Monday, 3 July 2017

Macro and Credit - The Trail of the Hawk

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato

Watching with interest the change in the narrative from our "Generous Gamblers" aka central bankers, leading to some rise in sovereign yields, when it came to selecting our title analogy, we reacquainted ourselves with Nobel Prize-winning novel 1915 "The Trail of the Hawk" by Sinclair Lewis. He was the first American writer to win the prestigious award. It is the fictional story of the life of Carl "Hawk" Ericson, from rural Minnesota. He begins his amazing career as a stunt pilot in the early years of aviation. As his friends and colleagues meet tragic ends, he realizes there must be a better way to use his life. His path is highly non-linear; he tries an assortment of opportunities (ZIRP, QE, NIRP). Fearing the mortal dangers of flying, maybe like Icarus who flew too close to the sun, at some point the hero Carl "Hawk" Ericson decides to retire to avoid the fate of his friends and colleagues. In similar fashion, it seems to us that our "liquidity" providers of recent years have decided to "retire" as of late, hence the recent small turmoil seen in the Government bond markets. 

In this week's conversation, we would like to look at other signs that the credit cycle is indeed in its last inning with the return of Jumbo leveraged deals and other cautious signs.

  • Macro and Credit - Credit mumbo jumbo
  • Final chart - Compensation costs and interest costs are not as in sync as they were in previous cycles.

  • Macro and Credit - Credit mumbo jumbo
Whereas "mumbo jumbo" is a language or ritual causing or intended to cause confusion or bewilderment, the latest U-turn taken by the ECB following Le Chiffre's comment (aka Mario Draghi) ties up nicely with the definition which is confusing or meaningless language. The phrase is often used to express humorous criticism of middle-management and civil-service doublespeak (or central bankers):
"The current context where global uncertainties remain elevated, there are strong grounds for prudence in the adjustment of monetary policy parameters, even when accompanying the recovery. Any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure," - Mario Draghi
What could be a better definition of "Credit mumbo jumbo" after vice president of the ECB Vitor Costancio suggested market participants had read too much into Draghi’s comments, and that they should not be considered a hawkish shift in language we wonder? But, as we have seen, as of late, it's not only the Fed that is on "The Trail of the Hawk", it seems the Bank of England and others are on a similar pattern.

While we have indicated in our past musings our growing 2007 feeling, with tighter spreads, higher leverage, clearly the returns of significant large deals in the LBO (Leverage Buy-Out) space is a clear reminder of the lateness in the credit cycle. LBOs are definitely a sign and we agree with DataGrapple's recent blog post on this subject on the 29th of July entitled "Jumbo Leveraged Deals Are Back":
"Roughly a year ago, SPLS’s (Staples Inc) attempt to buy ODP (Office Depot Inc) for $6.3Bln was thwarted by antitrust regulators. A tough year ensued after its CEO stepped down, during which the company scrambled for a plan B, closing stores and seeking to recast itself as a source of business services. It looks as if these transformation efforts seduced Sycamore though. They announced yesterday night that they are ready to bid $6.9Bln to buy SPLS in what could be the largest LBO announced this year. Even though a deal had been rumoured for some time – it was reported in May that a takeover offer from Cerberus had been rejected because it was too low -, investors initially sent SPLS’s 5-year risk premium soaring 50bps wider at 350bps, as such deals inevitably mean more debt. But soon it transpired that Sycamore, in a similar move to what it did when it bought Jones Group in 2014 and split it in 4 different independent operating companies, could divide SPLS into three different entities: US retail, Canadian retail and corporate-supply business. It inevitably raised the question of where the debt will sit and which entity (or entities) CDS currently referencing SPLS will cover. The answer is not necessarily the most leveraged. The CDS gave up all its widening and more, to close 25bps tighter on the day at 272bps." - source DataGrapple
At the same time we hear that Apollo Global Management has raised $23.5 billion for the largest buyout fund ever.  Blackstone's fund raise of nearly $22 billion in 2007 was near the top of the previous bull market as a reminder. For us this is another sign of the lateness in this credit cycle and no this time it's not different rest assured.

This is what we wrote about the return of LBOs in 2013 in our post "For whom the Dell tolls":
"In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fueled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 
The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  Energy Future Holdings was loaded with 37.4 billion USD worth of obligations whereas Texas Competitive was saddled with 32.2 billion USD in debt, 700 million USD of which was due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 
KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp moved towards bankruptcy and restructuring 
Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council." - source Macronomics, 2013
As a reminder, during the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news.

