Tuesday, 18 July 2017

Macro and Credit - The Rebound effect

"Credibility is a basic survival tool." Rebecca Solnit, American writer

While listening to the somewhat "dovish" comments of Fed in chief Janet Yellen as of late, we reminded ourselves for our title analogy of the "Rebound effect", being the emergence or re-emergence of symptoms that were either absent or controlled while taking a medication, but appear when that same medication is discontinued (QE taper), or reduced in dosage. In the case of re-emergence, the severity of the symptoms is often worse than pretreatment levels, such as valuations we would argue which are somewhat rich according to Janet Yellen. Obviously in "Rebound effect" one could argue that "rich" valuations get richer even with discontinuation of sedative substances. It seems that Janet Yellen's words have fallen on deaf ears given her latest "dovish" comments have had no effect to the partygoers who have gotten seriously intoxicated on the Fed's punch bowl in recent years as indicated by the ultra-low levels of volatility reached in various indices (VIX, MOVE, to name a few). Even implied credit volatility is steering towards historical lows while inflows into Investment Grade credit in 2017 have been spectacularly strong. 

In this week's conversation, we would like to look at low volatility in the credit space as yet another sign of complacency. While everyone is basking in the sun, we think that a return in volatility is lurking in the shadows yet Goldilocks in credit, one would have to admit has been saved again by a more Dovish tone from Janet Yellen. We wonder if the Fed's chair is not more interested in preserving her legacy while still at helm, hence the more recent rhetoric but we digress.

  • Macro and Credit - Oh My God! They Killed Volatility!
  • Final chart - Get over it, the Phillips curve is dead.

  • Macro and Credit - Oh My God! They Killed Volatility!
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 as reported by Bloomberg on the 17th of July in their article entitled "Europe's Junk-Bond Boom Triggers Alarm as Safety Nets Weakened":

"The whole European junk bond market is on track for the busiest July on record, whereas issuance in the U.S. is waning. So far this month, sales swelled by 400 percent from the same period last July, while equivalent U.S. offerings dropped about 75 percent, Bloomberg data show.
- source Bloomberg

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, as we indicated last week, 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. The warnings sent by our central bankers have continued to fall on deaf ears and the "beta" game is continued to be played although, recently High Yield fund flows have been weaker. What goes up often goes down to paraphrase Mark Yusko from Morgan Creek's previous quarterly gravity parabola. We would add that what goes too tight often goes too wide in relation to credit spreads. That was at least the story for the second part of 2016 when it comes to the Energy sector. But, as we indicated recently, it seems to us that in terms of risk-reward, High Yield has moved from expensive or "rich" to super expensive and in particular Euro High Yield. On that note we agree with Richard Barley's article in the Wall Street Journal entitled "The Vanishing Reward for Buying High-Yield Bonds":
"The risk premia on high-yield bonds in the U.S. and Europe were negative in June, PPMG calculates. The extra yield wasn’t enough to compensate investors for the risk of owning them over time.
This has happened before, most recently in 2014. That was followed by a selloff that gathered pace in 2015 as the falling oil price hit energy-company balance sheets, most notably in the U.S. There may not be an immediate catalyst for the market to fall now. But for investors buying high-yield bonds, the risk-reward balance doesn’t look encouraging."  - source Wall Street Journal
Although oil prices have been under pressure in 2017, credit has been widening at a much slower pace than what we saw in early 2016. It seems to some instance that overmedication have led to some sort of permanent anesthetization and significant complacency although central bankers have started reducing in earnest the prescription drugs recently. Many pundits have been impressed by how resilient credit has been in the latest bout of Sovereign yields volatility. Everyone and their dog has been focusing on the low levels touched on VIX as indicative of the current complacency, but, if there is one asset class that has shown low volatility for different reasons than the equities space, it is in credit. On that subject we read with interest Morgan Stanley's take from their Credit Derivatives Research note from the 14th of July entitled Vol AWOL.
"Over the past year, we have analyzed credit valuations through several frameworks and found US credit markets to be rich most ways we slice them. Spread per leverage is close to all-time tights, and spread per duration has rarely been lower, while the quality of the IG market has deteriorated over time (see Investment Grade Research: Not Your Parents’ Market). The one exception is that credit spreads adjusted for the level of volatility still look attractive relative to history. In other words, if this low-vol environment persists, then credit may remain an attractive carry trade.
In our view, the recent bout of low volatility (implied and realized) is yet another sign of complacency in credit markets. And while volatility has been low this year, it is worth remembering that we have seen considerably higher return volatility in this cycle than in prior bull markets, with IG and HY spreads hitting ‘recessionary’ levels twice (2011, 2016).
Therefore, focusing on just the last 3-4 months misses the bigger picture. In our view, central banks have been somewhat successful in this cycle at responding to periods of tighter financial conditions, muting volatility in the process. We believe recent hawkish rhetoric out of many global central banks, on top of the Fed pushing ahead with its plan to continue hiking rates while shrinking the balance sheet is a clear catalyst for vol to again rise (see US Fixed Income Strategy: Trading the Fed's Balance Sheet). And when that happens, buying credit as a carry trade at very tight spread levels will no longer look as appealing.
Just as investors have reached for yield in this cycle, low implied volatility levels have also been driven by a search for income, a trend that has accelerated at tight spreads. We think both fundamental (central bank policy) and technical (systematic selling of vol for income) factors have driven volatility to these low levels, and an unwind of these dynamics could impact volatility in the other direction on the way down. In this week’s report, we dig into credit volatility in more detail.
Volatility and Valuations
We start by looking at the current level of volatility in credit markets on an absolute basis and in the context of credit valuations. In Exhibit 3 below, we show the level of 3M implied volatility for CDX HY.

