Credit - Operation Mincemeat
"The greatest trick central bankers ever pulled was to convince the investing world that default risk didn't exist" - Macronomics.
Watching with interest government yields making new record lows
(Spanish 10-year yields at 2.63%, the least since 1993, and Italian
10-year yields at 2.723%, an all-time low), with the Itraxx Crossover
index, the CDS 5 year risk gauge for European High Yield falling 8 basis
points to 229 basis, the lowest level since June 2007, we thought we
had to adapt our quote above to reflect the "greatness" of our central
bankers magic tricks and deceptive actions which is of course a
reference to Usual Suspects' "Verbal Kint (when it comes to "Cantillon"
effect and creating excessive risk taking mentality) and to great text from the French poet Charles Baudelaire: "My God! Lord, my God! Please make the devil keep his word!"
One may therefore wonder why our chosen title. Given this week saw the
70th anniversary of the D-Day landing in Normandy, we reminded ourselves
of one of the greatest disinformation plans of World War II, namely Operation Mincemeat. It
was a widespread deception plan intended to cover the invasion of Italy
from North Africa. Operation Mincemeat helped convinced the German high
command the allied would land in Greece and Sardinia in 1943 rather
than the actual objective of Sicily. The glaring success of Operation
Mincemeat, caused the Germans to disregard later genuine documents finds
such as documents found 2 days after D-Day landings detailing future
military targets and disregard similar documents found during Operation
Market-Garden in the Netherlands in September 1944.
In similar fashion the successful concerted action from our "Generous Gambler"
aka Mario Draghi, with this week's new decisions from the ECB following
his 2012 "whatever it takes" moment have had similar effects on keeping
at bay the "feral bond hogs" and leading investors to completely disregard default risk.
Without the prior success of
Operation Mincemeat, D-Day landings could not have been successful. In
similar fashion the disappearance of "default risk" in Europe and the
ensuring "Japonification" process of yields would not have been
successful without the prior deceptive plan of the "OMT" ("believe me it
will be enough" moment). On a side note for those who want to read
great accounts of the D-Day landings in Normandy we recommend you read
Max Hastings' masterpiece "Overlord" and "Decision in Normandy" by Carlo
d'Este. For those of you who enjoy human's ability in practicing deception, like ourselves, we recommend the site "deceptology.com" dealing with its various forms.
But, moving back to this week's conversation, we would like this week to
look at the on-going "Japonification" process and what it entails in
terms of risk taking mentality and credit compression as well as the
"deception" process at play when it comes to the new measures being set
up by the ECB which are in fact once again supportive of the
deleveraging and recapitalisation process of the European banking sector
as a whole.
A good illustration of the "Japonification" process in the credit space
can be seen in the below graph illustrating the degree of tightening of
the Itraxx Crossover 5 year CDS index indicative of the risk gauge for
European High Yield (based on 50 European entities) - graph source
Bloomberg:
The spread is closing towards the lowest point encountered back in 2006 and 2007.
More worrinyingly, liquidity wise, as we have pointed out on numerous occasions on this blog, the degree of liquidity that can be provided by market makers is nothing comparable to what could be provided back then. Dealers simply do not have the inventories or the risk appetite to absorb a large sell-off should it occur in the market place. For instance, from a discussion with a large interdealer broker in the CDS space, it appears that only two banks are providing large enough liquidity in the High Yield CDS single name space in decent clip size (20-30 million of notional amount) whereas most of the time ticket size in the CDS single name space would be around 2-3 million per name in the CDS space. Markets have become indeed more defensive than in 2006-2007, particularly so when CDS dealers have a hard time recycling CDS bids being hit continuously with spread compression with no large loan books hedging taking place lifting protection in the process given the on-going deleveraging taking place in the European banking sector.
The latest move from the ECB has as well closed the gap between Investment Grade in Europe as seen in the credit index Itraxx Main Europe 5 year with its US counterpart CDX IG as illustrated recently by Bank of America Merrill Lynch's graph from their recent Credit Strategist note from the 6th of June entitled "Return to Order":
"Most measures - including the discussion of potential future ABS
based QE - are clearly positive for credit as investors are crowded out
of yield opportunities. Obviously most directly positive for European
credit, but also indirectly for US credit as relative value improves.
Hence US investment grade and high yield tightened 1.7bps and 0.26pts,
while European IG tightened as much as 3.8bps (iTraxx). It should not be
long before Main trades inside IG (Figure 9), especially as with the
ECB out of the way US interest rates can better reflect the strength of
the US economy." - source Bank of America Merrill Lynch
What of course the continuous tightening has done to Investment Grade Credit has been to increase the instability to sudden shock in rising rates, making the asset class increasingly more vulnerable than High Yield which from a convexity point of view is less sensitive to rates movements as indicated in the same report from Bank of America Merrill Lynch:
"The emerging June seasonal in rates
For the second consecutive year financial markets are working hard to establish a very bearish June seasonal for Treasuries, as 10-year interest rates two business days into the month have risen already 12bps. That represents the biggest 2-day increase in interest rates in more than six months (since 11/20/2013), but ranks only 15th since rates began to increase in May last year (Figure 21).
