Saturday, 4 July 2015

Credit - Blue Monday

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks
Watching with interest the dizzying gyrations in various markets on Monday following the Greek referendum "shocker", which no doubt has put additional pressure on already "stressed" VaR models, we reminded ourselves for our chosen title of a double analogy this time around, a musical one. Given Blue Monday is often associated to the most depressing day of the year in January (typically the third monday of the month), for us it as well a reference to the single released in 1983 by British band New Order, later remixed in 1988 and 1995, the biggest-selling 12" single of all time.

As far as our analogy goes, it was interesting to note the indiscriminate "selling" that occurred on Monday, particularly at the open of the credit markets where at some point the CDS High Yield European risk gauge 5 year CDS index Itraxx Crossover was wider by around 50 bps, which was reminiscent in earnest of the moves we saw back during the supposedly "dull" summer of 2007, which was indeed much warmer than usual, fo us credit guys at the time.

From the starting lyrics and with the on-going Greek situation, we think that our chosen title is indeed more than appropriate again, this time around:
"How does it feel to treat me like you do?
When you've laid your hands upon me and told me who you are.
I thought I was mistaken, I thought I heard your words.
Tell me how do I feel. Tell me now, how do I feel.
Those who came before me lived through their vocations
from the past until completion, they'll turn away no more.
And still I find it so hard to say what I need to say." - Blue Monday, New Order 1983
Indeed, we could even have gone one title better and select yet another song from our beloved great New Wave group "New Order". We could have selected another of their seminal tracks "Confusion" and some of its lyrics when it comes to relating to the Greek situation:
"You cause me confusion, you told me you cared
He's calling these changes that last to the end
Ask me no questions, I'll tell you no lies
The past is your present, the future is mine
You just can't believe me
When I show you what you mean to me
You just can't believe me" -  Confusion, New Order, 1983
But we ramble again...

Again, rather than focusing solely on the "Blue Monday" effect on asset prices thanks to the continuation of the Greek tragedy, in this week's conversation we want to focus our attention on the deteriorating trend in credit and the recent moves in Inverstment Grade Credit particularly in Europe which somewhat have validated our recent take from our conversation "Eternal Return":
"As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield spaceIn the current low yield environment, both duration and convexity are higher, therefore the price movement lower will be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!
So, should the volatility in the bond space continue in conjunction with a materialisation of a GREXIT, you could indeed face Poincaré's "recurrence theorem" and a vicious risk-reversal in illiquid secondary markets." - Macronomics, Eternal Return, 9th of June 2015
  • Convexity has no doubt started to "bite" credit, in particular Investment Grade Credit in Europe
  • How to cheaply hedge a potential Greece related sell-off using credit
  • The credit channel clock is ticking for High Yield
  • Balanced funds getting "unbalanced"
  • Final note: Cash holdings as a % of AUM is at the lowest since 2008
  • Convexity has no doubt started to "bite" credit, in particular Investment Grade Credit in Europe
While we mused on the 9th of June on the convexity issues surrounding Investment Grade credit and in particular Europe and warned about its rising "unattractiveness", we were not surprised to read from a recent Bank of America Merrill Lynch note Euro Excess Returns from the 1st of July 2015 entitled "Worse than the Taper Tantrum" that indeed the convexity issue we discussed a month ago has started to "bite" returns in earnest:
Worse than the Taper Tantrum
Euro credit had an unpleasant June. IG spreads widened 21bp as a series of events unfolded. 
At the start of the month, the confusing ECB message on “volatility” caused 10yr bund yields to surge higher (after having already moved materially higher in April). Rate volatility surged and this instigated a strong risk off move across markets. Later in the month, the tensions in Greece added to market weakness and drove a strong bid for protection. Throw in concerns over US rate increases, and a perfect storm brewed last month.
Heightened outflows
On top of all of this, the poor total return performance of credit over the last few months has been the catalyst for retail outflows to start. Euro high-grade credit total returns in Q2 were -2.8%. This is the worst quarterly performance in our index history (since 1996). Retail investors have withdrawn $6.4bn from Euro IG credit over the last 3 weeks, which is a bigger dollar outflow than seen during the June 2013 Taper Tantrum (see below chart).

Tantrums: then vs. now
In terms of comparisons with the 2013 Tantrum, the side table shows total return comparisons, split by maturity.
What’s interesting is that this time around, front end total returns have not been too bad, and certainly a lot less severe than in 2013. The ECB’s pledge to do more QE if necessary has anchored front-end yields. Yet, at the longer-end of the curve, total returns this time have been more painful that in 2013. 7-10yr total returns in June 15 were -3.37% vs. -2.75% in June 2013.
Ugly XS returns
High-grade excess returns were -1% last month, the worst performance since May 2012 (just before the OMT was announced). High-yield excess returns were -1.4%, which feels a bit of an outperformance by high-yield. In fact, the superior spreads and improving growth outlook have been somewhat of a cushion for high-yield over the last month. Note that single-B excess returns were better than BB excess returns (-1.2% vs. -1.4%) last month.
In high-grade, no sector posted positive excess returns last month. Insurance was the worst, despite the paradox that higher yields benefit life insurers. Nonetheless, the sector’s excess returns were -2.1%. Media lost 1.2%, which in part reflected the strengthening of the Euro lately (and thus not good for dollar revenues of media companies). Utilities and telecoms suffered because of the prevalence of long-dated debt. The “least bad” performers last month were leisure, capital goods and financial services (see the tables on the next page).
Year-to-date: equities way ahead of bonds now 
Year-to-date, Euro IG credit is down 1.4% in total return terms (83bp in excess return terms), Euro HY credit is up 2% in total return terms and Euro government debt is down 41bp in total returns. But stocks are eclipsing fixed-income now, even with the recent Greece related sell-off. The SX5E is up 11.5%, banks are up 15% and the Dax is up 14%.
If the Greece referendum returns a Yes vote at the weekend and tensions begin to ease, we think 2015 will begin to cement itself as the year of stocks over bonds (Table 2). 
- source Bank of America Merrill Lynch
No surprise there, we did warn about the end of the "goldilocks" period for Investment Grade credit in our conversation "Eternal Return":
"Should the volatility continue in the Government bond space, it will in the near term put upward pressure on credit spreads for both cash and synthetic indices such as the Itraxx Crossover (High Yield) 5 year CDS index taking the brunt of the widening stance we think as long as the GREXIT is "avoided".
Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process." - Macronomics, Eternal return, 9th of June 2015
We also indicated in our conversation that the Itraxx Main Europe 5 year CDS index was a good proxy "macro" hedge in case of Greek turmoils:
"Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process.
On a side note, the Itraxx Crossover 5 year CDS index, the "proxy" for High Yield, does includes two Greek companies, OTE and Hellenic Petroleum out of 75 entities within the Series 23 index which was implemented in March this year and rolls every 6 months. Also the US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to a potential GREXIT scenario playing out à la Poincaré..." - Macronomics, Eternal return, 9th of June 2015
iTraxx Europe is the benchmark investment grade CDS index in Europe and comprises CDS on 125 names. A new series begins to trade every six months (on 20 March and September). The current “on-therun” series is S23.