Quite simply, implied volatility is close to historical lows across many asset classes. In the context of credit vol specifically though, we would note a few additional points. First, the repricing in credit implied volatility has been more meaningful when compared to prior lows. For example, CDX HY 3M implied vol recently hit a level of 3.5% vs. 5.2% at the tights in spreads in 2014. In comparison, 3M SPX implied vol hit a recent low of 9.6%, marginally below the lows of 2014. Second, on a historical basis, implied credit volatility trades closer to realized than in many other markets (Exhibit 4).
The importance of low volatility for credit markets should not be understated. Credit is a low-beta asset class and is inherently short volatility and tail-risk. At low yields and tight spread levels, the case for credit rests in part on attractive risk-adjusted returns. Low levels of volatility boost ‘carry’ trades, make fund Sharpe ratios look better and of course, are a general barometer of risk appetite. In Exhibit 6 below, we show trailing CDX IG spreads normalized by the level of 3M price volatility. Volatility-adjusted spreads clearly do not look as extreme as other metrics, like spreads adjusted for balance sheet leverage (Exhibit 5).

The risk with looking at spread/vol is that volatility is backward looking and is much less stable than a fundamental measure like leverage. For example, 3M realized price volatility in CDX IG would need to rise by just 0.3% for vol-adjusted spreads to trade back to historical averages. In addition, an ‘extreme’ level of spread/ volatility has not been a great predictor of future market performance. In Exhibit 7 below, we break-out the spread to volatility ratio into different buckets and show the average 1M forward index return and hit rate of performance (percentage of times returns are positive). Across both these metrics, we find that when spread/vol is high, returns going forward tend to be low and positive returns are less frequent.

Drivers of Low Realized Volatility
There are clearly many drivers of the current low vol environment. While we won’t spend much time on the fundamental elements, central banks have clearly played a role. As Exhibit 8 shows, this cycle has been characterized by elevated uncertainty and multiple growth scares. 

These environments have led to big waves of spreads widening. However, each of these episodes have also been followed by unprecedented levels of stimulus from the Fed as well as other global central banks. This ‘Fed’ put has no doubt muted volatility, at least for extended periods of time in this cycle.
Beyond central banks, portfolio dispersion has also played a role in low volatility levels this year. In fact, we think the current low level of volatility is masking some underlying dynamics in the CDX market. For example, dispersion in US credit is actually higher today than it was at the tights of the cycle in 2014. We try to show this using two charts: First, comparing the widest 10 names in the CDX IG index vs. the rest of the portfolio (Exhibit 9).

Second, we look at the standard deviation of weekly cross-sectional spread changes for the CDX IG constituents and normalize it by the level of volatility (Exhibit 10).

Both these metrics show that credit dispersion is higher today than it was at the tights of the cycle back in 2014. Effectively, this has played some role in keeping the index levels more range-bound and less volatile than may be the case otherwise.
In the equity market, very low levels of single-stock correlations have helped drive low realized volatility. In that sense, this dispersion dynamic in credit markets is not that unique. However, we would highlight an important distinction. The low correlation level in equities seems more about sector rotation (Tech unwind, value vs. growth) and certain sector-specific factors (Financials). In credit, the drivers of dispersion are mostly negative stories related to certain sectors that either face structural or fundamental challenges (e.g. Retail, Energy, Autos). As we have noted in the past, issues in credit tend to show up first in the most fundamentally stressed sectors, and are initially treated as idiosyncratic. Eventually, the stress spreads to the broader market as credit conditions tighten. As a result, we would not use the dispersion argument in credit to justify low volatility levels over a long period of time.
Drivers of Low Implied Volatility
Having discussed some of the drivers of low realized volatility, we now shift to the drivers of implied credit volatility. The first point we note is the move lower in implied is not just a function of low realized volatility. For example, at the tights of the cycle in June 2014, CDX HY 3M vol traded 1.45x 3M realized vol and CDX IG traded 1.29x 3M realized vol. Today, CDX HY vol trades 1.17x, whereas IG trades 1.19x. We see a similar trend of implied compressing to realized when comparing the credit and equity markets. However, historically, credit implied vol has traded at a larger premium to realized than the implied premium to realized in the equity market. In recent months, this relationship has flipped (i.e., a lower implied/realized ratio in credit than equities).

More specifically, looking just over the past 12 months, we have noticed a large pick-up in systematic selling of credit volatility. Anecdotally, these investors have been most active in shorter-dated expiries. In Exhibit 12, we show 1M and 3M implied volatility levels in CDX IG to highlight the importance of these flows. While 3M implied spread vol in IG is just ~3.5% below the average levels around cycle-tights (June 2014), 1M implied volatility has repriced even more meaningfully, lower by 5%.
Broadly, this selling of volatility in the credit options market, motivated by the same global reach for yield driving flows into US credit, has helped compress implied volatility to new cycle lows. Arguably, as credit valuations richened, these flows if anything strengthened as the relative benefit of selling options (vs. long spreads) became more attractive.
To the extent the selling of volatility is driven by an income-generating alternative to long carry via spreads, we think these flows may be reaching a limit. Implied volatility, when adjusted by historical index spreads levels, is already very low. We show this in Exhibit 13 below.