However a representative IG ETF (long
term) has declined 1.29% over the last two days – a move not seen since
7/5/2013, and the 6th biggest move since May last year. A
benchmark HY ETF is down 0.76% over the same period, a move we have seen
earlier this year, and only the 23rd biggest decline since May last
year. Clearly this recent increase in rates is disproportionally adverse to IG returns compared with anything we have seen recently. The
main reason is that, as credit spreads have rallied significantly,
there is very little spread cushion available to offset the increase in
interest rates. Clearly high yield has more capacity, and thus returns
are faring better.
The past two days compare with the period 10/29/2013-12/31/2013, where the same representative IG ETF declined similarly (1.21% negative price return). However, that was on a 50bps move higher in 10-year interest rates (from 2.5% to 3.0%). One of the big differences is that back then credit spreads started at 144bps compared with just 112bps currently, and thus could play a bigger role in offsetting the rates move (Figure 22).
We continue to expect some spread tightening initially as rates go
back up, although this time much more modestly. This especially as
retail flows – that tends to be driven primarily by past returns – are
still driven in the short term by this year’s stellar performance
through May. However, the experience the past two days shows just how
fast returns erode this time when interest rate increase.
Thus eventually retail inflows end, which should more than offset the increase in institutional demand and lead to less favorable liquidity conditions and higher spread volatility." - source Bank of America Merrill Lynch
To illustrate further more interest sensitivity in conjunction with lack of liquidity, we discussed recently this very subject with our cross-asset friend and fellow blogger "Sormiou". For instance there are some new issues in investment grade in the primary market in the 300/400 million euro range size coming to the market. They are obviously smaller than the traditional 500 million benchmark size deals being generally placed and bought by mutual funds. They come with 10 year maturities with spread comprised between 70 and 90 bps. The problem is that on the secondary space these bonds are being priced by market makers with 10 bps bid/offer spread meaning that with a duration sensitivity of around 7/8 you lose 1 year of carry in the secondary space should you decide to part with your recently acquired bonds. So dear Investment Grade investors welcome to "Japonification" and "buy and hold" for the next 10 years...
The recent ECB decisions will of course reinforce the technical bid for credit even more and compressing even further already very tight spreads in the market place. In this environment, no doubt European High Yield will continue to perform as the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We therefore expect financials to outperform significantly non-financials, and in particular Italian financials credit and equities to be as well the big beneficiaries from the latest generosity from our "Generous Gambler" aka Mario Draghi. Let's face it, when your central bank offers you 400 billion 4 year loans at 25 bps, it is hardly an offer you can refuse to play the "carry" game even further. While the ECB is hoping that banks will use to pass it on to corporate via increase lending, the deception in "Operation Mincemeat" is that it will be used rather as yet another source of cheap funding given the real constraint face by the European financial sector has more to do with capital issues rather than liquidity issues.
What seems to be happening as well with the recent additional help of "Operation Mincemeat" by the ECB, is that investors are indeed pushed out even further out on the risk curve as confirmed by Morgan Stanley's Leveraged Finance Insights note from the 6th of June entitled "Here What You Own":
"We find that HY funds have gradually allocated away from high
quality in recent history. In December 2012, the allocation to BBs stood
at 36% (very much in line with the overall market, at 37%). The
allocation to Bs was also close to the broader market, at 49%. Over the
last five quarters, BBs have increased as a percentage of the overall
market by 7%. However, BBs increased as a percentage of total mutual
fund holdings by only 3.4% from 4Q12 to 4Q13 and remained flat from 4Q13
to 1Q14. Funds are now 5% underweight BBs compared to the overall
market, showing that rising rates have likely surprised investors this
year. To some extent though, we have seen moderation in risk-taking by
funds quarter over quarter. For example, funds have moved from 1%
overweight CCCs to 1% underweight, at the same time increasing their
overw eight to Bs." - source Morgan Stanley
The latest round of central bank generosity will further trigger additional yield seeking investment and boost no doubt asset prices further up as illustrated by the performance of European High Yield versus Equities since 2009 as displayed by Bank of America Merrill Lynch in their latest Thundering Word report entitled "So it begins":
In true Japanese fashion, credit in a deflationary environment does
indeed tend to outperform as we have previously discussed in our
conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"
We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4% these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great magicians. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:
On a final note and to illustrate further our "deception" analogy from our chosen title as well as our gently twisted starting quote from above, Mario Draghi is truly a great magician when it comes to deception tricks as indicated by the below Bank of America Merrill Lynch graph from their latest Thundering Word note entitled "So it begins" given that Italy now appears more creditworthy than the US:
"From ZIRP to NIRP
ECB policy ease induced a phenomenal rally in European credit markets. 5-year Italian bonds yielded 700bps more than US 5-year bonds less than 3 years ago; now they trade 25bps below (Chart 2)."
- source Bank of America Merrill Lynch.
For us it seems we are indeed moving from ZIRP to NIRP, to ZILCH, when it comes to yield levels and no doubt the last leg of the rally has some more room to "overshoot" on the way up rest assured.
