for a shock that would lead to a sustained increase in vol is a sharp increase in inflation
As noted above, exogenous shocks have historically played a significant role in increasing and sustaining vol at higher levels. Shocks in general of course tend to be inherently unpredictable. Our economists forecast is for a gradual rise in inflation. But in the current context a sharp increase in inflation sticks out as a leading candidate for a shock that raises volatility in a sustained manner in 2018 given the extent to which it is priced in and the likely reaction of monetary policy:
  • Slow inflation priced in. The slowdown in US inflation beginning in March this year had large impacts across asset classes and looks to be priced in (The Growth-Inflation Split, Sep 2017).
  • Few expect a sharp pickup in inflation. The market and FOMC narrative around low inflation with widespread buying into structural declines and a breakdown of traditional relationships looks to have gotten carried away (Six Myths About Inflation, Oct 2017). This suggests few are expecting a sharp pickup in inflation.
  • Four fundamental reasons to expect inflation to move up. First, the lagged impacts of inflation to the growth slowdown during the dollar and oil shocks points to a pick up. Second, the labor market continues to tighten and in our reading there is no reason to believe the traditional Phillips curve has broken down, just swamped by other factors. Third, the direct drag from the past appreciation of the dollar should begin to pass through. Fourth, idiosyncratic factors together have had a strong negative run but tend to mean revert over time. Acting in concert, the four factors clearly have the potential to create a sharp move higher in inflation.
  • A sharp pickup in inflation is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle. Fed hiking to keep inflation in check has been a—if not the —leading driver of recessions historically. Market expectations of Fed hikes are currently of course far below the Fed’s guidance and a sharp pickup in inflation is likely to entail a significant re-pricing. We don’t see Fed rate hikes from current low levels as ending the cycle any time soon (Is Unprecedented Monetary Policy Easing Creating Secular Stagnation? Jul 2016). But we do see faster rate hikes against the backdrop of a sharp pickup in inflation as having the potential of raising and sustaining vol at higher levels as concerns about the end of the cycle grow." - source Deutsche Bank
Make no mistake, inflation is the "Boogeyman" for financial markets. From the long interesting report from Deutsche Banks, three graph stand out when it comes to heightened risk for large "sigma" events in 2018 given how coiled the volatility spring is:
- source Deutsche Bank

No matter how high your "interval of confidence" is, your VaR model is looking/asking for trouble, particularly your "liquidity" hypothesis. It is time to build some cheap "convexity" defenses as we posited above, not to mention the need for your LBO screener with rising M&A risk and the sucker punches they can deliver to your Investment Grade portfolio à la 2007. Just some thoughts for 2018.

When it comes to the relentless flattening of the US Yield curve as a harbinger for rising recession risk in a classical macro way, we read with interest Deutsche Bank's take from their Global Market Strategy note from the 1st of December entitled "The Fed, the Curve and Risk Assets in the Great Rate Normalization about the recession risk transmission:
"Recession risk transmission
The sharp curve flattening has given renewed life to worries that recession risks are on the rise. Given the flattening, our recession probability metrics – one using the outright slope of the 1s10s yield curve, and one that adjusts the 1s10s curve for the level of 1s – both suggest that November’s flattening was worth a ~6pp increase of the probability that a recession will begin in the next 12 months.

Holding all other inputs equal (the u-rate vs nairu, aggregate hours worked growth, core CPI ex-shelter, and the change in oil prices) puts the probability of a recession beginning in the next 12 months at 16.4% on the unadjusted model, and 26.4% when we adjust the curve for the level of front-end rates. This is still low.
The parallels between the current environment and the Greenspan conundrum are inevitable given the apparent insensitivity of long-end rates to the Fed’s hiking cycle – particularly in the context of a balance sheet unwind that many expected to put sustained steepening pressure on the curve. There is no “conundrum” in our mind – the Fed is simply hiking into a very low neutral rate, with no evidence that inflation is set to materialize to allow them to move faster. This cycle is following a somewhat similar path, however, to the mid 2000’s cycle from the perspective of recession probability.