This brings us to the second point of our conversation,  namely how to benefit from "convexity" and on-going dislocation between equities and credit using credit as a good "macro" hedge for a potential "Grexit" in case of a new "Blue Monday" event.
  • How to cheaply hedge a potential Greece related sell-off using credit
We pointed out on numerous occasions the importance of CDS indices for credit investors and "macro" players. CDS indices plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity.

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
"Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays"
As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

We concluded at the time:
"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."
Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment and also by the fact that some dealers have pulled out of CDS trading in the single name space, reducing even more the liquidity. Large market maker Deutsche Bank pulled out altogether from this business, due to the high cost of capital of this fixed income activity.

So how does one cheaply hedge a potential Greece related sell-off using credit you might rightly ask? On that very subject we read with interest Deutsche Bank Cross Market Insights note from the 2nd of July 2015 entitled "Funding protection with Credit":
"Euro STOXX 50 (SX5E) is about 8% rich vs. iTraxx Europe S23 five-year spread SX5E price reflects the positive impact of ECB QE and is ~4% above pre-QE levels in spite of recent Greece-related sell-off. In contrast, iTraxx Europe spread is 8bp higher than pre-QE levels. (Figure 1) 
The dislocation provides an opportunity to cheaply hedge a potential Greece related sell-off.
Trade: buy SX5E 3000 strike Dec-15 expiry put (notional 1x) funded by selling protection on the iTraxx Europe S23 five-year index (notional 2.4x).
  • The gain in the iTraxx Europe position offsets the option premium in a benign environment.
  • The trade provides potential upside in a sell-off in which the SX5E reverses its recent outperformance vs. iTraxx Europe; it also provides significant upside in historic sell-off scenarios.
  • The trade is expected to have (small) positive P&L if markets rally between now and option expiry due to gain in the long risk iTraxx Europe position.
North American CDX.NA.IG also appears cheap vs. SX5E Investors looking for payout in USD can buy the put option above quantoed into USD, and sell protection on CDX.NA.IG.24 five-year index. 
Main risks
(1) Breakdown of the SX5E and CDS index relationships so that realised betas in a sell-off are materially lower than anticipated or credit experiences a sell-off while SX5E remains firm, (2) sell-off in equity implied vol, and (3) FX spot and vol fluctuations (for the USD trade). - source Deutsche Bank
Of course the story is one of rising convexity and on-going dislocation in the relationship between credit versus equities.

In their note, Deutsche Bank goes into more details on the on-going dislocations (linked for us, to the rise in "positive correlations" thanks to central banks "meddling"):
 "Euro STOXX 50 and iTraxx Europe prices dislocated
Uncertainty regarding Greece, ECB QE and core rates re-pricing have been the three major, and often conflicting, themes that have driven markets in 2015.
ECB QE, which should run until September 2016, is expected to provide long term support to risky assets (like equities, and credit spreads). The sharp move higher in core rates is seen as a more transient phenomenon with the most volatile periods likely behind us. Most market participants expect the Greek crisis to be contained and not lead to contagion like we saw in 2011. However, concern remains that material sell-offs can occur due to unexpected events in the saga, or due to policy missteps. 
Risk asset markets have not priced these factors in a consistent manner, especially in recent weeks. Figure 2 shows the evolution of the price of the Euro STOXX 50 (SX5E) equity index and the spread of the iTraxx Europe S23 CDS five-year index.

We also show equity and CDS index pricing at the time QE was announced. We see that the SX5E rallied 15% over its level at the time of QE announcement, and remains above that level in spite of the recent Greece-driven sell-off. iTraxx Europe S23, on the other hand, is now 8bp higher than before QE announcement. SX5E still remains buoyed by the QE effect, while iTraxx Europe seems to be discounting it.
Figure 3 and Figure 4 show the relationship in a different way. Figure 3 shows the beta of SX5E return to iTraxx Europe mark-to-market.

We see that the beta has steadily increased as risky asset markets have rallied over the past three years. This is to be expected. As markets rally, credit spreads get closer to their floor and so respond progressively less to bullish signals. Equities have no ceiling, and so can rise unabated. As a result, the equity-credit beta should rise over the course of a long rally. We see exactly that in Figure 3.
The beta links price changes between the two asset classes. Consequently, an increase in this beta in rising markets transforms into a convex relationship at the price level (Figure 4). The chart also shows that the iTraxx Europe S23 spread is too wide compared to SX5E, even after taking this convexity into account. In fact, the convex relationship shown in the chart implies that SX5E should be about 280pt (or ~8%) lower to price in line with its credit counterpart.
This observation is interesting but does not in itself mean that SX5E and iTraxx Europe S23 should re-price to fair levels over the next few weeks. However, it does give us confidence that SX5E will likely suffer more should markets selloff in the coming weeks – say due to unexpected events in Greece, or due to policy missteps (or miscommunication by policymakers), or if market participants begin to think that firewalls against contagion are inadequate.
Equity implied vol has already risen but not in a manner similar to what we saw in 2010-12 due to the formal mechanisms that have been constructed to minimize the danger of contagion. Given this background, investors see implied vol as already being quite high, and are considering strategies such as put spreads and ratios, and hybrid options to cheapen the cost of buying protection. Here, we utilise the richness of SX5E vs. iTraxx Europe to suggest a cheap hedging strategy." - source Deutsche Bank.
Of course, and always, regardless of the final melt up in asset prices, credit prices are indeed giving us clues for a stock market correction. And when it comes to credit and "Blue Monday", nothing last forever, particular when one takes into account the stellar performance of the asset class since 2009 and the fast rising leverage in the High Yield space, that warrants close monitoring we think which brings us to our the third point of our conversation.