For example implied CDX HY spread vol today is around 27%, relative to a regression implied level of 36% based on the last 7 years of data. Also, as we mentioned earlier, historically, implied credit volatility used to trade richer to realized than many other asset classes. This is not the case today and hence selling credit volatility may not look as attractive on a cross-asset basis.
At the other end of the spectrum, demand for credit option hedges has also slowed down quite meaningfully. Large non-economic buyers of credit vol, such as banks, have been much less active this year relative to prior years. Anecdotally, the lower demand for credit hedging has been driven by expectations for easier capital requirements around less onerous stress scenarios.
Bigger picture, in our view, the conditions for volatility to remain low seem to be fading. For example, central bank rhetoric globally has turned hawkish at the margin, with the Fed seemingly more focused on financial conditions as well as risk-asset valuations. And when volatility does start picking up, some of the technicals noted above that have pushed it to such low levels, could exacerbate volatility on the way down. Just as strong and consistent flows have pushed spreads to very tight levels in this cycle multiple times, but when these flows turn the other way, weak liquidity has driven sharp moves in the other direction." - source Morgan Stanley

As we have reiterated recently, the credit mousetrap is coiled and has been set by our "Generous Gamblers". Of course flow wise the credit mouse trap continue to be coiled on a weekly basis, particularly in Investment Grade Credit according to Bank of America Merrill Lynch Follow The Flow note from the 14th of July entitled "Not giving into your (rates) tantrum":
"IG inflows are strong and stable
The high volatility in the rates markets has done little to deter the inflow stream into high grade funds. The resilience of the credit bull story (thanks for the backdrop of CSPP) is proving strong. This is evident in the divergence seen in fixed income flows, as IG credit fund flows remain high and positive, while government bond flows have moved into negative territory.
Over the past week…
High grade funds recorded another week of inflows; their 25th in a row and the third consecutive one above the $2bn mark. High yield fund flows remained negative for a third week and we note that the volume of the outflow has remained strong for a second week. Looking into the domicile breakdown, the aggregate number has been pulled down predominantly by European-focused funds, just as US focused funds flows were negative for the sixth consecutive week.
Government bond fund flows turned negative for the first time in six weeks. Overall, Fixed Income funds recorded their 17th consecutive inflow, again predominately driven by strong flows into IG credit funds." - source Bank of America Merrill Lynch
The Rebound effect is still going strong credit wise. Investors continue chasing yields, having both extended their duration and credit risk in recent years thanks to central banks meddling and selling volatility as well. No wonder volatility has been neutered. As we pointed out last week, there is a growing disconnect between fundamentals from the real economy and asset prices. We have used this analogy before of Disney's Fantasia movie and the sorcerer's apprentice. At some point having poured so much water (liquidity) our little apprentice finally loses control and eventually the old and wise wizard has to step in (BIS?). We are slowly but surely getting there. Are central bankers ready to take the proverbial credit punch bowl away? We wonder. 

Right now there are still a lot of buyers in credit with still so much liquidity sloshing around but clouds are gathering such as the US debt limit falling in the first half of October. To repeat ourselves, in the current Goldilocks scenario for credit, there is still room for further credit spreads tightening. With such strong inflows, unless we see some exogenous geopolitical factors coming into play, even with the most recent toned down rhetoric from Janet Yellen, it is hard to see just yet a change in markets volatility dynamics. As this long rally continues to be hated by so many, eventually Goldilocks will finally catch up with the three bears but it isn't the time yet. For now it is still yield chasing time but you would be well advise to start building up some "duration" and "credit" defenses while it is still cheap, just a thought. 

In our conversation "The Trail of the Hawk" we indicated that cheap gamma could be found in credit options and that in Investment Grade there were relatively cheap to own. You might already been wondering if there is a trade here. On that subject we read with interest Bank of America Merrill Lynch take in their Relative Value Strategist note from the 13th of July entitled "Volatility is low. In credit, especially so":
"Within credit, IG vol appears cheaper than HY
As we wrote recently, the plunge in oil prices and weakness in retail names have made HY quite vulnerable to macros risks. The implied vol premium in HY reflects that risk. However, the realised volatility of HY hasn’t really increased relative to IG. As a matter of fact, the beta is near its lows
Is there a trade here?
The divergence between credit volatility and comparable equity metrics has persisted for a while now. It is a symptom, we think, of the low volatility-high fragility regime that has characterized markets over the last couple of years.

