Capital Context Update: Credit Crumbling

From Capital Context

Global growth proxies lost ground as 'stores of wealth' were stable after China, Germany, and France macro data.

Stocks underperformed credit today on a beta-adjusted basis for the second day in a row from a top-down perspective even as HY shifted above 450bps (its widest year-to-date). IG also weakened, led by financials, but CDS in the better quality names managed to outperform with crossover names clearly hurt harder in credit than other quality cohorts.

The message has been loud and clear from us for a while - that credit has been anticipating problems and the last few days has seen a re-emergence of the equity recognition of this as stocks pull back to more realistic relative valuations to credit. Secondary bond selling was significant today also - especially in financials as we suspect macro overlays have been lifted and underlying positions liquidated as fears are not abating.

Overnight saw further macro weakness with China PMI and Germany/France manufacturing which stalled the EUR and dragged our risk basket significantly lower. The interesting point from this is that oil and copper (think global growth proxies) lost notable ground today while gold/silver (think alternate safe assets and stores of wealth) were relatively unmoved (even as the USD strengthened quite significantly).

S&P futures opened low and just trod water for much of the day, staying closely synced (as opposed to last week's divergences) with the equity risk basket we have been tracking. Downgrades in European sovereigns and banks put more pressure on their spreads and that flopped over into US credit.

Credit outperformed stocks across all sectors, on our model-adjusted beta basis, except for financials which saw modest equity outperformance relative to credit. Utilities, Tech, and Energy were the best credit performers relative to equity today.

Up-in-Quality persists in credit and up-in-capital structure is clear.

As a slight change, low beta names in our capital structure context actually outperformed in stocks but underperformed in credit. High beta names were very modestly tighter on average while low beta names were wider. Vol was more balanced between high and low beta than in recent weeks -perhaps post OPEX is claming it down a little.

The bottom line is that our themes in credit are playing out as projected - up-in-quality and up-in-capital structure. Dispersion is rising which we also suggested as a theme based on positioning short correlation (thanks to the tri-party Financials, Energy/Basic Materials, and Others dislocation and clustering we have seen). Top-down we still see equities as having notable (at least 10-20%) downside relative to credit (and obviously more if we see HY cointonue to deteriorate as it has been recently).

At sector levels, we are jumping the gun a little with this output but we see Financials and Basic Materials as having the most implied upside for stocks (we are using the S&P sector ETFs for our modeling here) and Healthcare, Staples, and Industrials as having the most implied downside in stocks. These are short-term trading signals based on credit, vol, and stock behaviors for each of the sector cohorts. (we know we owe readers a sector wrap with this detail but client commitments have put that on hold until later this week).

The HYG-LQD proxy for HY-IG decompression has slowly gone our way and conviction remains high.

Our HY-IG decompression trade is slowly moving our way (based on the ETF trade we put on a couple of weeks ago) as is seen in the chart above (where we use HYG and LQD weighted based on our deltas to proxy this in a more actionable way for individual investors than our typical CDS approach).

The trade we like for our institutional investors is short IG insurer credit and long IG index credit as a low cost long vol play on further HY decompression - the correlation between insurers and HY is extreme and largely thanks to their huge undertakings of issuance over the last few years.

It is worth remembering that we have been out of stocks since late April based on our credit-equity TAA (Tactical Asset Allocation model) and feel comfortable with that view both fundamentally and quantitatively still (we will release the white paper on this impressive modeling approach shortly).

So IG has widened back to its 50-day average, HY is well above its and has closed above 450bps for the first time since April 18th and the on-the-run is at its widest close since Dec 27th (so year-to-date). IG was 2bps wider than current levels and S&P was 1257 and VIX 17.7% at that date so it seems only the S&P is really out of line currently on a pure like-for-like basis.