  • The credit channel clock is ticking for High Yield
As we posited in our May conversation "Cushing's syndrome", "overmedication" by central bankers have created an abnormally long credit cycle:
"What credit investors forget is that in a deflationary environment, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield. But, due to the "overmedication" thanks to our central bankers "market health" practitioners, the long credit cycle has indeed been extended into "overtime".
Investment Grade credit is a more interest rate volatility sensitive asset, High Yield is a more default sensitive asset. What warrant caution for both we think are, the risk of rising interest rates for the former as per our previous bullet point and the risk of rising default rates for the latter. For more on credit returns we suggest reading our March 2013 guest post from our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"
In terms of the credit channel clock ticking, the first quarter has recently shown that, indeed, when it comes to High Yield, it has been ticking much faster as indicated by Bank of America Merrill Lynch in their High Yield Credit Chartbook from the 2nd of July 2015 entitled "Stay tuned":
"June swoon
June came and brought with it setbacks for HY from all angles- geopolitical, fundamental and technical. Situation in the Eurozone deteriorated as a Greek deal proved elusive and trouble in Munis land brewed as Puerto Rico’s debt woes came to the fore once again. At the same time fundamentals in US HY continued on their negative trajectory with three more defaults pushing the US default rate to over 2% for the first time since 2013. These adverse changes prompted retail outflows, as we had envisioned and warned against, totaling $7bn in June. In what proved to be an unsurmountable climb for the asset class, HY spreads widened 50bps, and YTW jumped to 6.6%, most of the sell-off taking place in the last three days of the month alone as the cash cushion evaporated and pressure built up in the secondary to meet redemptions.
All asset classes we track declined; equity and rate volatility surged. Global equities took the worst hit in light of the negative news out of Europe, with EM equities returning -3.2% and SPX at -2.1%. EU HY took the next worst hit at -1.9%, while US HY returned -1.5%. Best performing asset classes, though still negative, were treasuries and mortgages. Within HY, belly of the curve outperformed the ends, as was also the case in IG. We have been recommending positioning in Bs, and believe the belly will continue to outperform in the 2H15. Stay tuned.
Tuning our HY earnings
HY market leverage increased dramatically in Q1 jumping 0.6 turns to 4.8x due to plunging EBITDAs, while coverage levels dropped. The main culprit being the Energy sector where EBITDAs declined by 130% YoY on an issuer-matched basis eroding $13bn in profits and sending leverages to new highs.

However, since most of these declines were a direct result of asset impairment charges, we found it necessary to tune HY earnings and strip out non-cash charges, in order to view the true trajectory of corporate health. In this month’s report, we introduce our Adjusted Leverage and Coverage metrics which we calculate using earnings adjusted forone-time items.
We find levels of leverage and coverage based on adjusted earnings to be markedly different compared to when using GAAP earnings. While headline HY leverage jumped from 4x to 4.7x over the last 2 quarters, adjusted leverage has increased only 0.3x from 3.5x to 3.8x. Similarly adjusted coverage shows a lesser decline (4.4x to 4.1x) vs 3.8x to 3.2x when using GAAP. Not only are the levels different but the pace of change of the two metrics has also diverged significantly since 2013.
This is because companies have consistently been reporting a net negative effect from on-time adjustments every quarter, amounting to 2%-4% of their cash earnings on an LTM basis. This disparity reached its peak in Q1, when a staggering 11% ($23bn) of LTM earnings were lost to non-cash charges. However, what hasn’t changed is that leverage is ticking up and has reached the unadjusted levels at the height of the last credit cycle. Adjusted coverage, while not as impacted mainly because of a conducive rates environment, too is heading in the wrong direction." - source Bank of America Merrill Lynch
What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:
"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube
Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. On that call we agree with Bank of America Merrill Lynch from their recent High Yield Wired note from the 29th of June entitled "Nothing last forever":
"HY market seems complacent about Greece risks
We have expressed concern over the last several weeks about the risk of the situation around Greece getting worse and the HY market’s reaction to such an event. In our view, most high yield investors seem complacent about events in Europe, instead concentrating on the low-yield, low-default environment as reason enough to continue to fund the asset class. In fact, many investors we have spoken with believe that Greece defaulting would be good for US high yield, as bunds collapse and treasury yields plummet towards 2% once again. We disagree; every time risk-free yields have fallen due to a flight to safety, HY has sold off meaningfully. In our view, this time will be no different. 
Issuance likely to increase over summer, as will HY spreads
After what has been a relatively slow June, we think issuance is likely to pick up this summer thanks to previously sidelined M&A transactions and more importantly, in anticipation of the Sep rate hike. The well-telegraphed nature of this hike and the absolute low level of current yields are likely to create a rush of deal volume.
Even outside of supply technicals, we have likely come close to a floor in spreads this year. Although it wouldn’t shock us to see OAS approach 430bp again, we think the trend will be higher. Investors are demanding a higher liquidity premium than in the past and with rates and geopolitical uncertainty on the rise and a backdrop of weak fundamentals, our anticipation is that we reach 500bp spreads before 400bp. 
Flows: US HY returns to inflows
US HY retail funds returned to inflows this week as optimism over Greece took hold in the earlier part of the week. US HY funds reported an inflow of +$790mn after posting two successive weeks of $2bn+ outflows. Non-US HY investors didn’t reflect the same level of optimism and pulled -$850mn from retail funds, putting the global total near zero. ETFs led the recovery within US HY with +$1.2bn of inflows. 
Issuance: moving along
DM high yield issuance was decent this week as 10 deals for a total of $5.5bn came to market. $4.5bn came from the US and $1.0bn came from Europe. Month-to-date, we have seen a total of $25.8bn come to market in June, while year-to-date we now stand at $215.6bn, about $10bn ahead of last year’s pace. Global loan issuance slowed down as $4.2bn was priced vs a strong $7.4 last week. Month-to-date, stand at $29.7bn while year-to-date we have seen a total of $141.5bn. Last year at this
time, we had already seen $233.2bn of new supply." - source Bank of America Merrill Lynch 
You can indeed expect additional "Blue Mondays" in the credit space, given we have been indeed moving into overtime in the credit cycle thanks to central banks' overmedication.