We are reluctant to recommend a credit-equity relative value trade here for two (related) reasons. One, cross-asset beta has been very unstable and it is difficult to pick the ‘right’ value with any degree of confidence. Two, we suspect that unless the economic cycle turns, stocks are likely to respond more aggressively to shocks than credit i.e. the risk premium in equity vol is probably justified. All that said, for those looking for a low cost hedge, IG volatility appears to be the cheapest here, relative to equities and HY.
Why is credit volatility so low?
There are several explanations for this persistently low implied volatility. For one, there are simply more sellers than buyers. CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. Among those who do employ derivatives, the bias has been towards selling volatility as a means to generate premium. This leaves banks as the sole structural buyers of index options. Secondly, implied volatility is low because realised volatility has remained persistently low. CDX IG has been realising less than 30% (annualised daily spread) volatility for a little over 6m now, longer than similar stretches in 2014 and 2015. Finally, economic data volatility has been subdued. While there have been some signs of weakness, the economic narrative hasn’t shifted dramatically. If economic volatility returns, either through the Fed committing a policy mistake or by falling behind the curve, we think credit volatility will follow suit." - source Bank of America Merrill Lynch
Whereas High Yield has remained more sensitive to macro risks such as the variation in oil prices, Investment Grade credit volatility has remained subdued hence its relative cheapness. Even in credit, when it comes to volatility, there is a simple rational behind the low level reached, there are simply more sellers than buyers as pointed out in Bank of America Merrill Lynch's note:
"Why is credit volatility so low?
The evident reason: more sellers than buyers CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. While some may choose to hedge using the underlying index, the practice isn’t prevalent among a majority of money managers. Among those who do employ derivatives, the bias has been towards selling protection or selling volatility as a means to park incoming funds while ramping up the portfolio or simply to generate carry/premium. This is particularly true in CDX IG, where for several years now there has been a large non-dealer long base in the index.
The reluctance to hedge with derivatives can be attributed to a few factors. For many, it
may just stem from unfamiliarity with the product and never having used derivatives
There is also the issue of mismatch between cash credit portfolios and CDX. CDX IG
doesn’t include any Banking names, which is the largest sector within High Grade.
Similarly, until recently CDX HY had very few Energy names even though the sector is
one of the largest in High Yield.
Corporate bond benchmarks and the portfolios that follow them are weighted by market capitalization, making them highly sensitive to the largest debt issuers. In contrast the CDX portfolio is equally weighted.
Beyond differences in portfolio construction, there is also the fundamental question of risk i.e. what is the exposure that needs to be hedged? CDX is a spread product, a vehicle to gain exposure to pure credit risk. However, most high yield accounts and more than half on the high grade side are ‘total return’ investors i.e. they are sensitive to both spreads and rates.
There is very little default risk in high grade portfolios and at the portfolio level there is perhaps more concern with hedging duration risk than credit risk. Also, since rates and spreads are negatively correlated, spread widening is often accompanied by lower rates, which softens the PnL impact.
In high yield, we also think there is some ‘hedge fatigue’. Because the CDX HY index did a poor job of representing the cash market in the past, it has not always held up as a good hedge for high yield bond portfolios. This issue has been corrected to some extent with changes in the index composition, but past experience perhaps continues to sting.
All this leaves banks as the sole structural buyers of credit options. They tend to buy low delta payers to hedge their loan books or origination activity or receive regulatory capital relief, among other things. What’s more, this technical is largely isolated to IG." - source Bank of America Merrill Lynch
So all in all, there much more concerns for investors with hedging duration risk rather than credit risk when it comes to Investment Grade credit. The risk of a "convexity event" with the perilous exercise of the reduction of the Fed balance sheet means that the focus should rather be on bond volatility and its indicator the MOVE index in the coming months. Obviously the recent dovish tone from Janet Yellen is we think representative of our "Generous gamblers" concerns with bond volatility given leveraged players and carry speculators, only love one thing and that's low rate volatility. Our central bankers are walking on a tight rope. After having coiled the volatility spring with their financial repression, they are trying to unwind it at a slow pace and avoid rocking the boat. It remains to be seen in the coming months how they are going to pull it off. 

While volatility seems to be at the moment "flatlining", so is the Phillips curve dear to the economists at the Fed, in true "Japanese" fashion as per our final chart. On a side note we have become more positive on gold and gold miners as of late thanks to Janet Yellen, therefore playing the "Rebound effect".