There lies the crux of the current tactical issue, leverage has been creeping up in US investment Grade and High Yield is facing headwinds thanks to rising oil woes, which is triggering some fund outflows as of late, including the feeble ETF retail space. Now as a credit portfolio manager, you probably want to dust out your LBO screeners. Not only are central bankers with their mumbo jumbo lingo triggering heightened volatility in government yields, but there are indeed potential sucker punches awaiting credit investors with the return of the 2007 LBO trend. In relation to the US Investment Grade Outlook we read with interest Wells Fargo's take on the subject in their latest outlook note entitled "Hoping for Carry":
"U.S. Investment Grade (IG) corporate credit spreads are currently close to the tights of the year (112 bps) but remain within our expected target of +/-10 bps this year. A healthy rally at the beginning of the year has given way to a steady ‘lo-vol’ grind as credit spreads remained in an 8 bps range over the quarter. The benefit of last year's aggressive loosening of global monetary conditions has started to fade, while hope for a meaningful fiscal stimulus in the U.S. has been tempered as well. That said, credit fundamentals appear to have stabilized as corporate profitability has improved. Looking forward, we expect the current environment of ‘lo-vol’ carry to continue with few macro catalysts on the near-term horizon. However , the trajectory of spreads could become more choppy as the summer ends and monetary and fiscal policies return to center stage. Over the course of the year, we expect the YTD range to hold for credit spreads with IG +/- 10 bps and HY +/- 50 bps, but in the near term, the grind should continue . To position portfolios, we recommend credit investors stay fully invested to capture as much carry and residual spread compression as possible, but also strongly recommend moving up in quality where possible to minimize a big macro beta bet and instead focus on more micro trades to drive outperformance. To do so, we recommend remaining Market Weight in IG and prefer to focus on sector and curve strategy.
Fundamentals: IG companies continue to run historically high levels of leverage with Non-Financial debt/EBITDA of 3.0x. Q1 earnings came in well ahead of expectations, marking the best earnings season since 2011, and strong earnings growth is expected to continue over the balance of the year. However, while earnings are rising, debt is also rising at a rapid clip, particularly for the lower beta portions of the market. As a result, overall Non-Financial leverage remains unchanged as leverage ex-Energy is expected to converge toward Energy over the balance of the year.
Technicals: Demand for IG continues to be robust in H1 2017 with record inflows to IG mutual funds and ETFs, pushing up total assets in IG mutual funds to $2.0 trillion. IG bond issuance has similarly clocked a record pace in H1, but the slowdown in Q2 from Q1 has allowed spreads to continue to grind tighter. Foreign demand has been choppier this year as the cost to hedge USD fixed income positions remains high and the USD has started to weaken. Looking forward, we expect slightly less technical support in 2017 versus 2016 as monetary policy moves tighter and foreign flows decelerate.
Valuations: The current spread level of 112 bps is through our year-end spread target of 120 bps. With expectations of modest widening, but still positive excess returns, we believe chasing beta is a low-quality trade and recommend investors move up in quality to take advantage of currently compressed valuations. We favor curve flatteners at the long end as we expect rates to end the year above today’s levels, while we favor curve steepeners at the front end to take advantage of historically flat curves." -source Wells Fargo
We keep repeating this but in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. In our January 2014 conversation "Actus Tragicus" we indicated that the end of low interest rate volatility would end the "goldilocks" period for Investment Grade credit. We therefore think that rather than being focusing your volatility attention towards the VIX index, you should switch your attention towards the MOVE index we discussed in our previous conversation:
"Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)." - Macronomics, January 2014.
As noted above for leveraged and carry players, namely the "Beta" crowd, interest rate volatility matters, particularly the "Risk-parity crowd". From a positioning perspective in an environment impacted by dwindling liquidity and rising "convexity" risk from both a duration and credit quality perspective, we believe in a defensive position in H2 on US investment Grade, meaning lower duration exposure in credit as well as higher credit quality given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication". Investors have had no choice but to take on more credit risk hence and what we have called in the past a credit "mousetrap". Recently we indicated that tactically going for duration again particularly in credit has been paying off nicely (MDGA - Make Duration Great Again). This positioning has been vindicated as shown in the below chart from Wells Fargo US Investment Grade Outlook note showing that IG 10 years + has been outperforming:
- source Wells Fargo

Why the advice to continue playing defense in H2 and reduce duration? Not only inflows and new issues have been very significant but, as per the below Wells Fargo chart, duration risk is at all-time high:
- source Wells Fargo

So far, with the latest gyrations in sovereign spreads thanks to "The Trail of the Hawks" has been contained in the Investment Grade space, yet, with a potential return of Interest Rates volatility, one would be wise in the current context to dial down a bit his duration exposure we think. 