If we use intrinsics (meaning we create indices of the fair-value going back for many years before the index was created based on the underlying components of the index) we can create longer-term more fungible histories to judge strength or weakness by. It turns out that both IG and HY are pretty close to unchanged now YTD. Hy is however dramatically wider than its mid-Feb tights and has decoupled from IG's performance (evident in the chart is the up-in-quality preference). We would not be at all surprised, given the forced preference for risky assets that QE2 post-Jackson Hole overlaid on the world, to see HY back to 525bps shortly and even with the up-in-quality preference and fund flows, IG to break back to 100bps as equity market participants begin to recognize the disconnect between a liquidity elevated asset price (USD numeraire - the US equity market and all commodities) and the DCF value of those assets as growth is lowered and discount rates rise.

HY and IG credit spreads are as good as unchanged YTD but HY is decompressing fast and in a way that signals cyclical change we have not seen since MAR09 lows.

The reason we spent time on this chart and created the hostory is because we hear so much about how low high yield 'yields' are and how that is apparently a positive. The only reason to buy a high yield bond is to capture a higher yield (or capital appreciation should you believe that is possible) and therefore it is the spread over risk free rates that is critical NOT the yield in risk comprehension (something we fear many individual investors fail to recognize). If TSY yields drop further, we will see rates on HY debt drop but spreads will likely widen - both on an empirically sensitive negative correlation to sticky bond prices as well as lower growth fundamentals.

Deflation is the absolute enemy of HY bonds - odd to say that given one always thinks of inflation as the enemy of fixed income - but the fact that assets and liabilities are much closer in a high yield firm means a deflating value of the assets with fixed liabilities will have a larger and larger negative impact on firm credit risk and that decompression in spreads will outweigh any lower growth-expectation that drops TSY yields. HY credit is clearly signaling worrisome times ahead as we have been saying for a while and the fact that dispersion is rising also means this is more than simple macro overlays protecting portfolios, this is beginning to be a very discriminatory shift by the investor class away from this good performer.

The fact that today and Friday saw increasing amounts of net selling in secondary bond markets should also raise flags as typically CDS overlays are put in place and then unwound. The overlay has happened (as HY underperformed above) and now the actual underlyings are being unwound (as opposed to the overlay removed as fears die down). Long-dated corporates were especially net sold today (from the buy side to the dealers) and today specifically saw very significant selling in financials overall in bond land (dominated by our majors and USD denominated Europeans also).

European markets underperformed US markets today with sovereign woes (thanks to the late friday downgrade and overnight;s weak macro data). We are happy to report that SovX and its intrinsic value has resynced at 202bps (having been more than 10bps aprt a week or so ago) - we say happy as we suggested this was what much of the spread compression in individual names was being driven by - index arb and basis trades.

Cash (bonds) and synthetics (CDS) traded side by side today suggesting little uncertainty in general that any restructuring or reprofiling will trigger CDS and keep their relative values in line. Portugal remains very notably cheap in bonds relative to CDS - despite the inverted curve - and offers the most upside for basis traders.

Financials were hammered as a number of greek banks got downgrades with FINSEN (senior financial debt) trading 11bps wider at 156bps and even non-Financials traded 2bps wider at 91bps. This handsome divergence once again helped our triangle trade as with SovX so wide we would expect financials to trade still notably wider than non-financials - even as austerity appears to be setting in and impacting more than just the peripherals themselves.

CEEMEA sovereigns were all wider today with the exception of Latvia as oil producing states underperformed.

Asia Ex-Japan (AXJ) underperformed considerably relative to Japan (compressing that spread and helping our normalization trade) as AXJ broke 110bps once again. Australia also followed AXJ and widened 4.5bps on the day - one of its largest single day moves and now trades wide of AXJ as banks underperformed led by Maquaria and ANZ - once again playing to our theme trade of Aussie financials underperforming Aussie corporates in general. Bank of China was also a decent loser overnight in credit space as was Sony on its loss.

