Guest post by Peter Tchir.
State of the High Yield Market
The ETF’s and Closed End Funds are attracting a lot of attention. Redemptions and poor performance in the past few days have caught a lot of people’s attention. It also sounds like it is hitting traditional mutual funds. It is worth looking at.
Unmitigated Disaster in Closed End Funds
Here is the craziest closed end fund I know of. The PHK fund was down 26% since its peak but still trades at a premium of 27%. I have never understood why people pay such a premium for a fixed income fund, and never will. To me it is completely irrelevant what this fund does, except as a sentiment for the least thoughtful retail investors. We saw steep declines in other closed end funds. Most had been trading at premium and are back to about intrinsic value. With the leverage they use and small market cap I rarely follow them, but the size of the move is worth looking at.
Even the leveraged loan closed end funds got hit hard. They are still at a premium but seeing drops of 3% to 5%. That is far in excess of the two day drop of BKLN which has had a 1% drop. The leverage and premium explain a lot of that additional drop.
Guest post by Peter Tchir.
Overnight we are hitting new lows with S&P futures touching 1414, a level not seen since early September and pre OMT and QEX. Nasdaq 100 futures are even worse, hitting levels last seen in early August, right after the “whatever it takes” speech finally got some traction.
Credit indices have been wider than this, even in October, so they are either about to take the next leg down or a sign of hope. I’m going with the view they are about to underperform since IG19 is trading 5 bps rich to intrinsic in a market where single name offers are hard to come by.
Crowded safe trades may be in jeopardy and high yield bonds seem particularly fragile. The total lack of fear about junk companies at low yields, issuing dividend deals while big companies are seeing hits to earnings is a little reminiscent of LCDX in 2007 (as I wrote on Saturday). There is still no obvious catalyst for a sell-off, but there never is. If retail has had enough and real default risk fears spark any selling, I can’t think of many institutions set up to buy rather than forced to sell to protect themselves.
Taibbi on Mitt Romney, CDS, financial innovation and much more. . Taibbi writes: “What most voters don’t know is the way Mitt Romney actually made his fortune: by borrowing vast sums of money that other people were forced to pay back. This is the plain, stark reality that has somehow eluded America’s top political journalists for two consecutive presidential campaigns: Mitt Romney is one of the greatest and most irresponsible debt creators of all time. In the past few decades, in fact, Romney has piled more debt onto more unsuspecting companies, written more gigantic checks that other people have to cover, than perhaps all but a handful of people on planet Earth.”
A few thoughts by Peter Tchir of TF Market Advisors.
Don’t Ignore the Irish Comeback This chart is important for a couple of reasons. The story in Ireland doesn’t get much attention, but what a comeback. The Irish 2016 bonds started the year yielding 7.5% and are now down to 4.43%. So while we are inundated with reports about “Italy is not Greece” we rarely see anything about the improvement in Ireland. Or for that matter, Portugal, where the 5 year bond started the year at 15.6%, peaked at almost 22% and is down to 7.6%. That is still in the danger zone, but a stunning turnaround.
So while it is easy, and even fun to point out how nothing worked in Greece, the situation in Ireland has turned around and even Portugal seems to be coming around. Heck, even the much maligned Greek PSI bonds are getting back to their CDS auction level from March. The “front-end” bonds (which are 2023 maturities) have clawed their way back to 22 from a low of 14, and have actually managed to accrue more than 1% of interest. I’m not making light of the situation there either and think it remains precarious unless the Troika does some form of debt extension (or better yet forgiveness), but there have been signs of slight improvements.
Patience is Running out in Spain and Delays are Costly
Over the past week or so, the market is starting to question whether anything will happen in Spain. The 2016 bond hit a low yield of 4.99% on August 21st and has drifted back to 5.45%. The move in the 10 year is more pronounced as it went from 6.18% to 6.83%.
One encouraging sign is that the 2 year has been pretty stable, moving from 3.42% to 3.59% and the yield here actually declined.
Guest post by Peter Tchir.
I liked the book. It was a good read. It is also a compelling strategy. Find something that costs next to nothing to put on with huge potential gains. The big short was the ultimate elephant hunting or lottery ticket.
The beauty of the big short is that some investors found some obvious flaws in a market. They thought the deals themselves had problems and the structure of the more complex deals was also done incorrectly. They went against the grain, they used logic and intelligence to find an opportunity, and in turn crushed it. It really is a great story and is incredibly compelling.
The problem is that things mostly trade rich, because they don’t have much value. CDS, contrary to popular opinion, doesn’t typically have big payouts. It often trades tight because most companies don’t run into trouble.
It is exciting to spot trouble, huge amounts of money can be made getting short, but it isn’t easy. More often than not, companies wiggle out of trouble and it is easy to be bled to death on carry. I like being short, it can be a great strategy, but it isn’t easy.
That to me is one of the biggest problems in the market. Investors, many of whom have underperformed, and are all looking for the big kill to make up the year. Everyone is looking for that one trade that will result in stellar returns, and as far as I can tell, most have come to the conclusion that being short is that trade. As volatility (VIX) has collapsed and stocks have marched higher, many have continued to look at CDS and the credit markets as an ideal short. “It doesn’t cost much” and “can have a huge payoff” is the rationale. To a large extent that is true, but so far it hasn’t worked.
We have received many questions on what shadow banking really is. Here is one of the easiest explanations, courtesy Azizonomics.
Meet James. James bought a house. It cost him $150,000, of which $30,000 had come from his own savings, leaving him with a $120,000 30-year fixed-rate mortgage from the WTF Bank, with a final cost (after 30 years of interest) of $200,000. Now, up until the ’80s, a mortgage was just a mortgage. Banks would lend the funds and profit from interest as the mortgage is paid back.
