Saturday, September 27, 2014

FLASH UPDATE: Is "Data Dependent" Necessary Language?

"Data dependent" is a term that Janet Yellen probably used ten times in her speech two weeks ago, and one that between Ben Bernanke and herself, has been uttered hundreds of times since the financial crisis.  Easing accommodations will be dependent upon the growth of the economy.  Since the 2008 recession, the economy has recovered slowly but surely.  Observe the following, since March 2009:

- The Industrial Production Index has risen approximately 24% (+4% in the last year)
- The ISM Manufacturing Index has risen by approximately 64% (+4% in the last year)
- New Housing Starts has risen by approximately 95% (+8% in the last year)
- The Case-Shiller Index has risen approximately 20% (+8% in the last year)
- The Unemployment Rate has fallen from approximately 8.7% to 6.1%
- GDP has risen from approximately -0.5% annually to +4.6% annualized (as of Q2)
- The St. Louis Fed Financial Stress Index has fallen approximately 130%
- The Consumer Sentiment Index has risen approximately 40% (+2% in the last year)
You can choose to believe all, some or none of these figures.  That being said, although many or most of these may be unsustainable, if easing accommodations is “data dependent”, What Are They Waiting For!?
Maybe the Fed has no intention of ever returning to a market driven, supply & demand focused economy where the level and length of government intervention is the only important driving factor.  Maybe they are just afraid to find out how the market reacts upon completion of the Taper and true withdrawal of liquidity from the system.  After all, it has been six years of zero-interest rate policy and six years of awash liquidity, where there is no precedent for what comes next. 

I expect that the end of Taper and the eventual withdrawal of liquidity will not go as smoothly as Chairwoman Yellen hopes it will.  Additionally, I think there is a possibility that without outside liquidity and support, the economy will not be quite as “strong” as it has been.  In the last 4-5 years, US HY issuance has been unprecedented, but with the background of the tepid growth environment there are many companies that have deteriorated significantly across many metrics.  We expect that will be exacerbated in a less liquid environment, one in which capital markets will be much more difficult and expensive to access and one in which we think might be on the horizon.
Enjoy your Sunday,
Richard Travia
Director of Research

Thursday, September 25, 2014

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 23 Sep 2014


Comment:

Treasuries rallied this week as 10yr yields tumbled to 2.53 from 2.62 on increased geopolitical concerns and strife in the Middle East. The rally came in spite of Thursday’s strong initial jobless claims that came in at 280k vs 305k expectations. Although rates rallied, the yield curve flattened yet another 2 bps, leaving the 10/5 spread at 77 bps. Implied volatility on the 1M X 10yr swaption fell 4 basis points to 61 (a local low) in the event-filled week that contained Fed minutes, Scottish Independence referendum, and airstrikes. In mortgages, the basis held up well vs 5yr hedges with lower coupons providing the greatest return in the rally.

The refi index fell an additional 99 points, further easing refi concerns for cuspy coupons that exhibit high convexity. This week was another active week in Agency IO/IIO ahead of the FOMC meeting as the market saw about $1 BB in BWICs. We saw OAS on premium IOs (4.5s+) tighten between 15 and 20 bps while IO 4.0s and below widened a couple of basis points. Higher coupons continue to be well bid as investors priced in materially lower expected prepayments.

In contrast to TBAs outperforming spec pools in the second week of September into a sell-off, we saw specified pool payups generally increase into the rally. Seasoned 2012, 2013 and 2014 collateral was between flat and up 3 ticks, with 4.5s seeing the most price action. The greatest change in payup we saw was FN 3.5 LLBs decreasing 4 ticks.

Noteworthy:
The MBX 400.10 -50bps swap (vs MBX 350.10) closed at $2-25 this week, leaving the price at the first percentile, or -2.5 standard deviations, from its 2 month mean. The trade offers ¼ of a tick in positive carry on a matched DV01 basis.

