Investment Grade CDS is going to 0
Guest post by Peter Tchir.
The one source of sellers that is missing, is the correlation desk. With that gone, you miss the leverage of some “less than smart” bank selling $100 million of mezz protection that turns into $1 billion of the sketchiest names out there, but the situation on bank hedging is interesting. Need to get through ECB this week, and some realistic quantification of LIBOR liebility, but CDS seems set to outperform stocks and bonds.
Is IG18 going to zero?
Probably not, but I think we could see an “eclipse” this week where IG18 trades lower than HY18. That has often been a sign of continued bullishness (though it failed in March) and I think IG could set new tights for the year.
I don’t particularly like U.S. equities here. I don’t like the ETF’s or liquid bonds. I like less liquid bonds as the liquidity premium is too high right now. I continue to think that High Yield High Beta CDS can be Highly Rewarding as we sent out on July 13th. But I’m becoming more convinced that IG CDS can perform extremely well here.
Before explaining my rationale, it is worth looking at this chart.
We often get sucked into looking at the recent past, and IG18 looks tight when we think about the past 4 years, but in 2007, the on the run IG index hit a low of 28. I remember it well, and think Jess may be the only person more bitter about being stopped out on a short within days of an all-time low. The point is that IG has only seems expensive at 105 in the post crisis world.
Here is why I think IG can go a lot tighter and doesn’t require great stock performance to do it.
Read My Lips: No Major Banks will be allowed to Default
Bush may have lied about taxes, but the one thing virtually every politician across the entire globe is certain of, and that is that they cannot let another big financial institutional fail. I think they are wrong to have that attitude, but what I think doesn’t matter. That is how the politicians think. They might pay lip service to “unwind plans” for big banks, but the reality is, after Lehman they will never let a big financial institution fail again. Even more importantly, the central bankers agree with them. Central banks will do everything they can to prevent big financial institutions from failing.
Although the banks aren’t in the U.S. credit indices they are one of the widest spread sectors out there. Residual concerns remain about them and they don’t help their case with things like the “whale trade” and the “Libor scandal” but they do seem cheap. If Europe takes immediate currency devaluation and default risk off the table, bank CDS can go much tighter.
Back in early 2007, JPM CDS traded around 15 bps. I remember seeing runs, all banks 15/15.5 50×50 and all brokers (there were still brokers) were 20.5/21 50×50. You could buy or sell $50 million of CDS on a bank on a ½ bp market. Equity market caps for the big banks have shrunk, but JPM has an equity cap of 83% of its March 2007 market cap, and even GS is 56% of its March 2007 cap. Citi has done worse, but these banks have large equity market caps and in the case of JPM, it isn’t that far off its 2007 peak. Yet the CDS trades at 125 for JPM instead of 15, and at 255 for GS instead of 20.
I’m not arguing that we go back to 2007 levels, but if there is a disconnect, it is that credit markets still price in too much fear.
The Volcker rule, SEFS, European bailout, and Basel III should all work to make bank credit spreads grind tighter. The Volcker rule may be bad for bank earnings, but it is actually good for credit spreads. The SEFS and derivative clearing should finally force banks to clean up their gross derivative exposures once and for all. That would reduce the fear factor, but also would reduce the counterparty hedging that occurs. Since funds and banks hedge their exposure to each other, reducing the gross amount of derivatives should reduce that hedging need and help bank spreads.
Speaking of Hedging, that Demand is Shrinking
Banks have been buyers of CDS as a way of hedging their loan book, but that demand to hedge is decreasing for several reasons.
Companies can currently borrow as much as they want at incredibly low yields from the bond market, so rely less on banks.
Banks, feeling the pinch from increased regulatory scrutiny and trading limits, will rely more heavily on NIM (net interest margin) to sustain revenues, and not spending money to hedge will be one way to increase revenue. Hedging has always been expensive, and with the “basis” high right now, it costs more to buy protection than you can make on the loan, by a lot. Banks will hedge less as they need interest income to increase.
The Fed is encouraging banks to use banking books rather than trading books for loans and using loan loss reserve rather than hedging as a risk management tool. The pressure from the regulators, while not directly obvious (and I think going wrong direction) will further reduce the demand for hedging.
Central clearing for derivatives should reduce the hedging done on banks in particular. This won’t help corporate credit spreads, but does help bank credit spreads as
So reduced protection buying from bank hedging desks should decrease demand for CDS.
Shorts are not having a fun year
It hasn’t been a horrible year to be short CDS, but the funds aren’t making a killing like they did in 2008 or even parts of 2011. Had it not been for the whale trade, it would have been an even more difficult year being short credit via CDS.
As investors get comfortable that Europe is not in imminent danger and the banks too are not at real risk, the search for “The Big Short” will diminish. Too many people are looking for the next “Big Short” and Paulson trade and just aren’t finding it. Hedge funds do not want to see AUM go down and if the trade isn’t working will cut. We aren’t there yet, but this source of demand can just as easily become a seller of protection if the mentality changes.
The “yield” floor
People argue whether it makes much of a difference or not, but I believe the overall level of yields impacts spreads. For a certain yield some investors can’t justify owning corporate bonds (usually regulatory capital related). So corporate bond yields can lag treasury yields in a market where treasury yields are at astronomically low levels. This becomes a “de facto” spread widening. If treasuries start to sell off, and yields increase, I think we will see a corporate spread tightening. The corporate bond yields won’t rise as quickly as treasury yields because they didn’t go down as quickly. This implicit spread tightening would impact CDS too.
I don’t see final demand for corporate bonds decreasing in the near term, so their outperformance in a rising yield environment should be significant.
Housing and the Mortgage Market
If the housing market just stabilizes, the mortgage market can do well. More and more investors are scrounging around for old distressed mortgage paper. It can rally hard from here with just stability, let along growth. There are enough signs that the housing market has stabilized that the possibility cannot be ignored.
The better mortgages do, the better banks can perform. The better builders can perform. The better insurers can perform. The bottoming of distressed mortgages would have the single biggest impact on credit spreads as the mortgage and home market has more direct impact on more big institutions than anything else.
I’m not calling for a rally in the housing market, but mere stability can be enough, and when combined with other factors mentioned can put downward pressure on credit spreads.
So IG Isn’t going to Zero, but New Tights on the Year likely
Watching the developments out of Europe but if Europe is successful, I like CDS better than bonds and far better than stocks. I see stocks as being capped soon regardless of the success of Europe. Bonds have had such strong demand that the only real value left there is in less liquid issues and smaller issuers. CDS on the other hand looks to offer better value and has lots of potential to see a shift in “technicals” that take out the natural buyers creating the potential to have a great short squeeze.