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk significantly as per the above Wells Fargo chart, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series. Durations have continued to extend thanks to lower coupons so to fully hedge out a market-based cash portfolio with 7.5 years of duration, you would require an extra 60% of protection to result in a CR01 neutral portfolio. This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if one wants to be "duration neutral" that is. So if indeed "The Trail of the Hawk" is the new mantra for our central bankers, not only you need to reassess your beta exposure credit wise, but, given the renewed pressure on High Yield outflows thanks to pressure on oil prices, you might as well need to rethink about "Gamma". On this subject we agree with DataGrapple post from the 28th of June entitled "Gamma or Theta?": 

"In the morning, investors appeared to be reappraising the outlook for global borrowing costs and monetary policy in the wake of the comments from the usually dovish Mr Draghi. Global central bankers are coalescing around the message that the cost of money is headed higher. These concerns about tighter monetary conditions were compounded by remarks by Mrs Yellen yesterday that asset valuations look high by some measures, another global cyber-attack, an IMF cut to their US growth forecast. As a precautionary measure, iTraxx Main (ITXEB) was sent 1.5bps at 56.5bps, iTraxx Crossover was sent 6bps wider at 244bps, and all risky assets felt a bit shaky. That proved too much for the ECB to handle and they felt they had to say markets had misjudged Mr Draghi speech on stimulus. It certainly produced the desired effect, and risky assets went in reverse across the board. So, for the first time in a while, volatility has reared its head again, with investors able to capture a 4bps total variation on ITXEB today. The potential for tape-bombs to rock the market is now clear to everyone. That leaves options players conflicted between owning cheap gamma and having positive theta for the US holiday week-end coming up." - source DataGrapple
So if you think that on top of LBOs bombs falling in Investment Grade, you might fell prey of the hawks' latest mumbo jumbo, you might want to think about owning indeed cheap gamma. You might enjoy the low volatility regime providing you so far a "Goldilocks" scenario for credit, but should you want to play it safe through "Gamma" rather than being negative carry through a straight purchase of CDS indices, then you might want to look at credit options given they are still relatively cheap to own as displayed in the below table from Barclays CDS Index Options note from the 27th of June:
- source Barclays

As per the above, even in credit, spot volatility has been trending down, mist likely thanks to the relentless hunt for yields and Structured Credit players continuing to sell protection and hitting the bid of market-makers in the process as discussed recently.

As we have indicated in recent musings, there are many late credit cycle similarities to the 2007 period with credit spreads tightening, low volatility and renewed structured credit activity, with investors extending both credit risk and duration risk. There is as well on "The Trail of the Hawk", tighter monetary policy and a flatter yield curve typical of late economic expansion. Yet as per our final chart below, there is something different this time around, which is that compensation costs and interest costs are not in sync. 

  • Final chart - Compensation costs and interest costs are not as in sync as they were in previous cycles.
As we concluded above, there is something puzzling in the current late credit cycle, namely that compensation costs and interest costs have been diverging, which remains an oddity. Our final chart comes from Société Générale American Themes note from the 29th of June entitled "US recession odds remain extremely low but concerns are growing". The chart displays the net margin expenses for US companies which in this current late cycle are not behaving like in previous cycles:
"One item different than previous cycles – Net interest margins remain low

We highlight the evolution of profit margins in a business cycle. Importantly, margins are getting squeezed due to labor compensation. We would be remiss not to point out the benign nature of net interest margins.
Net interest margins typically climb during the late phase of a business cycle. At present, we are not seeing that pattern. Low interest rates are restricting interest expenses despite heavy debt issuance.
Limited tightening from the Federal Reserve is keeping a lid on interest costs for US companies. If we are in the later stages of a business cycle, interest rate expenses are behaving in a different fashion than previous late-cycle periods. Conversely, the lack of interest expense pressures reduces the odds that the US economy is in a late cycle.
Tighter Fed monetary policy is a feature of many late economic expansions. In June, the Fed hiked rates for the fourth time in the current business cycle. The amount of tightening is low, the 10y Treasury yield is lower than it was when the Fed first hiked rates (December 2015), and credit spreads are mostly tighter. Do profit margins or interest costs matter more for the investment decision? The charts above offer some glimpse into a method of answering this question. Businesses seek profits and bear costs, such as interest expenses, to the point that margins justify the investment. The current period is unique in that compensation costs and interest costs are not as in sync as they were in previous cycles.
Debt stresses may be materializing despite restrained interest costs. Notably, we are seeing rising delinquencies in auto loans and rising charge-off rates for consumer credit. Further, the Fed’s Loan Officer Surveys show slowing credit demand and some instances of more restrictive credit. These debt features may be signs of stress not evident in issuance volumes or credit spreads." - source Société Générale
To paraphrase Bastiat, there is always what you see and what you don't see. Today the Treasury curve is the flattest it has been since March 2008. No doubt to us that the Treasury yield has had an historic accuracy. Additional rate hikes will increase the flattening on "The Trail of the Hawk". Also as we pointed out recently consumer credit recent weaknesses are a cause for concern and we are increasingly monitoring this space. If profit margins continue to shrink like they did through 1Q2017 to 12.5%, the lowest level since 2011, you could get your double whammy. The Trail of the Hawk might be tortuous but is nonetheless treacherous.

"To be interested in the changing seasons is a happier state of mind than to be hopelessly in love with spring." - George Santayana

Stay tuned!

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