Now 2 years into the current cycle, the recession probability is at a similar spot to mid-2006 (which was just months away from being within the 12 month window to the start of the great recession).
The risks presented by a flattening yield curve have a clear transmission mechanism to broader conditions as the Fed’s balance sheet shrinks. Before the Fed began to pare its balance sheet we discussed why a steep curve is important to a successful QE unwind – if the curve flattens too much, banks will have no incentive to hold securities over cash earning IOER, meaning non-banks will likely be the marginal buyers of securities no longer owned by the Fed, and deposits will leave the system. This in turn carries meaningful risks to loan growth, which had caught a fair amount of attention given the slowing earlier in the year. Our financial conditions index suggests that C&I growth should be accelerating, though that has not really materialized yet.

The lagged relationship between C&I loans and the Senior Loan Officer survey points to a pick-up in loan growth, but only into the ~5% y/y range, not the double digit range of years past. This has failed to materialize, however, and is a going risk amid the Fed’s balance sheet wind down.
It is still sufficiently early into the Fed’s balance sheet unwind that banks’ reaction function is hard to gauge – securities holdings have risen since the end of September, while cash holdings have been more or less stable and deposits have shown some recent volatility but might still be on an upward trend. So the limited evidence does not yet suggest that this is posing an imminent risk to the economy, but the flatter the curve gets, the more likely banks are to eschew securities for cash, increasing the risk that deposits leave the system, and banks have to pull back on lending."  - source Deutsche Bank

There you have it, no matter how strong the "volition" of the Fed is, the exercise is difficult to execute. While there is no imminent threat to the positive narrative from a fundamentals perspective, the relentless flattening of the Us yield curve is difficult to ignore on top of rising geopolitical exogenous factors. We could easily entertain a blow out of oil prices on the back of exogenous factor in an already tensed Middle East, which would no doubt spill into the inflation expectations surprises on the upside and lead to some repricing and heightened volatility. As we pointed out in our bullet point, when the going gets tough...volition or not.

In our last conversation, we pointed out that "volatility" conundrum was not a paranormal phenomenon, and no matter our strong the Fed's volition and "Forward Guidance" (or imprudence), what the US yield curve is telling us is that no matter how strong the Fed's volition is, they cannot escape Newtonian gravity:
"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward." - source Macronomics, November 2017 
Our final chart below points towards the gravitational pull the Fed is facing.

  • Final chart -  The Fed can't escape Newtonian gravity
No matter how strong the spells of the "wizards" at the Fed have been in recent years as pointed out by the wise wizard of the BIS aka Claudio Borio, the Fed's volition is one thing, Newtonian gravity is another. Our final chart comes from Bank of America Merrill Lynch's Weekly Securitization Overview from the 8th of December entitled "The gravity of the yield curve" and displays the 2Y10Y versus the US unemployment rate:
"Given the magnitude of recent yield curve flattening, we revisit our framework where we look at the 2y-10y spreads relative to the unemployment rate back to 1989 (Chart 1).

The flattener has moved more slowly than we anticipated back in 2014, dropping by about 50 bps per year over the last 4 years. Given where unemployment already is, and expectations that it will move lower in the year ahead, we see a strong gravitational pull lower on the curve. Moreover, given that the Fed likely has 4-5 rate hikes in store over the next year (including December 2017), while inflation readings remain low, dropping an additional 50 bps on the curve over the next year seems very achievable, particularly after the 30 bps drop in the 2y-10y spread in the past six weeks.
We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple “dovish” Fed hikes or pauses, and we acknowledge the potential for what we think would be steepening detours along the way.
Newton's law of gravitation resembles Coulomb's law of electrical forces, which is used to calculate the magnitude of the electrical force arising between two charged bodies. Both are inverse-square laws, where force is inversely proportional to the square of the distance between the bodies. In similar fashion, the relationship between the US 2Y10Y and the US unemployment rate could be seen as inverse-square laws when it comes to the ongoing flattening stance of the US yield curve but we ramble again...

"A man of genius makes no mistakes; his errors are volitional and are the portals of discovery." -  James Joyce
Stay tuned!