Regards,

Tradex Global Advisory Services, LLC
investorrelations@thetradexgroup.com 
203-863-1500
@Tradex_Global

Thursday, September 18, 2014

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 16 Sep 2014


Comment:

The yield curve steepened six basis points Tuesday to Tuesday between 5yr and 10yr maturities to 82 basis points ahead of the FOMC statement on Thursday. Market participants looked to see whether the ‘considerable time’ language remained in the FOMC statement with respect to the federal funds target range. The language indeed remained and the Committee decided continue to reinvest portfolio runoff past a rate hike. In line with the curve steepening, lower duration mortgages performed the best with FNMA 4.5s leading the stack up six ticks vs its 5yr hedge on the week. We continue to remain neutral on the basis as Fed takeout of total issuance is still large, but will inevitably decline. Analysts estimate that Fed reinvestment will result in a 30% takeout of gross issuance by the end of the year, down from 38% of current takeout, adjusting for CMOs.

The refi and purchase indices were relatively flat this week, both ending within a point of last week’s levels. There was a noticeable uptick in BWICs and trading volume in IO and IIO markets, with most selling coming from fast-money in lower coupons. Volatility ticked up this week pre FOMC, helping to push OAS wider. FN IO 4s of 13 led the widening at seven basis points wider. This week’s moderate widening reversed last week’s tightening in benchmark IOs (GNR 2010-26 QS, GNR 2010-20 SE, FNR 13-121 SA, etc.).

Specified pools payups were relatively unchanged this week. Most notably, LLB, MLB, and HLB payups on 4.0s all fell a tick. In terms of OAS, CK 4.5s widened the most (7 bps), while the street anticipates a convergence of speeds hedge ratios for specified 4s relative to TBAs. The carry profile of spec 4s, relative to TBA, should improve on converging speeds.

Noteworthy:

We like up in coupon IOS 4.5s of 2010 versus IOS 3.0s of 2012, matched one-for-one current face. The trade offers 3 ticks of positive carry and is poised to tighten in terms of OAS as investors become more comfortable with low prepayments in up in coupon IOs.

Regards,

Tradex Global Advisory Services, LLC
investorrelations@thetradexgroup.com 
203-863-1500
@Tradex_Global

Monday, September 15, 2014

FLASH UPDATE: Lack of Dispersion Creates Asymmetry of Short HY Opportunity

Although we are clearly starting to see some dispersion amongst specific credits, it is precisely the lack of dispersion that has created the asymmetry of the short high yield opportunity.  Today, well over 90% of the high yield market is trading over par.  On average, BB’s and B’s are trading approximately at 105 and CCC’s are trading approximately at par.  The spread between Investment Grade and High Yield according to JP Morgan is near 20-year tights at 185 bps versus the 20-year average of 371 bps. 

Generally, in the context of this fully heated credit market, there has not been a true differentiation between single names within a sector or within the entire HY universe.  Post-2008, there of course was an all-out effort to recapitalize and stabilize the US and global economy.  QE (and its derivatives & successors) were the confidence boosters that the economy needed to get going.  Banks were mandated to lend, and eventually succumbed to the pressures to do so.  Capital markets were open for business and, as we have said before, all companies, good and bad, were able to go out and issue debt.  US HY Issuance peaked out in 2007, with $132.7 B of bonds being brought to market.  This dropped to $50.7 B in 2008, but was followed by $127.4 B in 2009, $229.3 B in 2010, $184.6 B in 2011, $280.5 B in 2012, $270 B in 2013, and $153.6 B this year through 8/31.  Obviously issuance has been off the charts, and CCCs as a percent of the total HY issuance has been growing steadily, to what is now 21.5%. 


To illustrate the lack of dispersion, we have shown a summary of financials of four companies that operate in a similarly challenged sector, all with very disparate fundamentals and all trading at or near par:



We think that company fundamentals will very soon start to matter for challenged high yield companies, and we are observing some pockets of dispersion within specific sectors.  Retail shorts have been significant drivers of performance this month, a trend that we think will continue.  Please reach out if you’d like to discuss the opportunity to be short in the high yield space today.  Also, on Wednesday at 11:30AM EST we will be hosting a webinar on the current bubble in high yield credit with Dr. Ed Altman.


Tradex Global Advisory Services, LLC
investorrelations@thetradexgroup.com 
203-863-1500
@Tradex_Global  

Thursday, September 4, 2014

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 02 Sep 2014



Comment:
The yield curve steepened 3bps as the 5yr sold off 6 bps Tuesday to Tuesday on stronger ISM numbers. A few dealers speculated that the Sep 2 rates sell-off was a result of a peaceful weekend despite Prime Minister David Cameron raising Britain’s terror threat level to ‘severe’ last Friday. Implied volatility on the 1Mx10 YR swaption increased another 7 bps last week, of which 4 bps increase occurred on Friday.