  • Final chart - Get over it, the Phillips curve is dead.
Back in our May conversation "Wirth's law" we confided that we were part of the crowd claiming the death of the Phillips curve. As well, back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate in true "japanification" fashion. Our final chart comes from Deutsche Bank FX Daily note from the 14th of July entitled "When the Fed's punch bowl lacks punch" and displays the Phillips curve being flat on its back:
"From this we can conclude:
i) There is extreme inertia built in to inflation’s response to changes in economic activity, even if it is possible that the Phillips curve steepens in extreme circumstances of over and under capacity.
ii) The corollary is it is extremely difficult for the Fed to impact inflation through activity/growth measures. The Fed (and the Fed is not alone among Central Banks) has lost control over a half of its mandate.
iii) While doctrinaire goods and services inflation targeting persists, price cyclicality will be concentrated in larger asset price cycles. One difference between asset inflation compared with traditional goods & services inflation is that asset inflation also leads growth measures. The cycle then tends to show up as follows: asset inflation driving up capacity utilization, which does not show up meaningfully in traditional CPI measures, that leaves policy overly accommodative, that pumps up the asset cycle, until asset prices reach such extremes they turn on themselves.
iv) At least while the Phillips curve framework is being adhered to, the Fed will be very slow to ‘take away the punch bowl’.
v) The outstanding question for the Fed watchers is how will Fed deal with the status quo over the next year? IF inflation remains slightly below target, bonds handle the Fed balance sheet adjustment reasonably, risky assets remain strong, and growth remains at or above trend, will the Fed tighten in 2018? At least while the market cannot firmly answer in the affirmative, the USD is going to find limited support, especially against higher yielding currencies.
vi) The market assessment that there is more punch to be drunk, is probably correct. It still looks too early to bail-out of the positive risk story. In part because we have seen this narrative before in the late 1990s, asset froth in this cycle is prone to build more slowly and to lesser extremes. The Fed may have lost control, but the market will exert greater self-control. 
The optimistic risk conclusion is: drinking slowly from the punch bowl, extends the party – and should help with the hangover." - source Deutsche Bank
It looks to us that "The Rebound effect" is pushing towards a final melt-up regardless of the narrative of our "Generous Gamblers". For now, everyone keeps dancing, particularly in Investment Grade credit and in similar fashion to 2007, market makers keep getting hit on the bid, whether on CDS or Credit Options and continue to feel the pain of not being able to recycle effectively the relentless tightening seen in credit. As the sorcerer's apprentice in 1940 Disney's Fantasia movie, we would have to agree with Deutsche Bank, that the Fed has lost control and has tried too hard to exploit the Phillips curve as per Robert Lucas' critique. When unemployment becomes a target for the Fed, it ceases to be a good measure because like in Japan, over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. What these PhDs at the Fed need to understand is that these relationships change over time, making these models less reliable. At least you know that they will be slow in removing the punch bowl for the time being, that's a given. For more on the subject of the Phillips curve, we encourage you to read Hoisington Quarterly Review and Outlook for the Second Quarter 2017, a must read in our humble opinion. For now one could conclude from our conversation that "rich" valuations will get richer even with discontinuation of sedative substances. Sic transit gloria mundi...

"All things are only transitory." -  Johann Wolfgang von Goethe

Stay tuned!

Tuesday, 11 July 2017

Macro and Credit - Bond ruck

"It slightly worries me that when people find a problem, they rush to judgment of what to do." -  Janet Yellen

Looking at the growing convolutions of various bond markets, following a similar pattern seen during the previous "Taper tantrum" of 2013, we decided to use another term for the on-going situation for our title analogy. A ruck is a situation where a group of people are fighting or struggling, such as bond investors and CTAs alike as of late. But, in our much enjoyed game of rugby it is a situation where a group of players struggle for possession of the ball, leading to a loose scrum. A ruck typically evolves from a tackle situation and can develop into an effective method of retaining or contesting possession. A ruck can commit defenders, therefore creating an opportunity to create space. On formation of the ruck, offside lines are created. Admittedly for those in the know when it comes to rugby matters, a ruck is the most complex and subtle phase in rugby. It necessitates, individual talent, vivacity, and precision. While we remained bullish for the first semester of 2017, we have voiced on numerous occasions our concerns for the second part of 2017. Given the most recent "Bond ruck" thanks to central banks recent hawkish pattern, we think one should approach a more defensive stance for the second part of the year. In the on-going tussle between investors and central bankers, one would be wise to commit defenders as you can expect volatility to creep up in the coming months. As a piece of advice for the second part of the year, in a Bond ruck, you need strong posture to minimize injuries because the ruck is a tough place to be. You have been warned.

In this week's conversation, we would like to look at signs that we are about to enter a regime change in volatility, coming from the bond market which could easily spillover to equities in the coming months thanks to a potential risk for a convexity event.

  • Macro and Credit - On the road to a convexity event?
  • Final chart - Unemployment and volatility may be too low for the Fed
  • Macro and Credit - On the road to a convexity event?
Back in August 2013, in our conversation "Osmotic pressure" relating to the "Taper tantrum" effect on Emerging Markets, we reminded ourselves the wise words from one of our very astute credit friends (former head of European credit research at a house we know very well) on the subject of convexity in June 2013 in our conversation "Singin' in the Rain":
"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"
At the time we argued:
"The Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming." - Macronomics, June 2013
But, convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked during taper tantrum and all. In 2013 our very astute credit friend told us the Fed would basically have to do a ECB - stop buying USTs and start buying RMBS at some point, and guess what they did precisely that.

Why so? Pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR. So if cost of LIBOR goes up, then these are the whales you want to watch. Not the commercial banks. 

It looks like our very astute credit friend was prescient in 2013. In a roughly two-year span that ended in 2014, the Fed increased its MBS holdings by about $1 trillion, which it has maintained by reinvesting its maturing debt according to Bloomberg from February 2017 entitled "Everyone Is Suddenly Worried About This U.S. Mortgage-Bond Whale":
"In the past year alone, the Fed bought $387 billion of mortgage bonds just to maintain its holdings. Getting out of the bond-buying business as the economy strengthens could help lift 30-year mortgage rates past 6 percent within three years, according to Moody’s Analytics Inc.

Unwinding QE “will be a massive and long-lasting hit” for the mortgage market, said Michael Cloherty, the head of U.S. interest-rate strategy at RBC Capital Markets. He expects the Fed to start paring its investments in the fourth quarter and ultimately dispose of all its MBS holdings." - source Bloomberg

And of course the new dance routine was buying RMBS in size...In that sense the Fed executed perfectly its bond ruck in recent years to avoid a "convexity event".  