Tuesday, 28 November 2017

Macro and Credit - The Roots of Coincidence

"Coincidence is God's way of remaining anonymous." -  Albert Einstein
Watching the unabated inflows into Investment Grade funds, the 44th in a row, with pundits reaching for quality yield other quantity (High Yield), hence our "Great Rotation" narrative, when it came to selecting our title analogy we reminded ourselves of the 1972 book "The Roots of Coincidence" by Arthur Koestler. In his introductory book to parapsychology, including extrasensory and psychokinesis, Koestler postulates links between modern physics and their interaction with time and paranormal phenomena. His book was influenced by the work of Carl Jung and the concept of "synchronicity" which on a side note gave the title of the fifth and final studio album of English rock band the Police, the band's most successful release (the album Ghost in the Machine was also inspired by another Koestler's book). In his book, Koestler claims that paranormal events could be explained by theoretical physics. According to him, distinct types of coincidence are linked to serendipity aka "luck". You might be wondering already where we are going with this but we find it rather surreal to read the following essay by the New York Fed entitled "The Low Volatility Puzzle: Are Investors Complacent?" on the 13th of November in which the authors discuss the low volatility conundrum without a single time indicating the reason number one of the low volatility regime, namely their main employer and their buddies in other central banks being the main culprits in price manipulation on a grand scale. Overall this is akin to a circular reference pushed towards paroxysm we think, only for them to come to the conclusion in their paper that maybe central banks are responsible, maybe they are not hence our "Roots of Coincidence reference. No offense to the authors of the above Fed of New-York article but the low volatility regime is not a "paranormal phenomena" and the "Roots of Coincidence" has been the action of the central banks acting in "synchronicity". Whenever you have the S&P falling by 1% it seems you immediately get a Fed board member reassuring investors about the "free put" offered to them. The situation is similar in Europe and even worse in Japan where the Bank of Japan (BOJ) has become shareholder "numero uno" of many Japanese large caps via their ETFs guzzling. Maybe we are indeed not that intelligent and we don't really "get it", but when we read articles such as these, we are starting to question ourselves about the sanity of our central planners but we ramble again...

In this week's conversation, we would like to look at "roots of coincidence" in the ongoing "Goldilocks" given observable market conundrums that makes this current low volatility regime "paranormal" and therefore unsustainable.

  • Macro and Credit - The incidence of  central banks' "coincidences"
  • Final chart -  Cracks in the credit narrative - are we there yet?

  • Macro and Credit - The incidence of  central banks' "coincidences"
Last week we rebuked the "Minsky" moment in the High Yield market but, we did indicate we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. Yet the "roots of coincidence" have solely been based on central banks intervention in "price manipulation" leading to acute financial volatility repression and severe distortions. There is not a single day when there isn't the usual "permabear" pointing out to the severity of the distortion as we wait for that famous "Minsky" moment. To repeat ourselves, in our book, the match that will light the bear market narrative will simply be a significant rise in inflation expectations. We are not there yet. We don't pretend to have extrasensory  powers but we do believe that 2018 could mark the end of Goldilocks and lead to a significant rise in volatility, and we are particularly cautious for the second part of 2018, at least that's what our credit antennas are telling us but we digress. We have continuously been beating the credit drums about switching from quantity (High Yield) towards quality (Investment Grade). We continue to believe that when it comes to credit risk premia when it comes to European High Yield, we think that now there are more risks than rewards (Altice and their SFR woes being a case for caution), particularly when one looks at the flattening of the US Yield curve. Duration wise we'd rather own 5 year US Treasury Notes than an equivalent 5 year European High Yield fund or ETF. Sure, some pundits would probably like to point us towards convexity risk in Investment Grade, at least in the US you have somewhat more of an interest rate buffer than Europe (Veolia latest three year issue at negative yield anyone?). Also we started the year being US Dollar bears, and our contrarian stance has been validated so far regardless of the recent dead cat bounce. We continue to see headwinds for the US dollar even with tax cuts kicking in. This means that we would rather favor EM equities still over US equities in 2018. 

