Tracy Alloway

So it’s been a while and I don’t write as much as I’d like to anymore, but given the amount of current interest in the credit market I thought I’d put this here.

Market Selloff Played Out in the Most Hidden Corners of Credit
If you read one thing about credit this year, please make it this. Something you hear in the market quite a bit is that ‘X’ or ‘Y’ won’t be a huge problem because we don’t have as much leverage embedded in the financial system as we did in 2008. Back then, subprime mortgages got bundled into Triple A-rated bonds that then became the subject of all sorts of derivatives bets which then helped amplify the downside across the financial system. While it’s very probable we are nowhere near that scale when it comes to corporate credit, there is an added layer of leverage that doesn’t get nearly enough attention.

How February’s market sell-off played out in corporate credit is a useful example of this concern. The selloff arguable took place not in the cash market, but in derivatives attached to it including CDX indices and options on those indices. More worryingly, there is a concern among some market participants that those options end up having an impact on the underlying indices themselves during intense bouts of market action. Dealers have to rush to hedge as those price movements cause options to expire, exacerbating the price movements and potentially causing further pain. The point to all of this is that there’s a complex ecosystem of credit exposure that, I would argue, we do not have a very good understanding of.

(As an aside, we’ve seen negative gamma-sparked bouts of market volatility a couple times this year in different asset classes, including the VIX product blow-up and — somewhat more randomly — the oil market. Unfortunately, the Oxford Dictionaries declined my nomination of gamma as word of the year.)

Some other things worth reading:

Goldman Says Riskiest Junk Bonds Are Most ‘Mispriced’ Since 2007
Do you know a special someone who likes to say that “corporate credit’s a good buy so long as defaults remain low?” This holiday season get them this note from Goldman, in which the bank lays out that its “preferred valuation measure of corporate credit, which subtracts their projected expected-loss rates from current spreads, shows U.S. high-yield obligations are now mispriced for even the most benign [default] scenarios.”

Goldman Warns of Liquidity-Fueled Sell-Off After ‘Volmageddon’
From the guys that brought you “liquidity is the new leverage,” comes this piece warning that low liquidity may not be isolated to the corporate bond market but could be a problem across the broader (equity) market. You can quibble about the meaning of liquidity in this context, but I think the point is that the market is susceptible to sudden and dramatic pullbacks as *everyone* changes direction at once. See also the two items below.

It’s Not Just Italy. Shock Moves Jolt All-Or-Nothing Markets
Another way of saying this is that in this market, everything is fine until it isn’t. Assets can be priced for perfection and many red flags ignored until everyone suddenly rushes to the exits. The catalyst isn’t necessarily a change in the fundamental outlook for the asset, but a change in investor behavior. “The binary ‘all-in/all-out’ behavior, which up until now was relegated to the fringes of the financial markets, has gone mainstream,” says Peter Atwater. (There’s a bonus Galbraith’s ‘Bezzle’ reference here too).

This Is What Happens When Markets Stop Chasing Flows
On a completely related note – this is one of the defining features of post-crisis markets in my humble opinion. Investors used to chase assets until they became ‘overvalued,’ at which point the inflows would stop. But in a market characterized by sluggish economic growth and low yields, the way to generate outperformace was not by identifying assets with the most return potential based on fundamentals, but those most likely to attract other investors. Because you’re chasing flows and not fundamentals, the market is no longer self-limiting. In other words, there’s no natural place for asset valuations to stop so long as inflows continue. This story is terminal-only but you can read a similar argument over here.

Odd Lots: What David Barse Learned From Watching A Credit Fund Blow Up
The last major hiccup in credit markets took place in late 2015, when Third Avenue Management blew up. So it’s worth listening to the thoughts of the former Third Avenue CEO on this episode, even though you may not agree with them. (Also, please subscribe to Odd Lots. I often stay up until 11pm to make these and I like to think some people are profiting from my sleeplessness!)

Citi Warns U.S. Credit Locked in a Losing ‘Internecine’ Battle
If you think your BBB-rated bond is priced for perfection, what if it’s not really a BBB bond? There’s no denying that a huge chunk of the corporate credit market has migrated to the middle of the ratings bracket in recent years which suggests there is, by definition, some there is a lack of credit differentiation compared to previous years. In any case, it’s interesting to see different analysts pegging different ratings ‘buckets’ as the problem. Most people seem worried about BBB but there are others singling out the single As, for instance (ha). Here’s Citi: “An environment in which one single-A credit can be carted out into single-B spread territory almost overnight is perilous to ratings-constrained institutional investors, particularly in Asia, that have chased the yields of blue-chip U.S. debt into the low-A/mid-BBB territory.”

Fate of $1 Trillion in Risky U.S. Loans May Be in Japan’s Hands
Speaking of Asia, it’s usually not a good sign when the market starts looking for the bagholders but in this case you could do worse than Japanese banks, typically viewed as long-term buy-and-hold investors. Watch those FX hedging costs, that BOJ monetary policy as well as dealer activity, though. To bring everything here full-circle – It’s yet another example of complex interplay in credit markets. A bunch of these deals have been done through so-called repacks – meaning there’s typically a currency swap agreement done with another (often European) bank. So the market needs to worry about an extra layer of FX sots and dealer risk appetite/balance sheet, in addition to the underlying ‘health’ of the credit market.