Also, as we mentioned earlier on in our conversation, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger.

In their High Yield note Bank of America Merrill Lynch confirms this risk to the downside for High Yield prices:
"Asymmetric credit returnsChart 4 shows that the relationship between spread levels and subsequent returns is negatively sloping. 

This isn’t all that surprising for seasoned credit investors. Over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months. More importantly, the average spread widening in those scenarios was about 11% (~48bp at current spread), while the average tightening was in the 7% (~29bp) range in the 44% of the time that the market rallied. So that’s not only a slightly higher likelihood of widening than tightening, but the scale of the sell-off is also likelier to be larger than the scale of any rally. " - source Bank of America Merrill Lynch
With positive correlations on the rise and convexity effects, we indeed do expect significant price movements over the coming months given the spillover from bonds volatility in the credit space. As we posited in our May conversation "Cushing's syndrome" expect as well lower liquidity particularly during the supposedly "summer lull":
"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.
This brings us to our fourth point in our credit note, namely that with the ongoing volatility in the bond space, VaR has finally taken its toll leading to significant outflows in government bond funds or when "balanced funds" are finally getting "unbalanced"

  • Balanced funds getting "unbalanced"
As we indicated in our May conversation "Cushing's syndrome":
"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking"." - source Macronomics, May 2015
Indeed, this rise in bond volatility has led to significant outflows in government bond funds as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 3rd of July 2015 entitled "Not so safe assets":
" $3bn of government bond outflows
High grade credit flows moved back to positive during the last week, although only marginally ($65mn inflow). High yield on the other hand continued with the outflow trend at -$716mn, the fourth week of outflows in a row.
But the largest withdrawal was from government bond funds, where outflows were the highest ever last week at -$2.85bn.
The shock from the Greek referendum announcement pushed sovereign yields higher, adding more pressure to an already tense outlook. During the last five weeks, outflows from government bond funds have totalled $8.5bn. Money market funds also felt the heat of the Greek story: last week’s outflows were -$20bn, the highest this year.
The only significant inflow was recorded in equities, where inflows were $1.5bn, mainly from ETF funds. This brings the year-to-date inflow to $67bn, which is already the highest yearly inflow into European equity funds on record. " - source Bank of America Merrill Lynch
 This is indeed a materialization of the risk we discussed back in May when it comes to "Balanced funds":
"In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - source Macronomics, May 2015
We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:
"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle.The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets
Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are indeed facing an uphill struggle in maintaining their stellar records in this environment. And if indeed, cash is currently king, particularly in US dollar terms in the ongoing "Blue Monday" markets, you will indeed have interest in our final note for this week's conversation.

  • Final note: Cash holdings as a % of AUM is at the lowest since 2008

We read with great interest Citi's recent Globaliser Chartpack from the 29th of October. In terms of complacency, we find of great interest that the cash level in % of AUM dropped to 4.3%, which is indeed the lowest point since 2008, indicating that when it comes to equities, investors are indeed piling much more in equities, giving more ammunition to the "Great Rotation" crowd:
"Citi’s June poll: what do US investors think?
Our June poll results suggest the investment community seems fairly upbeat, with the current weighted average year-end S&P 500 objective of 2,177; 2015 earnings are expected to climb 4.5% on the Buy Side
‘The results of a late June poll suggest that investment community seems fairly upbeat’, declares US Strategist Tobias Levkovich, ‘and while investors have not shifted their expected year-end target for the S&P 500 much in the past two surveys, with a current weighted average objective of 2,177, more now anticipate a higher chance of a 20% rally vs a 20% pullback. The more striking result was the decline in cash holdings as a % of AUM. On average, the cash proportion dropped to 4.3%, the lowest figure we’ve seen since we began asking this specific question in 2008, indicating that money has been put to work, with 80% saying that they would allocate more funds to equities. Europe and Japan still lead the US as most favored equity markets for outperformance in 2015. Earnings are expected to climb 4.5% on the Buy Side for 2015, a tad below Citi’s 5.6% forecast, but still above the bottom-up and top-down Street consensus. Investors expect a Fed rate hike in 3Q15, underscoring a growing consensus around a September move’." - source CITI
Are investors suffering yet again from "Optimism bias"? We wonder...

"Hindsight bias makes surprises vanish." - Daniel Kahneman, psychologist

Stay tuned! 

Wednesday, 17 June 2015

Credit - The Third Punic War

"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus, Greek historian
While coming close to "Grexithaustion" thanks to the never ending Greek tragedy, which seems to be a manifestation of Henri Poincaré's "recurrence theorem" we discussed in our last conversation "Eternal Return", we decided to use this week a reference to Rome's Third Punic War as this week's title analogy. In similar fashion to Carthage, Greece has been asked increasing unrealistic demands from their "debt masters" leading at the time to Carthaginians defecting the negotiations in true John Forbes Nash fashion, which led to the Third Punic War and the eventual destruction of Carthage:
"In 149 BC, Rome declared war against Carthage. The Carthaginians made a series of attempts to appease Rome, and received a promise that if three hundred children of well-born Carthaginians were sent as hostages to Rome the Carthaginians would keep the rights to their land and self-government. Even after this was done the allied Punic city of Utica defected to Rome, and a Roman army of 80,000 men gathered there. The consuls then demanded that Carthage hand over all weapons and armour. After those had been handed over, Rome additionally demanded that the Carthaginians move at least sixteen kilometers inland, while the city itself was to be burned. When the Carthaginians learned of this they abandoned negotiations and the city was immediately besieged, beginning the Third Punic War." - source Wikipedia
Being history buffs ourselves we find it amusing from a "light" historical comparison, that while Greece is being increasingly punished, by the defacto leaders of Europe namely Germany, its closest neighbor France is already slipping the structural reforms trail, passing "cosmetic" laws such as the Macron law in order to avoid the wrath of the European Commission and powerful neighbors using in the process article 49.3 to bypass parliamentary vote. 
In similar fashion, while Rome was letting Numibia continue abusing its Carthaginians neighbors, it was busy imposing more and more harsher treatments on its rival Carthage.