In mortgages, primary rates reached a local trough at the end of August as we saw the refi index increase 1.4% to the highest level in 12 weeks. Not surprisingly, payups to TBA increased the most (+0-8) for call-protected CR >125 LTV 4.5s this week. On a z-score basis, LLB, MLB, and HLB 3.5s increased more than 3 standard deviations (+0-060 each) over the past 5 days as call protection cost increases. The price of call protection is currently the highest for >105 LTVs and LLBs for 4.5s as refi concerns gain momentum. Projected 1M speeds for these stories are 9.59 and 23.46, respectively.

Benchmark IO OAS continues to widen as FN30.400.13 increased 7bps to 176 bps on higher volatility and lower mortgage rates. FN30.400.11 IOs are trading much richer at 60 bps as seasoning plays a significant factor in pricing. Price multiples for IO 4s of 13 and IO 4s of 11 closed the week at 6.664 and 6.398, respectively. Despite recent widening, we still see valuations at the tighter end of the range with a lot of interest in higher coupon Ginnies.

Noteworthy:

Trace data show that August saw the lowest Agency mortgage derivative volume of the year. Despite the low volume, it was the second highest net customer derivatives buying of the year. The seemingly juxtaposed circumstance points to low customer selling and low new issuance.

Regards,

Tradex Global Advisory Services, LLC
investorrelations@thetradexgroup.com 
203-863-1500
@Tradex_Global

Monday, September 1, 2014

FLASH UPDATE: Ready, Set, Pop!

When balloons inflate, it is typically a long and slow process and always difficult to tell when they are full.  Towards the end, the balloon stretches and stretches, making room for those last few short breaths.  When you've reached the end though, it just doesn't feel right and you start to think more cautiously.  Of course as we all know, balloons burst.  Once that magical maximum capacity is reached, the balloon POPS in spectacular fashion, exploding with vigor - loudly and violently.  

There are three phases in the trajectory of the current fully-heated high yield market:  1) Overbought conditions, 2) Rate tantrums, and 3) Defaults.


Overbought Conditions
Clearly we have been in "Overbought" territory for quite some time.  According to the BAML Master High Yield Index, the average current high yield bond price is 104.10.  The average new issue clearing yield is 6.28%, down from 7.33% two years ago.  In the last year alone, the CCC new issue clearing yield has fallen from 8.77% to 7.79%.  The average yield-to-maturity is 6.18%, down from 7.35% two years ago.  


Forward calendar volume is already starting to reflect a small amount of hesitation in appetite, coming in at 19% lower than this time last year.  After growing rapidly over the past 10-15 years, high yield now comprises roughly 15% of the overall corporate (investment grade) bond market, which itself is estimated at roughly $9.8 trillion, trailing the U.S. Treasury market ($12.1 trillion outstanding) but larger than the municipal bond market ($3.7 trillion outstanding), according to first-half 2014 estimates by industry trade group Securities Industry and Financial Markets Association (SIFMA).  In 1996, the  high yield market was $200 billion.  

  
As the market has grown and issuance has exploded, Cov-Lite, PIK and PIK-Toggle issuance has had a resurgence, on pace to surpass the most recent highest annual volume in 2008.  PIKs are viewed as more highly speculative debt securities.  Essentially, the company through in-kind payment is creating more debt in a situation where it doesn’t have the capital to service the debt.  This blatant disregard for credit risk among the already obvious reach for yield is clearly setting up the next default cycle.

  

Rate Tantrums
On May 22, 2013, Former Fed Chairman Ben Bernanke announced that the Central Bank would begin scaling back its monthly asset purchase program.  This was followed up with a June 19th press conference, where he optimistically described then-current economic conditions, and reiterated that the taper would commence later in 2013.  In the next 48 hours, the 10Y Treasury yield rose approximately 35 bps, from 2.20% to 2.55%.  The 10Y Treasury yield hit 3% by the end of 2013.    


The value of the USD vs other currencies also rose significantly on the announcement, with some EM FX falling as much as 15-20% vs the USD.  In the four weeks following the May 22nd announcement, high yield ETFs and mutual funds saw $12.3 billion in redemptions.  This alarming outflow was only recently surpassed by outflows in the July-August 2014 technical sell-off ($12.6 billion in outflows).  Given that the Fed makes up approximately 90% of the new-issue MBS purchases, the reaction in the mortgage market was even more violent.  Annaly (NLY), a well-known mortgage REIT, lost 35% of its value from the date of the announcement to the end of 2013.  