To add more fuel to the "roots of coincidence" relating to the overall complacency in volatility we read with interest Société Générale's take from the Multi Asset Portfolio note from the 28th of November entitled "Be ready for the end of Goldilocks":
"Low volatility and liquidity withdrawal are key concerns
In a goldilocks scenario of low interest rates, abundant liquidity, stable growth and a focus on the “positive” Trump, investors continue to push asset prices, volatility and leverage to historical extremes. Yet, a low volatility carry environment with rather extreme positioning is a dangerous combination, which we recently likened to dancing on the rim of a volcano. 

Volatility remains low across asset classes, on the verge of further monetary policy normalisation
It is true that volatility is relatively expensive for some asset classes, as realised volatility is now lower than implied volatility. But overall, we still observe low volatility across asset classes. With asset prices reaching record high levels, and pushing volatility down, we as investors run the risk of reliving the parable of the boiling frog: the gradual heating is so comfortable that the frog does not perceive the danger and ends up cooked. It seems that markets for now are unwilling or unable to perceive the gathering threats.
We don’t believe that it is sustainable. Additional rate hikes from the Fed over the next two years in order to reach the 2.8% neutral rate should start putting pressure on the VIX, as has been the case historically, with contagion effects across asset classes.
Liquidity withdrawal will be the main story next year – switch from equities to bonds
Growth in both developed and emerging markets will continue to creep gradually higher, with the US setting the tempo but likely reaching a peak sometime during the course of next year. In this context, we expect the main central banks to further reduce the size of their balance sheets. A direct consequence will be liquidity withdrawal from the financial system, which will put upward pressure on sovereign bonds yields, especially at the back end of the curve through some normalisation of abnormally low term premium. We prefer sovereign bonds to equity, especially in the US.
Indeed, the last 50 years have been characterised by the secular downward trend in developed markets sovereign bond yields, exacerbated by the post-crisis waves of QE. The equity space benefited significantly from the lower interest rate environment, which pushed index prices up, and from the add-on from dividends in a recovering economy while investors searched for yield. Low bond yields pushed investors into riskier asset classes to enhance returns.
Going forward, as UST yields normalise, especially at the back end of the curve (we see 10y USTs reaching 2.80% by 3Q18), the competitive advantage of US equities will start to fade.
Positioning is stretched
Another sign of complacency can be found in positioning. Having a closer look at hedge funds’ net positioning across 24 assets, we try to understand throughout the years – in January of each year – the percentage of assets with extreme positioning. We define extreme positioning as a net position level higher or lower than one standard deviation away from the historical average.
The chart on the following page shows that in January 2017, 54% of hedge funds’ net positioning on the pool of assets under review can be considered extreme (currently at 54.2%). The main culprits are: VIX, as being short VIX future volatility has delivered tremendous return since 2016; US 5y, reflecting the anticipation of further Fed hikes and improved fundamentals; crude oil; and copper. The last time positioning was stretched on such a similar share of the assets under review happened to be in January 2007, or a few months before the global financial crisis.

Low correlation within assets can exacerbate a sell off
The low level of correlation within assets is also worrying in our view. For now, as mentioned previously, the goldilocks environment – lukewarm growth and contained inflation expectations – favours the expression of idiosyncratic risks or fundamentals versus big macro drivers. The average cross asset correlation has been on a downward trend, while the average equity correlation is reaching 20%, near its lows.

The low correlation is good as of now, as it brings some diversification benefit within a multi-asset portfolio – for example, the decorrelation between EM and global equity markets observed last quarter persists and partly justifies our 7% allocation within the multi-asset portfolio, alongside the supportive growth, yield and US dollar outlooks. However, it also gives a false sense of security, as the correlation regime can quickly reverse in case of risk-off events in the markets and exacerbate a market sell-off." - source Société Générale
When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward. 

As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game. The "Roots of Coincidence" thanks to our central bankers has led to some markets conundrums as highlighted by Deutsche Bank in their Global Financial Strategy note from the 28th of November entitled "Markets upsets: Rationally explaining five conundrums":
"Five market conundrums
Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)
90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.
Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model (see our 7 November Global Financial Strategy, “Rates declining after Lower House election; share prices remain high”). Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3).

