Fixed Income Overview

Guest post by Peter Tchir.

From Risk Off to Risk Neutral

Until Friday of last week, we had been in a risk off stance.  We had believed that the market was too optimistic about what immediate impact QE would have and that too many had over-estimated how eager Europe was to proceed with new and bigger bailouts.  Those all helped our view, but in the end, earnings turned out far worse than most were expecting.  The earnings story has been a drag on the market for the first time in recent memory.  Even Apple struggled.  The outlooks were even gloomier than the actual results.

So why are we switching from Risk Off to Risk Neutral or even Risk On?

First, S&P 1,400 helps.  We believe the range on this downside move had been 1,375 to 1,400 so there is still some room lower, but we hit levels that make sense for us to look for a reversal.  Then there is Apple.  For the first time in a long time, I can see some strength building for Apple.  Maybe we will get more profit taking, but given their earnings, the cash on hand, and the magic of round numbers, right around $600 seems like we could see some support and new investors who missed the surge to $700, step in and take a shot.  Apple is so large in the Nasdaq, the Nasdaq 100 (QQQ) that it alone can drive the indices.  Even the S&P is affected directly and indirectly by Apple.

But the real reason is OMT.  The market is a little spooked this morning by the Troika finally admitting that the “Official Sector” would have to take some losses on their Greek exposure.  It really shouldn’t have taken 10’s of millions of dollars of taxpayer funded money to pay for the people and their trips to reach such an obvious conclusion, but it did.  In any case, that is another reason to be legitimately fearful that the EU is tiring of bailouts.  It is this feeling that Europe is getting sick of bailouts that makes me believe we see OMT very soon.

Spain and Italy ultimately need the support of OMT (ECB) and the ESM.  Playing a waiting game has become too dangerous.  If Spain and Italy aren’t nicely nestled into a program soon, they may not get one.  Spain, the most stubborn of all potential recipients may finally be aware of this and will act.  It does them no good to delay for better terms, when the most likely outcome of further delays is “no terms”.

I don’t think the ensuing rally will be large or last long, but that is how we see the market playing out over the near term.

A Dull Weak in Treasuries

Treasuries had small gains across the board last week.  The moves in treasuries tracked equities reasonably well as the “risk on” and “risk off” mentality was clearly evident.  TIIPS actually eked out a gain last week in spite of a decline in the CRB index.

Weakness in Corporate Credit

High Yield was the weakest, being down about 0.5% on the weak.  High Yield cash actually outperformed the CDS market, but we finally saw some concerns that earnings could impact the high yield market.  High Yield should perform well if we get another “risk on” move, and so far we have not seen significant outflows, but if earnings continue to be weak, we will see some shift out of high yield bonds.  The catalyst could be a large miss on earnings from a highly leveraged, widely owned name.  Names like CHK, HCA, would certainly fit the bill.  I’m not expecting that yet, but it is time to remain vigilant.

Investment grade was down a little on the week on an outright basis, and significantly down on a spread basis as treasuries, particularly the longer end managed gains.  On the CDS side, the index struggled as investors started to put on hedges and some active money started trading form the short side.  The fact that LQD is trading at a reasonable premium in spite of market weakness is either a very good sign, that there is still underlying demand or just a delayed reaction as investors still covet bonds relative to CDS.  That has been a warning sign in past.  Bond investors don’t want to sell bond “they won’t be able to buy back” and instead hedge with CDS.  Given my current “risk on” view, I’m not particularly concerned, but it yet another thing that bears watching.

I like leveraged loans the best.  The closed end ETF’s have seen their discount shrink, so any “cheap way” to play the market is gone.  CLO’s continue to price and do well, so there is demand on that front.  Banks are once again becoming lenders, which further reduces selling pressure on the market.  I am a bit concerned that many of the loans are less secure than I would like, but at this stage in the game, I think they offer better protection than high yield still, and the yield differential is relatively small.  Leveraged loans are currently our favorite “carry” trade with high yield offering the most near term upside.