When it comes to the current state of the market, everyone knows – whether they admit it or not – that it is broken. And we aren’t talking HFT which while rigging price discovery, generally does so on a microburst momentum basis which at most lasts for the duration of the trading day. The real culprit of the broken market is the Fed, a Fed which as we have explained over the years, is simply seeking to compensate for the collapse in stock (and flow) from the unwind of shadow banking which was nearly crushed in the days after Lehman.
Citigroup‘s Stephen Antczak admits as much: “QE has obviously created a huge distortion in the marketplace, pushing risk-free rates and risk premiums well through many “fair value” metrics. But that said, doesn’t every credit cycle seem to have distorting factors of some sort? For example, one can easily argue that back in the pre-Lehman era the shadow banking system was every bit as much of a distorting influence as QE is now. (Shadow banking is defined as forms of intermediation that create credit without being subject to regulatory oversight, i.e., unlisted derivatives, hedge funds, etc.)”
However, the silver lining at least to Citi, is that while massive Shadow Banking, peaking at over $20 trillion in 2008, was inherently unstable and subject to liquidity runs (which did in fact happen in September 2008 when first money markets, and then other shadow conduits, froze up), the Fed is far more stable. Antczak’s amusingly quips that “we are not going to see a BWIC from the Fed anytime soon.” Which to be sure is yet another “certainty” among the economist community – just like every economist saw the US economy picking up in 2014, and 67 out of 67 economists polled in April expected higher bond yields in 6 months. If there is one thing we know about a unanimous opinion share by economists is that it is always wrong. All we have to say here is: “subprime is contained“, and, “housing prices can not possibly ever go down.” Nuf said.
But let’s ignore the “improbable” end game unwind for the time being.
A more practical concern, and one which Citi’s credit guru Stephen Antczak focuses his attention on, are the factors that in 2014 are as bad as or worse than during the heyday of the last credit bubble in 2007.
Here they are:
With regard to valuations, spreads are still north of the levels seen in ’07 in an absolute sense, but to a large extent the extra spread represents compensation for factors that have evolved since ’07. These factors include higher dollar prices (typical HG non-fin trades at $109 now vs. $103 in early ’07) and lower liquidity, among others. After adjusting for such factors, spreads in many parts of the market are more or less equivalent to ’07 levels.
In fact, it is not all that difficult to find names that now trade through ’07 levels. IBM on-the-run 10-years are trading at 76 bp, or 7 bp through ’07 levels (in OAS terms). And KO 10-year benchmarks are now at 65 bp, or 13 bp through ’07 levels (Figure 2).
But for those of you who worry that these examples may be the exception rather than the rule, we looked at the distribution of the spread change of name matched on-the-run 10-year bonds since Jan ’07 (Figure 3). It’s almost shocking that the proportion of credits that are tighter now than they were in ’07 is only a hair shy of the proportion of those that are wider. What this tells us is that it wasn’t really all that hard to find names like IBM and KO – pick out of a hat and 1 in every 2 are trading through ’07 spreads.
Liquidity, defined as the bid / ask for a given trade size, is far less ample now than it was in the pre-Lehman era. This is in part due to how dramatically dealer balance sheets have shrunk — back then dealer B/S totaled almost 4% of corporate bonds outstanding, relative to only 1% now (Figure 4).
But that said, it’s very easy to overlook how problematic liquidity was back then. The reason is because everyone seemed to take abundant liquidity as a given back then, and trading strategies were based on this expectation — negative basis trades, CPDOs, SIVs, leveraged loans in TRS form, etc. all fit this profile. But this is certainly not the case anymore. In fact, if investors assume anything about liquidity at this stage, it’s that it won’t be there when it’s needed, in our view. And investment strategies have been adjusted accordingly.
To illustrate in real world terms, consider the triple-A CLO market then vs. now. In early ’07 triple-A CLOs traded in a 1 to 2 cent market for sizes in the 10 mm to 20 mm range. Now the bid / ask is about 25 cents for the same size. So in this context the advantage obviously goes to ’07. But as we know, the ability to actually transfer risk in ’07 at these levels was fleeting.
Figure 5 shows that the typical triple-A fell over 30 pts when the banks prop books that owned the vast majority of this “liquid” paper had to unwind their positions and a new buyer had to be discovered. Conversely, the biggest downturn in recent years was approximately -$2.2 pts.
Treasury yields are low and the consensus expectation is that they will rise at some point. The problem is that mutual fund holdings of corporate bonds are higher now than they have ever been — 15% of the market (Figure 6) — and if outflows occur in response they could overwhelm dealer balance sheets.
We did not have this problem in ’07 for three reasons. First, rates were higher than they are now (they averaged 4.6% then vs. 2.7% now), so it wasn’t a given that yields would move higher. Second, mutual funds only accounted for 8% of the corporate market, about half as much as now. Third, as noted above, dealer balance sheets were much larger, providing more cushion for risk transfer activity.
But that said, how much pressure could we see as a result of a rates-induced selloff? We built a framework to estimate mutual fund flows given various Treasury yields, and we find that a yield of 3.5% by year-end would cause an outflow of about $15 bn. Certainly not good, but potentially manageable, in our view.
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Among the factors that Citi doesn’t think are as bad as they were in 2007 are corporate leverage (which is ironic because as we won’t tire of showing, corporate leverage has never been higher), Investor Leverage (before one agrees, take a quick look at this chart of Prime Broker-enabled hedge fund leverage), and Treasury Curves (considering the Fed is sitting on the front end, if only until the time of the “dots” arrives, we wouldn’t assign much value to yet another manipulated metric).
But all of the above is completely meaningless in its own factual vacuum: at the end of the day all that matters is what traders and investors think and believe. And a perfect indicator of what said belief is, we paraphrase a statement a Portfolio Manager made to Citi:
“You’re picking up pennies on a train track. You are not getting paid much but you are sure that there will be a very negative surprise at some point. The risk / reward profile is as bad as ’07.”
Judging by recent comments by such hedge fund luminaries as David Tepper this is increasingly the norm. Which is why anyone expecting the same 30% return in 2014 as in 2013, will certainly be very disappointed on December 31 of this year.