As we stated on numerous occasions, France is the new barometer of risk, as it seems the country seems impossible to reform. As stated in our March "China syndrome" conversation:
"Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term."
Whereas "The Third Punic War", this time being is being waged on Greece, while captivating numerous pundits, for us it is a side show as many more risks are indeed brewing, when it comes to "instability" given once more, the Fed has failed to act early. and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 

  • Wave number 1 - Financial crisis 
  • Wave number 2 - Sovereign crisis 
  • Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
If The Fed normalizes, get ready for a big US dollar Margin call, carry traders and leverage players beware...We touched on the issue of the rise of the US dollar in our September conversation "The Tourist Trap" where we argued:
"All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates." - Macronomics, September 2013
Therefore in this week's conversation, rather than focusing on the Greek tragedy, we would rather focus our attention to some macro and micro aspects that warrants, we think a closer attention.

  • Bear markets for US equities generally coincide with a tick up in core inflation
  • France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
  • Beware of the Repo drought
  • US Interest Rates and the US Corporate pensions gap
  • Final chart: In High Grade Credit, liquidity is coming fast at a premium

What we find of interest is that "Bear markets for US equities have usually coincided with high global core inflation". The recent acceleration in wage upside pressure as well as in rent pressure could indeed surprise to the upside, particularly due to the rebound in oil prices since March (+40%). This should translate into the headline CPI where rental prices represent 25% in the calculations and overall housing 42%:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008" - Macronomics, 5th of June 2014
- source

Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with higher core inflation makes us more and more cautious on the sustainability of the US equities rally. So we will eagerly watch that space in the coming weeks and months.

  • France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
In our conversation "The European crisis: The Greatest Show on Earth", we indicated:
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers.
In our end of May conversation "Optimal Bluffing", we advised our readers to start following these debilitating micro trends to assess the health of the French corporate sector. 

The latest survey published on the 12th of June points to a continued deterioration in the Terms of Payments, which indicates that the improving trend since mid-2012 has turned decisively negative:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their June survey have reported an increase by corporate treasurers. Overall +18% of corporate treasurers reported an increase compared to the previous month (+19.8% revised), bringing it back to the level reached at the end of 2013. The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 is now turning and more negative overall according to the survey:
The monthly question asked to French Corporate Treasurers is as follows:
"Is your overall cash position compared to last month falling, remains stable or rising?"
Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's came at -13%, April at -0.5% and May was revised from -9.5% to -6.1% with June coming at -3.7%

We will restate what we mentioned back in our March 2015 conversation "Zugzwang":
"The French government policy is based on "hope" and their strategy is based on "wishful thinking". No matter what, we do not see unemployment falling with these deteriorating conditions."
Like any behavioral therapist would do we focus on the process, rather than the content. Hence our dubious faith in the much vaunted "cosmetic" structural reform coming from the Macron law, given that now French President Hollande is effectively on the campaign trail.

As we indicated in our conversation as well is that there was a large contingent of public servants supporting François Hollande representing 22% of the working population compared to 11% in Germany. To validate our prognosis, we find it amusing that Public Service Minister Marylise Lebranchu has announced on the 16th of June 2015 that public servants would see their salary increases as of 2017 without any mention of course of the budgetary impact it would have! Also, she mentioned that while salaries have been currently frozen thanks the stability of the index used for deciding on salary increases which depends on the economic situation, it is a possibility that in spring 2016, there could be an increase prior to the 2017 presidential elections....
The impact of a 1% increase would cost an additional €1.8 billion euros according to the Court of Auditors.
"The Court of Auditors (in French Cour des comptes) is a quasi-judicial body of the French government charged with conducting financial and legislative audits of most public institutions and some private institutions, including the central Government, national public corporations, social security agencies (since 1950), and public services (since 1976).)" - source Wikipedia
Meanwhile the French Government has announced that in order to reduce French unemployment, it would create another additional 100,000 "subsidized" jobs. Most of these jobs are for low qualified persons at a cost of €3 billion for the 346,083 benefiting from it according to the 2015 budget equating to 27% of the budget of the Minister of Labor. These additional 100,000 will cost €300 million to the budget in 2015 and €700 million in 2017 according to the Minister of Labor. It would have been much better to use these spendings in training such as what Germany does with its very successful "apprenticeship" programs which explain Germany's very low unemployment youth. So you have 100,000 low skilled public jobs created out of 5.99 million of unemployed people in France as per April 2015 data. According to DARES, which is the department in charge of analyzing the labor market in terms of statistics at the Minister of Labor, only one third of these "subsidized" job lead to full employment 6 months later. 

Whereas the Third Punic War is coming to a close, we still believe that France warrants close monitoring given its impossibility to reform. Whereas Rome was having none of it with Carthage like Germany with Greece, the current indulgence displayed with French's lack of progress is reminiscent of Rome's attitude towards Numibia we think.

Moving on to our next point, which deals once more with credit in general and repo in particular, we think it is an important point to follow when it comes to assessing the dwindling "liquidity" picture.

  • Beware of the Repo drought
When it comes to the Third Punic War and Rome's insatiable demands, the reduction in liquidity is a direct consequences of the overwhelming regulatory burden set on banks which, in retrospect is having once again "unintended" consequences particularly in the Repo market in Europe.

As a reminder:
Basel III proposals - BIS ratios to manage liquidity risk:
The Liquidity Coverage Ratio (LCR).
The LCR requires that a bank has sufficient liquidity to survive for 30 days under a stressed scenario when global financial markets are assumed to be in crisis, all wholesale funding has dried up, unsecured lines of credit provided by other financial institutions are withdrawn and banks experience partial deposit flight. To mitigate this risk, the LCR requires that banks hold a liquidity buffer of high quality, liquid, central bank repo eligible, unencumbered assets, which are at least equal to the amount of net cash outflows a bank may face over a 30-day period.

The on-going deleveraging in the European Banking space is leading to a reduction in the financial "grease" of financial markets, namely repo markets. On that subject we have read with interest Citi's not from the 8th of June entitled "Declining Financial "Grease" Hits Market Liquidity from their European Banks Insights:
"Repo Under Pressure — Repo markets are often considered the “oil that greases the financial markets”. The leverage ratio has become the binding constraint for many wholesale banks, which have pulled back from balance-sheet-intensive, low-return repo. We estimate gross repo at global wholesale and custody banks has declined by c11% over 2012-14, with European banks bearing the brunt (down 16%, Figure 1).