As a reminder from our conversation "Cloud Nine" from July 2013 year of the "Taper Tantrum": 

"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2." - source Macronomics, July 2013

What matters for these guys is the velocity in the rise in interest rates. So if the Fed is facing a raft of sellers and the economy is not as strong as it seems they might need to revisit QE at some point but we are not there yet dear friends.

All in all, we think today the Fed is in a bind with is planned reduction of its balance sheet and hiking rates at the same time, hence our Bond ruck title analogy.

From Bloomberg article above:

"Mortgage rates have started to rise as the Fed moves to increase short-term borrowing costs. Rates for 30-year home loans surged to an almost three-year high of 4.32 percent in December. While rates have edged lower since, they’ve jumped more than three-quarters of a percentage point in just four months.

The surge in mortgage rates is already putting a dent in housing demand. Sales of previously owned homes declined more than forecast in December, even as full-year figures were the strongest in a decade, according to data from the National Association of Realtors." - source Bloomberg

And guess what Marc Faber, Dr Doom said in 2013?
"Yields will go down first, and if they go up further, it will kill the economy including the housing market". - Marc Faber
As we have argued in our March 2012 conversation "Modicum of relief":
"In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters)."
In their paper they also added:
"Latent residual effects are highest when aggregate default conditions (the ‘default cycle’) diverge significantly from what is implied by aggregate macroeconomic conditions (the ‘business cycle’), e.g. due to unobserved shifts in credit supply. Historically, frailty effects have been pronounced during bad times, such as the savings and loan crisis in the U.S. leading up to the 1991 recession, or exceptionally good times, such as the years 2005-07 leading up to the recent financial crisis. In the latter years, default conditions are much too benign compared to observed macro and financial data. In either case, a macro-prudential policy maker should be aware of a possible decoupling of systematic default risk conditions from their macro-financial fundamentals." - source Bernd Schwaab, Siem Jan Koopman and André Lucas
What we are seeing right now we think is a similar decoupling mentioned in their very interesting paper where they also added:
"Changes in the ease of credit access surely affect credit risk conditions: it is hard to default if one is drowning in credit. As a result, systematic default risk (‘the default cycle’) can decouple from what is implied by macro-financial conditions (‘the business cycle’)."  - source Bernd Schwaab, Siem Jan Koopman and André Lucas
As we have mentioned in our previous conversations, we are very closely monitoring the change in credit from the Fed Senior Loan Officer Opinion Survey published on a quarterly basis (SLOOs) as well at the weakening tone as of late in consumer credit.

In our book, the variation of global private credit growth matters and matters a lot, hence our growing concerns relating to the divergence between the credit cycle and the business cycle. A slowdown in nonrevolving consumer credit in the US is a worrying sign we think.

On the specific matter of divergence between the two cycles we read with interest JP Morgan's note from the 30th of June entitled "Credit growth slows, reinforcing already tame cycle":

  • "Global private credit growth has slowed further…
  • ...driven by EM and US businesses
  • In DM, credit has shifted from growth drag to neutral
  •  In EM ex. China, deleveraging an ongoing headwind

The growth of global private nonfinancial credit has slowed in recent quarters, dropping to an estimated 5.5%oya pace as of 1Q17. Credit growth has been subdued throughout this economic expansion and the recent moderation reinforces this point (Figure 1).

In part, credit growth is lower than in past cycles because inflation is lower. More important, the mid-cycle surge typical of recent economic expansions has been missing this time around.
The bifurcated nature of the credit cycle also continues to stand out. The DM and the EM are totally out of sync. DM credit is recovering slowly following a long phase of deleveraging that dragged on economic growth from 2010 through 2014 (Figure 2).

Even so, DM credit growth remains sluggish and only is equal to nominal GDP growth. EM credit growth  has decelerated to about 8%oya overall and just 5.8%oya excluding China, down from peak rates near 20%oya in 2011. Indeed, the EM private sector is now deleveraging: 15 of the 23 countries meet this criterion in our sample, which is limited to the countries in our global economic forecast.
Both supply and demand factors have influenced credit growth. Surveys of senior loan officers show that banks tightened credit standards during and after the Great Recession. In the DM, banks subsequently removed a portion of this restraint although it seems likely that credit supply remains tighter than a decade ago. In the EM, banks have tightened standards in recent years, the opposite of the DM (Figure 3).

With respect to demand, the evidence suggests that DM households have radically altered their use of credit. Personal saving rates are elevated across the DM, wealth effects are largely absent, and credit growth remains weak following a long period of deleveraging (Figure 4; for more details see “In a break with the past, DM households are saving more,” GDW, June 2, 2017).

In the EM ex. China, corporates are deleveraging following a huge increase in debt.Our economic forecast envisions little change in credit dynamics. In the DM, we look for personal saving rates to remain near current levels despite rising confidence and household wealth. This shift in household behavior is manifested in low credit growth. In turn, the moderate growth of household demand is restraining business borrowing and spending. This backdrop helps to explain the relatively trend-like and stable GDP growth during this expansion. Although the credit cycle has turned more neutral for DM economic growth, this marks a sharp contrast with past expansions when rapid credit growth fueled GDP growth, notably in the household sector.In the EM, we look for the credit cycle to remain a headwind to economic growth in coming quarters. Deleveraging appears likely to persist as higher rates of private saving reinforce lingering credit restraint.
DM: Credit shifts from headwind to neutralThe buildup of DM private-sector debt during the 2000s expansion was concentrated in the household sector though corporates joined in during 2006 and 2007 (Figure 5).

