Credit Markets: Looking Under The Hood

Includes: DIA, HYG, IWM, JNK, LQD, SPY
by: Peter Tchir

Yesterday was a busy day in the markets. The new issue market was very busy, 9 issuers came bringing a total of $10.5 billion. GECC was the biggest deal with $3 billion in total. I think the Time Warner bonds were the most interesting as it was $1 billion in total and the largest non financial issuer on the day.

My conclusion is that on a standalone basis the U.S. credit markets are in okay shape, not great, but have gotten ahead of themselves relative to what is going on in Europe and that investors are once again getting positioned for a rally that requires full risk on participation and that just hasn’t happened yet, and I think is too risky of a way to play the market. I’m neutral at best, but would be long some liquid bonds versus being short indices or ETFs (ETFs until NAV catches up with Price, and CDX indices longer term).

Investment Grade New Issue Indicates Market is in Okay Shape

The old TWX 10 year benchmark, the 4.75% of 2021 were trading close to T+200 late last week, but with the rally in stocks on Monday, they had gotten as tight as 187 on Tuesday. The TWX 4% of 2022 came at T+200. Initial price talk was 210, but the deal priced at 200 on the back of very strong demand. There was over $6 billion in orders for the 2 new TWX bonds, a good sign, but can’t be relied on too heavily without knowing the quality of the orders. At 210, the bonds were coming at a steep concession to the secondary market and would have been a “flippers” delight. At T+200, the bonds were attractive, but not screaming cheap. It was encouraging that the existing bonds moved tighter with the market and traded as good at 183 over. The new bonds opened about 10 bps tighter and traded as tight as T+185, so 15 tighter, but ended the day at T+192, so a decent tightening, but it faded quicker than I would have expected. It looks like the bonds are opening close to T+195 this morning on general weakness.

What does this deal mean in terms of the overall market? I think it means the market is in okay shape. It isn’t in great shape, because the tightening should have lasted longer, and in a really good market, we would have seen not only the new deal perform well, but the old deal, which is largely tucked away and benefits from the curve, tighten more than it did. On the other hand, the minimal concession was a good sign and can’t be ignored, and it is still trading tighter than issue. I’d rate the market about a B or B- on the back of how this deal was done.

Active High Yield Bonds show demand for risk is good

Harrahs 10% of 2018 were the most active bond traded. It traded 46 times. All the trades were round lot trades ($1 million or more) which is good as the flows were real. It started the day at 67.5 (having closed at 66.5 on Tuesday) and got as high as 69.5. It finished the day closer to 69, but still a healthy 2.5 point gain on the day. The trades included 17 Sells by dealers, 8 Buys, and 21 interdealer trades. Clients were clearly buying from dealers, which is also encouraging. It is good to see that dealers were selling to clients, which proves there is some actual demand. The only negative I see in the data is that the early trades were the street selling, and the later trades had a higher proportion of dealers buying, so scrambling to cover some shorts.

For those not familiar with the TRACE reporting, here is an example for Case New Holland bonds. It had a similar pattern, though the mix of Sells, Buys, and Dealer trades was better, it also had less of a price increase. Which makes sense as the higher quality names outperformed on the downside and have less room to appreciate. Overall, judging from the trading in the active High Yield bonds, that market is trading well and could pop as dealers appear to be reducing inventory or getting short.

(Click to enlarge)

Low Activity Bonds are present a less compelling story

205 bonds TRACE’d in round lots only once yesterday. The vast majority of those trades were dealers selling to clients. In that respect it is positive. Clients are buying bonds from dealers, but only once. What concerns me about these trades is that it feels like managers who are underperforming and cannot understand why the illiquid bonds are underperforming, have decided to buy more, because “they have to catch up.” It was only 2 weeks ago when everyone was lamenting the lack of liquidity. Many managers were swearing up and down that they would reduce illiquid exposure if they got a chance. They wanted out of illiquid assets and to focus on liquid assets. Yet, after watching their HY17 hedge run up (or even worse, their HY16 short) they have decided the rotation out of illiquid into liquid can wait. Once the market “responds as it should” they will rotate out of illiquid assets. I am concerned that these flows are setting up bigger weak longs. So although clients buying should be a strong signal, these trades don’t give me that comfort. It looks too much like people adding to weak positions and trying to “clean up the street” to get some positive momentum, but not really chasing them higher. No one seems ready to capitulate at these levels now that the market “is so strong.”

ETF Activity is constructive, but possibly too far too fast (again)

One thing that you have to give (NYSEARCA:HYG), (NYSEARCA:JNK), and (NYSEARCA:LQD) credit for, is being open on Monday. It seems that the equity traders responsible for trading these ETFs overshot the mark on Monday as they closed lower on Tuesday, but if you wanted to trade US credit on Monday, this was the only option. HYG alone had volumes of about $175 million. Not enough to move the needle for a big fund, but certainly big enough that hedges could have been traded on Monday and if a bond investor had decided that 2% was overdoing it, they could have set a nice short.

Shares outstanding in HYG, JNK, and LQD continue to grow. LQD in particular spiked higher. Since retail investors tend to focus on the yield of LQD, rather than the spread, it makes sense that they put some money in. I’m still trying to figure out the quality of share increases and whether there are “good” share increases and “bad” share increases, but at least for the past week the moves make sense as they are in the same direction as the market – which is typical.

HYG seems to have moved a bit too far and is running away from NAV. NAV may be understated but I think this time it is about right. The liquid bonds are trading actively and have buyers and sellers, so they are going into NAV at the right prices. The illiquid weak bonds are not trading, and although offers are moving higher, that increase is being price into NAV. Unless a real "liftathon" starts in the weakest, most illiquid bonds, I think that HYG has gotten too far ahead of itself. I’m neutral the high yield market. I had thought it offered value a couple weeks ago, but after the big rally, I think the risk/reward is more balanced for the market as a whole, and I would buy liquid bonds here rather than HYG, at least until NAV and Price come back in line.

CDX Indices – Trading in Line with Fair Value – Hedges have been removed

IG17 and HY17 are both finally trading in line with fair value. For IG, we finally saw single names catch up. This is much more balanced than it has been where the IG index in particular, was trading very rich to fair value. With single names catching up, the market is much more balanced. That is generally good, but should put an end to the “squeeziness” we have seen in CDX indices. I think the market is being back to long cash, possibly longer than ever illiquid cash, and have taken off a lot of their hedges. Banks are not removing hedges – they want to report zero exposures and will ride the P&L swings in order to be able to say they have no net exposure – so it is the mark-to-market money that has taken off the hedges. If things turn, they will be just as fast to put on hedges, and still prefer to put longs into bonds rather than index. I think the risk/reward in indices, is better from the short side here as it will be first to react to any weakness and likely lag on more strength.

Contagion is alive and well

In spite of the enthusiasm we are seeing in equity markets, the bonds of Italy and Spain continue to weaken. Today, 5 year Italy is 11 bps higher, while Spanish 5 year bonds are 9 bps higher, and that is with Bunds 5 bps lower, so 16 and 14 bps of spread widening for the two countries Europe is trying hardest to protect. That is NOT good any way you look at it. It was bad enough when yields were going higher across the board in Europe (at least then you could argue spreads weren’t widening much), but this is just bad. Italy and Spain are going to have to pay more outright and more relative to Germany. It is probably a sign that someone in the sovereign debt market isn’t buying into the plan that Germany will provide a blank check. French 5 year yields are unchanged – guess they haven’t migrated to the bad crowd yet, but they are no longer viewed as a safe haven either.

Disclosure: I am short SPY. I will trade the ETFs actively, both long and short