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The year in credit (2019)

The year in credit (2019)

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I’m a little late to this annual tradition but here it is — highlights from 2019’s collection of credit-related stories. This is by no means a full list of my work this year, but these are the things that I’m thinking about as we enter the new decade.

Did Fed Know What Credit Markets Didn’t? Loan Bankers Get Strict, February 7
It’s easy to forget this now, but in early 2019 the market was all-aflutter over the Federal Reserve’s Senior Loan Officers Survey, which showed banks tightened lending standards over the last three months at the fastest rate since the middle of 2016. The furor died down as banks began easing standards again (though tightening for C&I loans has since resumed) and the Fed lowered rates, but it hints at the amount of concern out there about overheating in the credit market.

Hot Rally Raises Questions of What’s Really Cooking in Credit, March 22
The almost complete recovery in credit markets since the sell-off in late 2018 plus a dovish Federal Reserve helped refocus attention this year on the multiyear boom in corporate debt. That boom means investors are arguably accepting worse deals for less return. For Deutsche Bank analysts, the dynamic has shades of a previous Wall Street boom.

CLOs Are Starting to Look More Alike, Stirring Uneasy Memories, June 11
Another entry for the ‘history doesn’t repeat, but it does rhyme’ category. Rampant demand for leveraged loans has outpaced supply in recent years, leaving CLO managers with a more limited pool of loans from which to create their deals. That means the chance of two CLOs holding the same underlying debt increases so a single soured loan could wind up hitting multiple investors.

Convexity Hedging Beast’ Blamed for Lower Bond Yields, August 19
This isn’t strictly a credit-related piece, but I include it as an example of the reflexivity of markets. It’s very possible that the yield curve inversion we were all worrying about this year was the result of technical forces (convexity hedging), or at least exacerbated by it. That sort of begs the question of whether this kind of technical activity can end up worsening, or event creating, trouble in markets. See also, the VIX exchange-traded product blow-up of early 2018 or the occasional rumblings of a similar dynamic in credit derivatives and the cash market.

Repo Fragility Exacerbated by a Hot New Corner of Funding Market
JPMorgan Warns U.S. Money-Market Stress to Get Much Worse
Odd Lots: Why the Repo Market Went Crazy
Repo Oracle Zoltan Pozsar Expects Even More Turmoil
Repo! A blow-up in the repo market happened this year! Again, this is not strictly credit-related, but turmoil in this crucial short-term lending market can end up impacting dealers’ risk appetite and therefore wider markets. Of particular interest is the role of sponsored repo outlined in the first piece. This is something the Bank for International Settlements ended up singling out as a key catalyst for the troubles.

Goodbye Bond King, we hardly knew ye

Goodbye Bond King, we hardly knew ye

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Bill Gross, the erstwhile ‘Bond King,’ has announced his retirement. Over the course of four decades, Gross made his name actively trading bonds and started doing that before those bonds were really even considered things that were actively traded. He co-founded Pimco, then moved to Janus in late 2014 in an abrupt and somewhat drama-filled chapter of market history.

While buckets of ink have been spilt on Gross’s career and legacy, I want to point out two things. The first is that, as the title suggests, there’s still a lot we don’t know about the Bond King’s strategy. While investing in bonds might seem like a straightforward activity, it’s no secret that Pimco augmented its performance with a host of derivatives and ‘overlays.’

See for instance, Zoltan Pozsar’s work on the topic in early 2015, which I wrote up in a column for the Financial Times around the same time:

Reach for returns takes funds into the shadows

… The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.

Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.


Gross was also famously vocal when it came to espousing a short-volatility strategy in mid-2014. Doing so wasn’t necessarily wrong, as Gross noted it was “part and parcel” of an overall investment strategy that rested on sluggish U.S. growth and low interest rates, but it nevertheless raised eyebrows among his peers and competitors who viewed the new crop of buy-side volatility-sellers as tourists in a somewhat dangerous market.

The second point is that the sheer size of Gross’s creation — Pimco — has at times had massive effects on the wider market. “Big West Coast player” means just one thing for many in fixed income, and Pimco was said by plenty of observers to have frequently thrown around its gorilla-esque weight to get favourable pricing and allocation on new bond deals. Conversely, however, the sheer size of the Total Return Fund (which from memory peaked at almost $300 billion), was also said by market participants to pose challenges for its managers, the idea being the fund had grown so large it effectively struggled to beat its benchmarks.

That size could also have more deleterious effects. Few people seem to remember now, for instance, that when Gross left Pimco, it coincided with a noticeable sell-off in inflation-linked bonds and junk-rated paper. Or that the flash crash in U.S. Treasuries in October 2014 was rumoured to have been sparked by a sudden liquidation of interest rate positions favoured by Gross. There are still so many interesting open-ended questions posited by Bill Gross’s adventures in Bond Land, and from that perspective I’m somewhat sorry to see him go.

Anyway, for those interested in mulling these questions more, here’s some previous work — much of it done with the FT’s fantastic Mike Mackenzie:

Gross exit from Pimco tests bond market – September, 2014
Pimco upheaval rattles bond market – September, 2014
Wall St sheds light on Bill Gross reign after Pimco departure – October, 2014
Bonds: Anatomy of a market meltdown – November 2014
Caught on the wrong side of the ‘vol’ trade – December, 2014
Reach for returns takes funds into the shadows – February, 2015

The year in credit (2018)

The year in credit (2018)

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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.