Double-digit growth rates in household credit were common across the DM except for Japan, where credit contracted in most years (Figure 6).

Not surprisingly, the deleveraging phase (defined as a decline in credit/GDP ratio) that followed in 2010-14 also was focused in the household sector. As noted above, DM deleveraging was accompanied by a break in personal saving behavior, specifically, the virtual absence of the “wealth effect” that helped power the economy in past cycles.In recent years, DM household credit growth has firmed slowly though only to match the growth of nominal income. DM personal saving rates remain high even after a dramatic improvement in balance sheet positions. The ratio of household net worth to disposable personal income has increased to a record high while debt/income ratios have declined substantially.US households were central to these trends. US household debt rose steadily during the 2000s, largely driven by mortgages used to finance home purchases and consumption. In the years after the housing bust, mortgage balances fell steadily as households paid down some debts and lenders wrote off others. In the last couple of years, the ratio of household debt to GDP has stabilized. Mortgage balances as a share of GDP have continued to drift down, but have been offset by rising  consumer and student loans. On net, the ratio of household debt to GDP now stands near where it was in 2002.
US business leverage is highAlthough DM businesses got less over-indebted than households during the last cycle, the recovery in business credit during the current economic expansion has been moderate nonetheless (Figure 5). Against his backdrop, the somewhat more robust growth in US business credit has stood out (Figure 7).

On balance, the US has experienced a stronger capex recovery than the other majors, although it fell behind the Euro area and Japan in the past two years. 
US corporates have issued bonds heavily during this expansion, often using the proceeds to buy back equity. This behavior has left US corporates highly levered by historical standards on a variety of leverage metrics shown in Table 1 (for more details on the different metrics see “Monitoring US nonfinancial leverage,” GDW, August 17, 2016).

The ratio of nonfinancial business debt to GDP is just shy of its all-time high reached in 2008 and now exceeds the peaks reached in advance of the 1990 and 2001 recessions (Figure 8).

Low interest rates mean that interest coverage ratios still look healthy and lengthened debt maturities will likely cushion the impact of Federal Reserve rate hikes relative to past cycles. We also take some reassurance that US corporate profits recently have returned to growth. Nonetheless, the US corporate sector appears vulnerable to potential economic shocks.
A gradual slowdown in US corporate borrowing would likely be a positive sign for the durability of the expansion, as it could increase the likelihood of the economy achieving a soft landing at a lower rate of growth in the coming years. This is what appears to be happening (Figure 9).

Total business credit growth reached a high of about 7%oya in 2015 and early 2016 but has since moderated to just above 5%oya as of 1Q17. To be sure, the growth of C&I loans, which comprise less than 20% of the total, have slowed much more sharply. However, the downshift in this high-beta category has been mitigated by resilient growth in bond financing (which accounts for about half the total) and mortgage credit. For this reason, we have not been overly concerned by the slowdown in C&I loan growth. The most pressing issue would be if some combination of tight credit or corporate attempts to deleverage produced a renewed capex contraction. However, the opposite appears to be happening. US capex growth has picked up along with corporate profits and confidence even as debt growth has slowed. The drop-off in C&I loan growth may be tied to the recent stall in business inventory growth.
That said, we continue to monitor US credit metrics and the Fed’s quarterly survey of senior loan officers carefully. High US business leverage and the decline in profit margins are among a number of indicators that look increasingly “late cycle,” and indeed we recognize substantial risk of the next recession beginning within a few years." - source JP Morgan
The problem of course, is to paraphrase again Bastiat, in the case of this growing divergence between the two cycles is that there is always what you see and what you don't see.