Not so today. James’s $200,000 mortgage was packaged up with 1,000 other mortgages into a £180 million MBS, (mortgage backed security), and sold for an immediate gain by WTF Bank to Privet Asset Management, a hedge fund. Privet then placed this MBS with Sacks of Gold, an investment bank, in return for a $18 billion short-term collateralised (“hypothecated”) loan. Two days later Sacks of Gold faced a margin call, and so re-hypothecated this collateral for another short-term collateralised $18 billion loan with J.P. Morecocaine, another investment bank. Three weeks later, a huge stock market crash resulted in a liquidity panic, resulting in more margin calls, more forced selling, which left Privet Asset Management — who had already lost a lot of money betting stocks would go up — completely insolvent.
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.
Rickards, hedge fund manager and the author of the must read Currency war, delivers some rather harsh comments regarding the derivatives world. Ban derivatives….From USN.
Myth No. 3: Bank management has derivatives risks under control using mathematical models that capture the complex interaction of factors embedded in derivatives trades. This view is laughable on its face given the continual series of notorious derivatives fiascoes from Long-Term Capital Management to AIG to J.P. Morgan and many others.
Yet, this myth is pernicious at a deeper level because many bank managers actually believe it. They have constructed elaborate management tools based on empirically false assumptions about the frequency and severity of bad events and the correlations among them. Risk managers sometimes acknowledge these limitations but then say their tools are “better than nothing.” This is false too. Bad tools are not better than nothing. They lead to bad investments with the taxpayers picking up the losses every time things go wrong. It would be more honest to admit what we don’t know and limit derivatives until the state of the art improves.
Peter Tchir gives some interesting insight into the LIBOR vs CDS prices.
Here are the 3 month USD LIBOR submissions for some of the banks, along with where 1 year CDS was quoted at the time. The 1 year CDS data is not the best, but is indicative and certainly reflects what I remember as the relative safety perception. I’m also looking into CD rates, bonds, and stock prices, but I find a few things interesting here.
Angela Merkel, the German chancellor, declared on Thursday that Europe was “in a race with the markets” to turn its monetary union into a fully fledged political union, even as she warned her partners notto overburden the German economy in the eurozone crisis. Her intervention coincided with a new surge in borrowing costs for Spain, following a downgrade by Moody’s rating agency, while Italy moved to reassure the markets by promising further cuts in public spending. http://www.ft.com/intl/cms/s/0/7d1842e2-b642-11e1-8ad0-00144feabdc0.html#axzz1xe4lV9a0
The U.K. introduced a series of measures designed to shield its financial system from the ongoing European crisis, with plans to flood banks with cheap credit in an attempt to jump-start lending to British businesses and households. The efforts helped push the euro up 0.6% overnight to $1.2633, late in New York, though the single currency weakened slightly in Asia to $1.2625. The dollar weakened against the yen to 79.25, compared with 79.35 on Thursday night. The Australian dollar was trading just above parity against the dollar early on Friday, at $1.0004. Japan’s Nikkei was up 0.2%, ahead of the Bank of Japan’s policy meeting later in the day; South Korea’s Kospi was down 0.8%, while Australia’s S&P ASX 200 was up 0.3%. Hong Kong’s Hang Seng Index gained 1%, the China Shanghai Composite edged up 0.3%, and Singapore’s Strait Times Index was 0.4% higher. http://online.wsj.com/article/SB10001424052702303734204577467353499921894.html?mod=WSJASIA_hpp_LEFTTopWhatNews
The U.K. on Thursday unveiled an extraordinary series of measures designed to insulate the British financial system and economy from the euro zone’s deepening crisis. Chancellor of the Exchequer George Osborne and Bank of England Gov. Mervyn King announced plans to flood banks with cheap funds in an attempt to jump-start lending to British households and businesses and to fend off potential financial problems at big U.K. lenders. The British programs resemble some of the emergency measures enacted by central banks in Europe and the U.S. earlier in the financial crisis. The British announcement on Thursday, at an annual black-tie dinner with bankers in central London, reflects leaders’ intensifying concerns that Europe’s crisis threatens to drag down the U.K. economy and financial system. “These are very difficult economic times—as difficult perhaps as any our country or our continent has faced outside of war,” Mr. Osborne said. “Together we can deploy new firepower to defend our economy from the crisis on our doorstep.” The British programs resemble some of the emergency measures enacted by central banks in Europe and the U.S. earlier in the financial crisis. The British announcement on Thursday, at an annual black-tie dinner with bankers in central London, reflects leaders’ intensifying concerns that Europe’s crisis threatens to drag down the U.K. economy and financial system. http://online.wsj.com/article/SB10001424052702303822204577466790091232290.html?mod=WSJEurope_hpp_LEFTTopStories
Germany alone can’t solve the euro-area sovereign debt crisis, German Chancellor Angela Merkel warned on Thursday, as she urged the world’s largest economies to play their part in helping to restore growth. Speaking ahead of a meeting of the Group of 20 industrial and developing nations, Ms. Merkel told parliament in Berlin: “The causes of the weakening global economy are indeed not only in the euro area. “Everyone must be prepared to overcome their specific weaknesses,” she said. Since the start of the debt crisis, Ms. Merkel and Germany have come under intense pressure to do everything possible to keep the monetary union from breaking apart. As the euro zone’s largest economy, Germany has accepted the greatest financial share of the bailout packages. The country has taken responsibility for as much as €401 billion ($503.54 billion) of the agreed temporary and permanent bailout programs’ entire resources, according to an estimate from Credit Suisse. http://online.wsj.com/article/SB10001424052702303734204577465910985870838.html?mod=WSJEurope_hpp_LEFTTopStories