  
The stock market continued to show relative strength though, only selling off approximately 5.5% in the month following the original announcement.  These collective reactions caused what is now referred to as "Taper Tantrum".  

The nervousness in the market about a new and improved tantrum is starting to become evident.  Bloomberg reported caution from UBS and other market participants last week.  Larry Hatheway, UBS's Chief Economist said, “The main show is soon to arrive.  With the ‘taper’ nearly complete, there are fundamental and institutional reasons aplenty to fret that last summer’s ‘taper tantrum’ will be find its sequel. Beware ‘rate rage.’”.  The Barron's this weekend is calling for significant forthcoming volatility in the bond market, suggesting that the announcement to raise rates may come as soon as the Fed's September 16th meeting.  As US Treasury yields hit lows due to geopolitical concerns and buying from sovereign debt relative value players, the rise could catch many off-guard, despite pretty much everybody knowing in their heart that it's coming.  

Investors notoriously chase returns.  The St. Louis Fed recently wrote a paper on the dangers of chasing returns (it was focused on equity mutual funds, but the premise holds true), which pointed to a high correlation of flows to past returns, of course resulting in inflows at exactly the wrong time.  Despite the recent ETF & mutual fund outflow hiccup in high yield, overall growth of the market has been unprecedented since 2010.  Some ETF operators have even caught on to the fear of rising rates, putting together what the Barron's expects could be a recipe for disaster - Long High Yield ETFs hedged with Short Treasuries.  (Although I agree that interest rates will rise over time, perhaps significantly, in the fickle world of trigger-finger happy retail investors, at the first sign of a risk-off environment these products could lose on both sides of the trade.  Investors thought all they were doing was protecting their coupon, when in reality they were ignoring credit quality again.)  


Defaults
Dr. Ed Altman, a world renowned expert on corporate bankruptcy, is an advisor to our short-biased high yield fund, and has conducted in depth research on the current credit bubble.  The current benign credit cycle, which has been near or below 2% for the last five years, is expected to considerably increase over the next three to five years.  Without taking the currently fully heated credit environment into account, it is clear that high yield default rates are incredibly cyclical.  The average annual default rate since 1971 is 3.14%, with below average default cycles lasting three to four years typically, and above average default cycles lasting one to two years.  Any sustained period of extraordinarily low defaults has typically been followed by a significant spike in default rates.  

The corporate high yield sector has been refinancing and increasing their debt significantly and consistently since the current benign credit cycle started in 2010.  New high yield issuance topped $200 billion for the first time ever in 2010.  2011 new high yield issuance was just below $200 billion, and 2012, 2013 and 2014 (the pace through the 1st half) have all topped $200 billion since.

Issuance is unprecedented, and the quality of that issuance is clearly suspect, with CCC issuance 21.5% of all high yield issuance, a figure not topped since 2008.  The 2nd quarter's CCC issuance jumped to 25.9% of total high yield issuance, a figure only second to the all-time record in 2007.  The five-year cumulative mortality rate for CCC's is 47.4%, a sobering statistic given the amount of low-rated debt issuance since 2010.  46% of the 1st half high yield issuance was Cov-Lite, another factor which typically results in lower recovery rates should the debtor company default.  Dr. Altman's well-known Z-Score metric, which quantifies a company's probability of default, shows that the credit quality of companies in the peak of the current cycle is lower than that of the last cycle peak in 2007.  


Marty Fridson's recent study suggested that the next default upsurge may be $1.576 trillion of face value between 2016 and 2020, a startling prediction given high yield's lofty status, which on average continues to trade well above par.  The price of weak credits typically fall well before the default rate spikes.  As an example, we point to 2007 and 2008 where the default rate was below 2% for every month except December 2008.  By the time the big spike in defaults occurred, the recovery (and QE) were already well in place.
    
  
Please enjoy your Labor Day and be safe.  I will be in NYC tomorrow for meetings if you'd like to meet, and I'll be at Citi Field for a Goldman event on Thursday (followed most likely by the US Open) if you'd like to catch up then.  We look forward to speaking with most of you in further detail about the current opportunity set throughout the next few months.  

Richard Travia

Director of Research