Index/Intrinsics Changes

CDX16 IG +1.88bps to 91.88 ($-0.06 to $100.3) (FV +1.14bps to 89.5) (89 wider - 12 tighter <> 65 steeper - 54 flatter) - No Trend.
CDX16 HVOL +1.9bps to 149.3 (FV +2.54bps to 149.76) (24 wider - 2 tighter <> 17 steeper - 12 flatter) - No Trend.
CDX16 ExHVOL +1.87bps to 73.75 (FV +0.79bps to 71.25) (66 wider - 30 tighter <> 47 steeper - 49 flatter).
CDX16 HY (30% recovery) Px $-0.37 to $101.94 / +9bps to 452.4 (FV +8.33bps to 438.6) (95 wider - 0 tighter <> 32 steeper - 65 flatter) - Trend Wider.
LCDX16 (70% recovery) Px $-0.12 to $101.375 / +3.06bps to 253.06 - No Trend.
MCDX16 +6.75bps to 129bps. - Trend Wider.
ITRX15 Main +3.81bps to 103.75bps (FV+3.28bps to 105.72bps).
ITRX15 HiVol +4bps to 140bps (FV+4.19bps to 140.88bps).
ITRX15 Xover +11bps to 375bps (FV+11.63bps to 362.96bps).
ITRX15 FINLs +10.75bps to 156bps (FV+7.72bps to 150.13bps).
DXY strengthened 0.93% to 76.14.
Oil fell $2.03 to $97.46.
Gold rose $4.93 to $1517.23.
VIX increased 0.84pts to 18.27%.
10Y US Treasury yields fell 1.7bps to 3.13%.
S&P500 Futures lost 0.98% to 1314.8.

Spreads were broadly wider in the US as all the indices deteriorated. IG trades 0.3bps tight (rich) to its 50d moving average, which is a Z-Score of -0.1s.d.. At 91.88bps, IG has closed tighter on 86 days in the last 615 trading days (JAN09). The last five days have seen IG flat to its 50d moving average. HY trades 8.2bps wide (cheap) to its 50d moving average, which is a Z-Score of 2s.d. and at 452.38bps, HY has closed tighter on 102 days in the last 615 trading days (JAN09). Indices typically underperformed single-names with skews widening in general.

Comparing the relative HY and IG moves to their 50-day rolling beta, we see that HY underperformed by around 4.4bps (or 50% of today's move). Interestingly, based on short-run empirical betas between IG, HY, and the S&P, stocks underperformed HY by an equivalent 8.5bps, and stocks underperformed IG by an equivalent 1.8bps - (implying IG outperformed HY (on an equity-adjusted basis)).

Among the IG names in the US, the worst performing names (on a DV01-adjusted basis) were Toll Brothers, Inc. (+8bps) [+0.06bps], MDC Holdings Inc (+6.5bps) [+0.05bps], and Metlife, Inc. (+6bps) [+0.05bps], and the best performing names were Reynolds American Inc. (-1.5bps) [-0.01bps], Hewlett-Packard Company (-1bps) [-0.01bps], and Marriott International Inc. (-1bps) [-0.01bps] // (absolute spread chg) [HY index impact].

Among the HY names in the US, the worst performing names (on a DV01-adjusted basis) were K Hovnanian Enterprises, Inc. (+51.12bps) [+0.36bps], PMI Group Inc/The (+39.39bps) [+0.29bps], and McClatchy Co./The (+26.7bps) [+0.22bps], and the best performing names were Boyd Gaming Corporation (0bps) [+0bps], Owens-Illinois Inc. (0bps) [+0bps], and Tesoro Corporation (0bps) [+0bps] // (absolute spread chg) [HY index impact].

Among the European IG names, the worst performing names (on a DV01-adjusted basis) were Banca Monte dei Paschi di Siena SpA (+15.5bps) [+0.12bps], Banco Bilbao Vizcaya Argentaria SA (+14.75bps) [+0.11bps], and Banco Popolare SC (+14bps) [+0.11bps], and the best performing names were Rentokil Initial Plc (-7.5bps) [-0.06bps], Suedzucker AG (-0.5bps) [-0bps], and Pearson Plc (-0.25bps) [-0bps] // (absolute spread chg) [HY index impact].

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