At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again (see our 16 November report, “Back to normal? Japanese equities return to model after volatility shock”). Recently volatility decreased, and stocks have begun to diverge upward from our model again.
Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)
Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.
Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).

A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.
Question 3: Ongoing yield-curve flattening
Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11).

Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.
Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13).

If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.
Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.
Question 4: Ongoing decline in interest-rate and stock-price volatility
As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.

In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding.

In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.
In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.

While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17).
There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.
Question 5: Ongoing tightening in credit spreads
Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.
The default rate (Figure 30) clearly shows that the corporate credit cycle reversed.

The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).

Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end."  -source Deutsche Bank
While financial conditions remain loose as indicated by Deutsche Bank, the hiking path of the Fed is the "Roots of Coincidence" in the start of some tightening of some lending standards. The question in relation to the change of the narrative is how long until the Fed breaks something? We wonder. Also, there is a heightened probability that the Fed finds itself once more behind the curve should renewed inflationary expectations materialize in 2018. It's not only the Fed which is in a bind of its own, the ECB should be worried from the heat coming from Germany and it's not only in real estate...

Credit wise for 2018 low spreads means potential negative excess returns in 2018 at least for European High Yield, making it particularly vulnerable to exogenous factors of the geopolitical type. There is no "Roots of Coincidence" once you reach the lower bound in credit spreads in the "beta" game, yet rising dispersion means better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversation, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. This is also indicated by Société Générale in their Credit Strategy Outlook for 2018 published on the 28th of November and entitled "The sword of Damocles unsheathed":
"Markets follow a predictable pattern in the relationship between dispersion (alpha risk) and direction (beta risk) as summed up Table 8 below.

We see dispersion rising in 1H 2018. At the beginning, this dispersion is not likely to drive spreads wider as a whole, but soon the market will go from phase 2 to Phase 3, with higher dispersion pulling spreads as a whole wider too." - source Société Générale.
There is no "Roots of Coincidence" there, dispersion as we posited last week is indicative of credit cracks in the narrative.

For our final chart, one might wonder what would be a better leading indicator to rising problems in credit markets.

  • Final chart -  Cracks in the credit narrative - are we there yet?
So you have tightening credit standards for some segments of US consumer credit, while overall financial conditions remain loose, yet rising dispersion in conjunction with negative basis are a sign that some cracks are starting to show up in the credit narrative making many investor pundits wondering what would be a useful indicator for spotting additional problems coming up. Our final chart is from Société Générale Market Wrap-up note from the 27th of November entitled "The one leverage ratio that tells you when spreads will widen" and displays balance sheet leverage figures as an indicator of rising problems in credit markets:
"While focusing on EBITDA is useful, there is a better leading indicator for problems in credit markets – balance sheet leverage figures such as debt/equity or debt/assets. Chart 5 shows the non-financial debt/assets ratio in the US relative to spreads: the average ratio weighted by the market cap of the debt is shown in blue, the median ratio is shown in brown, and US corporate spreads using the Moody’s series are shown in grey.
"The high levels of leverage in 1999 on a weighted average basis preceded the spread widening in 2001-2002. The rise in leverage from 2005-2007 was a warning ahead of the credit sell-off of 2008. Since 2013, balance sheet leverage has been widening and has continued to rise despite the 2015 spread widening (which has now been fully reversed). Credit investors should focus on this leverage ratio when considering how markets will perform in 2018." - source Société Générale
There you go, no offense to the musings of the New-York Fed and their paranormal questioning relative to the low volatility regime issue, the credit mouse trap has been set by our central planners and they are indeed at the "Roots" of the everything has a low volatility "coincidence". We don't need extrasensory and psychokinesis powers to determine the main culprit we think but we are rambling and ranting again it seems...

"The worst possible turn can not be programmed. It is caused by coincidence." -  Friedrich Durrenmatt

Stay tuned !

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.

  • 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!

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