This broadly matches the c13% decline in total repo (Figure 3).
Velocity But No Depth — Although market ‘velocity’ (traded volume) has increased, market ‘depth’ has declined. For example, the market depth of 10yr UST is US$125m vs peak levels of US$500m in 2007, while the US Treasury market is nearly three-fold over the same period:

Increasing frequency of “flash crashes” and “air pockets” may be here to stay (see The liquidity paradox). Whilst the strongest declines in repo books have come from DBK, UBS and RBS, the likes of the major French banks, HSBC and Barclays look less efficient even if the latter has made significant progress over the past 3 years.
  • Global wholesale and custody banks have reduced their gross repo books by c11% between end-2012 and end-2014. European banks’ repo outstandings fell by 16% vs US banks’ by 6%, mirroring the shift in FICC market share in favour of US banks.
  • In USD-terms, DB has downsized most aggressively (c40% in USD or c34% EUR) and is looking to further optimise its Prime Finance business, per its recently announced Strategy 2020.
  • The French banks are the notable exceptions amongst European banks. BNPP and SOGN in particular have grown their repo books by 41% and 13%, respectively, which has not necessarily translated to higher sales & trading revenue market share over the same period
The decline in US repo may also be driven by greater rationalisation by European banks, partly in response to stringent upcoming US FBO requirements. Repo or ’financial grease’ is likely to fall further & correspondingly, risks are likely to increase, in our view." - source Citi
This is not a surprise to see a continued deleveraging of European banks through the Repo markets. We have touched on the difference between the deleveraging between US banks and European banks extensively about the profitability in our conversation "The Pigou effect" as well as in our conversation "The Secondguesser":
"When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:
This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.
We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value." - source Macronomics, April 2015
"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."
Given the amount of deleveraging that still needs to occur in the European banking space, this divergence between the profitability of US banks versus European banks will continue to grow and it will be reflected into the Repo markets rest assured.

As indicated previously, in the US QE was more effective for a simple reason: stocks vs flows:
The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks.

On numerous occasions the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.
Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The problems facing Europe and Japan are driven by a demographic not financial cycle. European banks will continue to destroy value given the amount of deleveraging that still needs to take place and do not appear to us, at least in the equities space as an enticing investment proposal when it comes to long term returns and stability.

As further reasoning behind our assertion and as highlighted in Citi's report, Banks' market revenues are well correlated to "Repo":
Banks’ trading market share appears to be reasonably well correlated with repo, as highlighted in the above charts.
European banks have already lost market share in Sales & Trading, particularly in FICC but also in Equities. Although we do not discount the effects of re-pricing and optimisation, as banks continue to increase balance sheet efficiency, further reductions in repo (as well as in other products) may drive further consolidation." - Source Citi
Lower repo, lower Net Interest Margins, lower profitability and Return On Equity (ROE). That simple.

On top of that we read that Fitch Ratings has released a report, “Corporate Bonds and Fire Sale Risk: Repo Collateral Pools Highlight Liquidity Issues ” that examines the composition of corporate bonds that are pledged as collateral in the tri-party repo market and the potential for forced sales of securities during periods of market stress and here is a summary of the findings:
"•A significant maturity mismatch exists between the short-term repos, over 70% of which mature in 5 days or less, and the long-term corporate bonds being financed. This could create risks as a withdrawal of repo funding can lead to the forced selling of collateral.

Dealers post a significant amount of bank and other financial institution notes and bonds as collateral, exposing them to wrong way risk. About 29% of the corporate collateral that Fitch studied was from banks and other financial institutions.

•Liquidity is low in some of the bonds posted as collateral, as determined by trading frequency. Almost 30% of the bonds in the Fitch study traded on less than half of trading days in 2014." - source Fitch
It will interesting to see how the LCR included in the BASEL III proposals is going to "operate" given the dwindling Repo markets and the consequences on more friction and less grease in the financial markets during the next financial crisis. 

Given the balance sheet intensive nature of fixed income trading and the elimination of the favorable risk-based capital treatment of repo and banks' holdings of Treasuries and agencies under the risk-based capital rules in the US, we do not think the United States will be spared, though less exposed than Europe.

The bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity, hence increased volatility.

A smoothly functioning repo market is vital to the health of markets. Remember financial crisis are always triggered by liquidity crisis.

  • US Interest Rates and the US Corporate pensions gap
Or why the Fed has painted itself into a corner...and has to raise interest rates.

In our November 2014 conversation "The Golden Mean" we argued the following:
"What our "wealth effect" planners at the Fed should take into account is that rising stock prices may do relatively little to bolster the finances of corporate pension funds. Bonds matter because increases in projected distributions put even more pressure on yield hunting leading to an increase in duration risk exposure and high yield exposure. Volatility in funds’ asset value and relatively low interest rates have made managing pensions increasingly difficult for corporate managers, one of the solution they have found is shifting into bonds and away from stocks. Of course if the "magicians" at the Fed had respected the "Golden Mean" and prevented past and present excesses, funding gaps and overall pension pressures would have been avoided in the first place, but we are ranting again..." - source Macronomics
As a reminder from our conversation "Goodhart's law" in June 2013:
As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:
"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.
We remember as well the observations from our good credit friend in 2013 from our conversation "Simpson's paradox" in July 2013 following the "Taper Tantrum as the Fed tries to re-establish somewhat the "Golden Mean":
"Economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on."
Hence the importance of maintaining "grease" or repo in the financial system!

In our conversation "Supervaluationism" we indicated a CITI report showing that outflows from Equities to Fixed Income have been lessened by the proposed update in mortality tables:
"What could curtail outflows from pension funds from Equities to Fixed Income could come from Updated Mortality Tables according to another CITI report from the 10th of April:
"The Society of Actuaries released drafts of proposed new mortality tables (RP- 2014) and mortality improvement scales (MP-2014) that provide the basis for determining pension liabilities. These are significant updates.-The new tables and schedules increase life expectancy at age 65 by 2.0 years for males (from 84.6 years to 86.6 years) and by 2.4 years for females (from 86.4 years to 88.8 years).-The previous set of mortality tables was published in 2000 (RP-2000), and the most widely used mortality improvement scale (Scale AA) dates back to 1995.We have estimates that longer life expectancies resulting from the updated mortality tables will increase the value of pension liabilities by 3% to 10% depending on the nature of the plan and prior assumptions.-If we take Aon Hewitt's estimate of a 7% increase in plan liabilities, that would reduce funded status by approximately 6%, or about half of the improvement experienced in 2013.-Plan durations should extend, but we do not have good estimates of how much.With lower funded statuses using the updated tables, it is likely that de-risking flows from equities to fixed income will be lower than they otherwise would have been under the previous mortality regime." - source CITI" - Macronomics, February 2015
The Society of Actuaries updated the mortality tables end of October 2014. These tables are used by pension plans to project the life expectancy of plan participants and beneficiaries to reflect that people are living longer. For example, average life expectancy for a 45-year-old has increased from 83 to 87. When fully implemented over the next few years, the new tables are expected to increase pension plan liabilities by an average of 6-9%. The issue of course is that these pension plans remain underfunded.