Moving back to the issue of convexity, some would argue that in a rising rates environment you would be better off with buying short duration High Yield bonds with callable features as well as RMBS thanks to negative convexity features. But, for the second item, there is a catch given the non-linearity of RMBS, you would need to significantly "delta hedge" as described in March 2014 article from Liberty Street Economics paper entitled "Convexity Event Risks in a Rising Interest Rate Environment":
"When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.
Duration hedging of MBS can be done with interest rate swaps or Treasury bonds and notes. When rates decline, hedgers will seek to increase the duration of their positions. This can be achieved by buying Treasury notes or bonds, or by receiving fixed payments in an interest rate swap. Conversely, MBS holders will find the duration of their MBS extending when rates increase, which they may choose to offset by selling Treasury notes or bonds, or by paying fixed in swaps. If sufficiently strong, this hedging activity can itself cause interest rates to rise further, and further increase duration for MBS holders, inducing another round of selling of Treasuries.
A Convexity Event Averted
A sudden initial rise in medium- to long-term rates can therefore trigger a self-reinforcing sell-off in Treasury yields and related fixed income markets, fueled by MBS hedging - a phenomenon known as a convexity event. During a convexity event, MBS hedgers collectively attempt to decrease duration risk by selling Treasury securities or paying fixed in swaps. The two most important factors that determine the likelihood of a convexity event are the size of the MBS portfolio held by duration hedgers and the convexity of that portfolio. The large-scale purchases of MBS initiated by the Federal Reserve in November 2008 as part of the post-crisis LSAPs have had a profound impact on both these determinants.
MBS investors, broadly speaking, fall into two categories: those holding MBS on an unhedged or infrequently hedged basis and those that actively hedge the interest rate risk exposure. Unhedged or infrequently hedged investors include the Federal Reserve, foreign sovereign wealth funds, banks, and mutual funds benchmarked against an MBS index. MBS holders who actively hedge include real estate investment trusts (REITs), mortgage servicers, and the government-sponsored enterprises (GSEs)." - source Liberty Street Economics
You probably understand more therefore our Bond ruck title analogy given that a "convexity event" was avoided thanks to the massive Fed purchases of RMBS following the 2013 "Taper Tantrum". Admittedly for those in the know when it comes to convexity matters, a "Bond ruck" will be the most complex and subtle phase in bond markets for the Fed. It necessitates individual talent, vivacity, and precision in their balance sheet reduction. Therefore you need strong posture in Fixed Income markets to minimize injuries because the "Bond ruck" is a tough place to be and this is we think, where we are heading.

Right now, we think complacency in credit markets, particularly in Investment Grade which has received massive fund inflows is staggering. US HG (High Grade) fund inflows YTD has also been very strong, which has already reached 91% of the full year record inflows in 2016 according to JP Morgan.

One might even wonder if credit can widen. On that specific case we agree with DataGrapple's blog post from the 7th of July entitled "Credit Cannot Widen, Can It?":
"It was another fairly weak and lacklustre session. Credit indices were pushed wider in the morning as investors were still digesting the sale-off in rates yesterday which took 10-year rates at their highest in 18 months in Europe. But it never felt that the market was about to melt, and no one rushed to add hedges to the downside. Quite the opposite happened actually. Most people looked at it as an opportunity to “buy the dip”. It was obvious in the option market. Hardly anyone was buying payers - which give you the right to purchase protection - and enquiries received by dealers came from investors asking to buy receivers – which give you the right to sell protection – across August, September and October expiry, with the 52.5 and 55bps strikes very popular for iTraxx Main. Market participants feel very relaxed about any downside at the moment, and they are more worried about a sudden rip tighter in risk premia." - source DataGrapple.
Indeed, market participants seem very relaxed about any downside and a bit too much for comfort we think. We would rather be on the other side of the trade "gamma" wise, rather than picking nickels in front of a steamroller should we continue to see a rise in Government bond yields. Given the convergence between US treasuries and the German Bund, the interest rate buffer is close to zero these days so your margin of error is very slim confidence wise. Remember what we said last week:

"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"." - source Macronomics, July 2017.
All in all, volatility might be the new target for the Fed given their growing discomfort with loose financial conditions and low unemployment as per our final chart below.

  • Final chart - Unemployment and volatility may be too low for the Fed
As we move towards a "Bond ruck" with a Fed aiming at hiking further rates in conjunction with reducing its bloated balance sheet, there is indeed a heightened risk of a "convexity event" down the road we think. The next play by the Fed, in similar fashion to the rugby play is no doubt a very technical move that demands tremendous skills from their part. You can therefore expect a return of volatility, particularly in the Interest rate space (hence the importance of tracking the MOVE index) which would no doubt weight heavily on risky assets. Our final chart comes from Bank of America Merrill Lynch Securitization Weekly Overview note from the 7th of July entitled "Targeting higher volatility (effectively) as policy objective". It displays the Unemployment rate versus volatility as it might be too low for the Fed:
"In “Is Yellen a Hawk?” BofAML Chief Economist Ethan Harris argues that the Fed simply is concerned with an unemployment rate that is too far below NAIRU; if left unchecked, as in the case of the 1960s, excess inflation could be seen down the road. The risk for the Fed is that if it waits too long, and has to tighten aggressively when inflation does show up, it could increase the unemployment rate by enough to cause recession.
From our perspective, whatever the Fed’s focus may be, we think the hawkish shift is likely to bring with it higher volatility. In other words, effectively, higher volatility is now a policy objective for the Fed.
The comparison of the Merrill Lynch Option Volatility Estimate (MOVE) index to the unemployment rate in Chart 3 gives some perspective on this view. 

Arguably, depending on the viewpoint, both are now too low or at risk of moving even lower. The goal is to avoid even a mild repeat of the 2007-2008 experience, when volatility first rose sharply and then unemployment followed. Rather, by preemptively moving them modestly higher or perhaps just preventing further declines, the pain of massive spikes down the road can be avoided." -source Bank of America Merrill Lynch
If indeed in this on-going "Bond ruck" volatility is now a policy objective for the Fed, in the coming difficult balance sheet exercise, the leverage community should take note, particularly the CTA crowd and Risk-Parity community which have been burn recently on the violent gyrations seen. As we pointed out in a "Bond ruck", you need strong posture to minimize injuries so you better polish your rugby skills we think...

“Ballroom dancing is a contact sport. Rugby is a collision sport.” – Bulls coach Heyneke Meyer
Stay tuned!

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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