"Profit is sweet, even if it comes from deception." - Sophocles
Stay tuned!
More worrinyingly, liquidity wise, as we have pointed out on numerous occasions on this blog, the degree of liquidity that can be provided by market makers is nothing comparable to what could be provided back then. Dealers simply do not have the inventories or the risk appetite to absorb a large sell-off should it occur in the market place. For instance, from a discussion with a large interdealer broker in the CDS space, it appears that only two banks are providing large enough liquidity in the High Yield CDS single name space in decent clip size (20-30 million of notional amount) whereas most of the time ticket size in the CDS single name space would be around 2-3 million per name in the CDS space. Markets have become indeed more defensive than in 2006-2007, particularly so when CDS dealers have a hard time recycling CDS bids being hit continuously with spread compression with no large loan books hedging taking place lifting protection in the process given the on-going deleveraging taking place in the European banking sector.
The latest move from the ECB has as well closed the gap between Investment Grade in Europe as seen in the credit index Itraxx Main Europe 5 year with its US counterpart CDX IG as illustrated recently by Bank of America Merrill Lynch's graph from their recent Credit Strategist note from the 6th of June entitled "Return to Order":
What of course the continuous tightening has done to Investment Grade Credit has been to increase the instability to sudden shock in rising rates, making the asset class increasingly more vulnerable than High Yield which from a convexity point of view is less sensitive to rates movements as indicated in the same report from Bank of America Merrill Lynch:
"The emerging June seasonal in rates
For the second consecutive year financial markets are working hard to establish a very bearish June seasonal for Treasuries, as 10-year interest rates two business days into the month have risen already 12bps. That represents the biggest 2-day increase in interest rates in more than six months (since 11/20/2013), but ranks only 15th since rates began to increase in May last year (Figure 21).
The past two days compare with the period 10/29/2013-12/31/2013, where the same representative IG ETF declined similarly (1.21% negative price return). However, that was on a 50bps move higher in 10-year interest rates (from 2.5% to 3.0%). One of the big differences is that back then credit spreads started at 144bps compared with just 112bps currently, and thus could play a bigger role in offsetting the rates move (Figure 22).
Thus eventually retail inflows end, which should more than offset the increase in institutional demand and lead to less favorable liquidity conditions and higher spread volatility." - source Bank of America Merrill Lynch
To illustrate further more interest sensitivity in conjunction with lack of liquidity, we discussed recently this very subject with our cross-asset friend and fellow blogger "Sormiou". For instance there are some new issues in investment grade in the primary market in the 300/400 million euro range size coming to the market. They are obviously smaller than the traditional 500 million benchmark size deals being generally placed and bought by mutual funds. They come with 10 year maturities with spread comprised between 70 and 90 bps. The problem is that on the secondary space these bonds are being priced by market makers with 10 bps bid/offer spread meaning that with a duration sensitivity of around 7/8 you lose 1 year of carry in the secondary space should you decide to part with your recently acquired bonds. So dear Investment Grade investors welcome to "Japonification" and "buy and hold" for the next 10 years...
The recent ECB decisions will of course reinforce the technical bid for credit even more and compressing even further already very tight spreads in the market place. In this environment, no doubt European High Yield will continue to perform as the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We therefore expect financials to outperform significantly non-financials, and in particular Italian financials credit and equities to be as well the big beneficiaries from the latest generosity from our "Generous Gambler" aka Mario Draghi. Let's face it, when your central bank offers you 400 billion 4 year loans at 25 bps, it is hardly an offer you can refuse to play the "carry" game even further. While the ECB is hoping that banks will use to pass it on to corporate via increase lending, the deception in "Operation Mincemeat" is that it will be used rather as yet another source of cheap funding given the real constraint face by the European financial sector has more to do with capital issues rather than liquidity issues.
What seems to be happening as well with the recent additional help of "Operation Mincemeat" by the ECB, is that investors are indeed pushed out even further out on the risk curve as confirmed by Morgan Stanley's Leveraged Finance Insights note from the 6th of June entitled "Here What You Own":
The latest round of central bank generosity will further trigger additional yield seeking investment and boost no doubt asset prices further up as illustrated by the performance of European High Yield versus Equities since 2009 as displayed by Bank of America Merrill Lynch in their latest Thundering Word report entitled "So it begins":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"
We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4% these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great magicians. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:
On a final note and to illustrate further our "deception" analogy from our chosen title as well as our gently twisted starting quote from above, Mario Draghi is truly a great magician when it comes to deception tricks as indicated by the below Bank of America Merrill Lynch graph from their latest Thundering Word note entitled "So it begins" given that Italy now appears more creditworthy than the US:
"From ZIRP to NIRP
ECB policy ease induced a phenomenal rally in European credit markets. 5-year Italian bonds yielded 700bps more than US 5-year bonds less than 3 years ago; now they trade 25bps below (Chart 2)."
For us it seems we are indeed moving from ZIRP to NIRP, to ZILCH, when it comes to yield levels and no doubt the last leg of the rally has some more room to "overshoot" on the way up rest assured.
"Profit is sweet, even if it comes from deception." - Sophocles
Stay tuned!