On this specific matter we read with interest CITI Equity Strategy note from the 11th of June entitled "Pension Comprehension in 2014":
  • "Despite the S&P 500’s 11.4% gain in 2014, low interest rates and higher longevity tables pressured corporate pension and Other Post-Employment Benefits (OPEB) funding status in 2014. Notwithstanding the S&P 500 tripling off of its 2009 lows, corporate pension funds remain underfunded with a $389 billion underfunded status in 2014, still fairly close to 2012’s peak of $452 billion. Surprisingly, pension funding dropped to 81% of obligations at the end of 2014, down from 88% in 2013, but it was up from 77% in 2012.
  • Funding status comparisons are not apples-to-apples in 2014. The Society of Actuaries’ update to private pension plan mortality tables (Retirement Plan-2014 “RP-2014”) led to a one-time significant increase in pension liabilities. While adoption of RP-2014 is at the discretion of the plan sponsor, US GAAP requires a “best estimate” for assumptions and the current tables were well accepted. Accordingly, this “one-time” hit to funded status aligned liabilities with the actuarial organization’s best estimates.
  • Robust free cash flow, earnings and cash holdings alleviate some of the unease surrounding pension funding. Investors have been concerned about pension funding levels since 2007-08, but corporate cash flows provide comfort as companies have the ability to make large contributions to pension funds.
  • After edging higher in 2013, the discount rate fell back to 3.92% in 2014, causing pension obligations to swell. The present value of corporate pension obligations is heavily influenced by interest rates and thus lower yields typically cause deterioration in funding status. While forecasts for higher yields in the future should lead to decreased concerns over the underfunded status of US pensions, OPEB accounts remain significantly underfunded as corporations attempt to shift these costs on to individuals. The value of OPEB underfunding at the end of 2014 grew to $196 billion vs. $181 billion in 2013.
  • All ten S&P 500 sectors remain underfunded, with Energy continuing to be the least funded sector. Health Care and Industrials saw the largest drop in funding status amongst the sectors. As the overall S&P 500 pension funding status has declined, it is worth noting that only 21 companies within the S&P 500 were fully funded at year-end 2014, with nearly half of the overfunded companies coming from the Financials sector. Notably, the number of fully funded companies was down sharply from 51 companies in 2013.
  • S&P 500 pension plans’ allocation to equities slid down to 44.5% in 2014 from 46.9% in 2013. The equity allocation increased most within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a sharp pullback along with Industrials and Energy.
The drop to 81% of obligations at the end of 2014, could be link, we think to the amendments in Mortality Tables which is in fact increasing liabilities of the pensions over the long term by an average 6 to 9% as stated above.
"Pension under-funding continues to be a major issue for S&P 500 constituents even after some of the intense investor scrutiny back in 2008 and 2009 softened to some extent in 2011 as markets improved. Nonetheless, very respectable equity market gains over the last six years have not substantially alleviated pension pressures.
The S&P 500 was up more than 201% at the end of 2014 since the low in 2009 but the aggregate underfunded status of $389 billion in December 2014 is now 26% higher than the $308 billion under-funding peak seen in December 2008 (see Figure 1).

While the funding status in 2013 improved by more than $225 billion versus 2012 alongside strengthening equity market performance and a higher discount rate, this trend reversed in 2014. Specifically, revised longevity tables and lower interest rates contributed to the reduction in 2014’s pension funding status." - source CITI
So we are wondering where is indeed that famous "wealth effect" thanks to QE and ZIRP for US future retirees. Definitely not in US pension plans.

The reason? The lack of conviction from Pension funds in believing in the much vaunted "Great rotation" story as discussed by CITI in their report:
"Pension funds have been unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years clobbered pension programs leaving allocators and consultants relatively risk averse with liability driven investing taking over the mindset. Moreover, current ERISA requirements call for companies to keep enough short-term cash and equivalents available to pay out current pension liabilities. Fortunately, corporate cash flow, free-cash flow, earnings and cash holdings are at or near record highs making required cash contributions to pension funds a much more manageable expense for S&P 500 constituents. Note that the funding status at 81.2% declined from the 87.9% level seen in 2013, which was the best reading in six years, but remained markedly better than 2012’s 77.3%, which was the weakest point since 1991." source CITI
Cash is king it seems...

But moving back to the Fed's "pensions plan" conundrum lies in the nefarious effects of ZIRP as clearly indicated by CITI's report:
"Meanwhile, persistently low interest rates on long-term bonds translate into lower discount rates for determining pension obligations, making the actuarial assumptions for the present value of these obligations appear larger than if discount rates were more in-line with the long-term average." - source CITI
Exactly, with updated mortality tables and continued ZIRP, US corporate pension plans are struggling in achieving their targeted rates.

They also added:
"S&P 500 constituents’ pension plan allocations to equities edged down to 44.5% in 2014 from 46.9% in 2013, yet remain better than 2008’s 43.7% (see Figure 8) and far below 2007 levels of 61.3%. 
However, much of the gains from 2008 would have been attributable to the increased value of equity assets within corporate pension portfolios relative to overall holdings rather than new equity-oriented allocations. Interestingly, flows returned to bond mutual funds, as released by ICI, which saw more than $43 billion flow into bond funds last year (and inflows of roughly $40 billion so far this year), US pension funds followed suit with fixed income allocation increasing by more than 3% (see Figure 9).
Moreover, defined benefit plan managers were net buyers of bonds in the last three quarters in 2014 but they have not started to buy equities just yet (see Figure 10). 

The shift to equities increased most notably within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a steep decline in allocation along with Industrials and Energy over the past year. Fascinatingly, the funded status deteriorated for every sector in 2014, with Health Care and Industrials highlighting the weakest sectors but once again, the actuarial adjustments may be playing a role here as well. The 2014 data compares unfavorably to 2013 data, where the funded status for all ten sectors improved. However, the key difference may have been the effect of the near 30% return for the S&P 500 in 2013 versus the more modest 11.4% gain experienced last year.
As Figure 11 shows, the greatest under-funding can be found in the Energy sector followed by Telecom Services and Materials as well as old-line Industrial/manufacturing equities that have accrued large pension obligations due to long-term operations. However, in order to fund pension obligations, these companies must begin to get pension expenses under control lest their products lose competitiveness versus international peers due to higher prices.
The expected pension return rate for S&P 500 constituents continued to decrease in 2014 (see Figure 12), sustaining the trend which has been in place since 2001.
We are not that surprised by the continued decrease in pension return rate expectations in 2014 given low yields from “safe” Treasury instruments which are looking riskier now." - source CITI
The law of diminishing returns it seems...Note as well the impact the Great Financial Crisis (GFC) has had on the funding status for Telecom Services. One word: brutal.

Of course our "wealth effect planners" at the Fed are indeed in a bind given the asset side of the pension story as clearly illustrated by CITI in their most interesting report:
"Bear in mind that the stock market is crucial to the asset side of the pension story (see Figure 18).

Since we envision only modest mid-single digit gains from current levels through mid-2015, it will not close the gap entirely. The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the timeline of fully funded status. With roughly $755.1 billion of pension assets in stocks currently (assuming the year-end 2014 figure appreciated by roughly 1% thus far in 2015 using the S&P 500 Index as a benchmark), there would need to be a more than 50% upward move in equity markets to close the $390 billion funding gap without an increase in discount rates to decrease the pension obligation. Thus, it will be more of a gradual move even as significant progress has been made in spite of investor anxiety over the pension issue from time to time." - source CITI
So go ahead dear Fed, damn if you do raise interest rates, damn if you don't. When it comes to US pension plans and their large exposure to credit and given the lack of liquidity and the dwindling repo market, it seems there are indeed larger issue at stake, no offense to our Greek readers, than the closure of the Third Punic War in Europe it seems.

  • Final chart: In High Grade, liquidity is coming fast at a premium
With Repo levels falling and liquidity concerns in conjunction with oversupply in the primary markets, US Investment Grade Credit as we posited in our last conversation "Eternal return" is fast becoming a "crowded" trade we think and we are not the only one given's Bank of America Merrill Lynch's take from their Situation Room note from the 15th of June entitled "Bonds 0 - CDS 1":
"Liquidity at a premium
With Fed liftoff fast approaching and increasing long term interest rates, liquidity conditions in the high grade corporate market are worsening. Our view remains that the unintended consequence of the intended consequence of financial regulation (the decline in dealer balance sheets, Figure 10) is that liquidity conditions in the market deteriorate. 
However, so far this effect has been masked by inflows – hence the change as this year the credit market makes the transition from inflows to outflows. We are about to feel the true extent of the unintended consequence of financial regulation – namely the collapse in liquidity." - source Bank of America Merrill Lynch
In this context, and as per our last conversation "Eternal return", we expect volatility in the Fixed Income space to continue to rise. In our May conversation "Cushing's syndrome" we asked ourselves:
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured.
 In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - Macronomics, May 2015
In these jittery markets, no wonder giant fund manager BlackRock has therefore been forced to "recalibrate" its VaR models as described in Bloomberg by Eshe Nelson in her article from the 15th of June entitled "Bond Swings so Extreme Even BlackRock rewrites Risk Measures":
"BlackRock is testing how risky its holdings are by running them through new worst-case scenarios that assume more volatility and varying correlation among asset classes. And strategists at JPMorgan Chase & Co., the world’s biggest debt underwriter, now see the need to calculate a “liquidity premium” for top-rated, longer-maturity government bonds in Europe, a new wrinkle for benchmark securities that are considered the safest assets available because of their deep markets.
The selloff is “questioning what is the right price given the current illiquidity in these asset classes,” said Nandini Srivastava, a global market strategist at JPMorgan in London. The difficulty in assessing the amount of risk “exacerbates the problem as you have investors on the sidelines thinking ‘Are these really the right prices and yield levels?’”
Volatility Surge
Yield volatility on 10-year bunds has climbed to nine-times its average during the past 15 years, giving traders a taste of the turbulence European Central Bank President Mario Draghi said June 3 they should get used to as the byproduct of record monetary stimulus.
A measure of 30-day volatility on bunds surged to 300 percent in May. It hadn’t gone above 100 before this year, in data compiled by Bloomberg going back to the middle of 2005. The market’s gyrations are being magnified by record-low yields: In the week of Draghi’s remarks, yields soared 0.36 percentage point, the biggest jump since 1998. The yield was at 0.82 percent on Monday at 1:30 p.m. in New York, up from a record of 0.049 percent on April 17.
“Investors should be pricing in more risk,” said Grant Peterkin, a money manager at Lombard Odier Investment Managers, which oversees 161 billion Swiss francs ($172 billion). “Given bonds steadily rallied for a long period of time, the low volatility suggested they were low risk, which potentially forced investors to buy more of them.”The danger is that this kind of instability may seep into other assets, he said. This could pressure companies as well as governments with rising borrowing costs. Yields on junk bonds around the world have collapsed to about 6.6 percent, versus their average of 9.7 percent since the end of 1997, according to Bank of America Merrill Lynch index data.
Risk Measure
Citigroup strategists are recommending investors measure their vulnerability by placing more emphasis on duration -- a gauge of a bond’s sensitivity to interest-rate changes -- and the amount a country has borrowed, in addition to volatility, according to Alessandro Tentori, head of international rates strategy.
BlackRock is testing how its holdings would perform in scenarios like the dislocation in peripheral debt in 2011 and 2013’s taper tantrum. It’s also looking at how they’d react to sharp moves in the Standard & Poor’s 500 Index.
“It’s challenging, particularly when the correlations change, that’s the most difficult thing,” Thiel said." - Source Bloomberg
Credit bubbles generated by ZIRP will not preserve equity, nor US pension plans rest assured as per the conclusion of  our November 2014 "The Golden Mean" conversation and Poincaré's recurrence theorem...

"The only good is knowledge, and the only evil is ignorance." - Herodotus, Greek historian