Thursday, 30 May 2013

Chart of the Day - Emerging Markets now contribute 33% of European companies' revenues

"When you cease to make a contribution, you begin to die."- Eleanor Roosevelt 

The rising importance of Emerging Markets in European companies' revenue is now doubt an important factor to take into account in this ever growing globalised and correlated world we think.

The chart below comes from Morgan Stanley's recent "Global Exposure Guide 2013" published on the 28th of May:
"European companies continue to diversify their revenue exposure away from Developed Europe.
As shown in Exhibit 2, the proportion of European revenues generated within developed Europe has been falling relatively consistently since we published our first Global Exposure Guide in 1997, when developed Europe accounted for 71% of all European revenues. Our analysis shows that this figure will have fallen to just 46% in 2013." 
Emerging Markets account for 33% of total revenues.
Reflecting both the relative growth rates in the respective regions and corporate expansion within the region, the revenue exposure in EM is now over two-thirds the level of developed Europe. As shown in Exhibit 1, we expect revenues from emerging markets now to make up 33% of European companies’ revenues. Exhibit 3 plots the rapid progression of EM since 1997 from just 12% of European revenues – an increase of 2.8 times in 16 years.
US revenue exposure is expected to rise to nearly 16% in 2013 
We expect the share of European companies’ revenues derived from North America (US+Canada) to return to2005 levels of 18%, as shown in Exhibit 3. 
US exposure will have risen to nearly 16% this year, our analysis suggests, the highest since our data start in 2007. However, Emerging Markets still account for over double the share of revenues from the US." - source Morgan Stanley

Welcome to a higher correlated world!

"I am disillusioned enough to know that no man's opinion on any subject is worth a damn unless backed up with enough genuine information to make him really know what he's talking about." 
- H. P. Lovecraft 

Stay tuned!

Wednesday, 29 May 2013

Bonds - When volatility is waking up

"Those who have compared our life to a dream were right... we were sleeping wake, and waking sleep." - Michel de Montaigne 

Given the on-going speculations around "QE tapering" and looking at the recent US data, markets participants have had much lower inflation expectations in the world, leading to a clear divergence between the S&P 500 and the US 10 year breakeven, as pointed out recently by our friend Cullen Roche from, graph source Bloomberg:

With such a divergence, US bonds could remain relatively nervous - top chart US 10 year yield, bottom chart MOVE index (MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.):

 This rise in bonds volatility could trigger more volatility on other asset classes.

As we argued last week-end, the recent move in the MOVE and CVIX indices warrant caution - source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

We also pointed out in our recent conversation that the huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space.

As far as Japan, is concerned, we concluded our conversation "Japanese Whispers" with the following:
"Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials."

Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Itraxx Japan 5 year CDS since January 2010 until today - source Bloomberg:
As per 2011, the spike in volatility in Japan has been preceding the widening move in CDS spreads for the Itraxx Japan.

"In waking a tiger, use a long stick." - Mao Zedong

Stay tuned!

Sunday, 26 May 2013

Credit - The Week That Changed The CDS World

"One must change one's tactics every ten years if one wishes to maintain one's superiority." - Napoleon Bonaparte 

Looking at the epic compression in recent weeks of the Itraxx CDS financial subordinated index versus the Itraxx Senior Financial CDS 5 year index, tied up to the recent ISDA proposals to include Bail-In Credit Event, we decided our reference this week ought to be a shorthand for describing surprising and uncharacteristic actions in similar fashion to Kissinger's 1971 secret trip to China. This secret trip laid the groundwork for the historic visit of Nixon to China that followed in 1972. 

Given the upcoming clean up of ISDA's 2003 Credit Derivatives Credit Event definitions which were in dire need of a brush up following the recent Dutch banks SNS subordinated debt saga, as per our Napoleon Bonaparte quote goes, arguably, one indeed must change tactics every ten years if ones wishes to maintains one's superiority. It could not be more truer than for the viability of the CDS market. What happened this week in the CDS world, with the proposed introduction of a new credit event for financial CDS in the case of a bail-in triggered by a government agency and the change in deliverability rules, made this week an important one from a credit perspective.

We already discussed the implications of the SNS case in our previous conversation "House of pain and House of cards":
"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."

So in this week's conversation we will look at the wider implications for the financial CDS market on the proposed ISDA Credit Events revamp on the 10 year anniversary of the ISDA 2003 Credit event definitions because the validity of the CDS market as a hedge had been put in jeopardy quite significantly by the SNS case. We will also look at debt disturbances and price-level disturbances, revisiting the wisdom of Irving Fisher in the process.

The CDS compression story in one chart - Itraxx Financial Senior index versus Itraxx Financial Subordinated 5 year index - source Bloomberg:
From the above chart one can see the severity and rapidity of the move in the subordinated financial CDS space.  

So is the move justified?

Here is BNP Paribas take on the move from their 23rd of May entitled  "ISDA Proposes Bail-in Credit Event:
"Is the Sub CDS move since last Friday justified?
Sub CDS has collapsed by more than 40bp since 16 May and the Sub/Sen ratio is now just below 1.4x, after having been at a mean of around 1.7x for a long time. The timing surprised us, as the new definitions are not finalised nor implemented yet. In addition, the market could have already reacted more than it did after the SNS news. Therefore, while we were proponents of the general Sub/Sen compression theme, we were surprised both in terms of timing and severity of the market move.
How do we explain the move then? The rapid compression of Sub vs. Sen over just a few trading sessions was probably due to the realisation that existing financial CDS contracts will over time be replaced by the new ones, making the old contracts less valuable from a long protection perspective. Thin market conditions due to European holidays may have exacerbated the move.
Other possible explanations of the significant move are the general bull market and search for yield, the gradual acceptance and pricing in of senior bail-in and the possibility of depositor preference over senior. Finally, investors may expect that, with the arrival of a new CDS contract, authorities would be less careful about legacy CDS (i.e. about making sure that there are deliverables, as the Irish authorities had ensured). That said, the change of definitions had been mentioned for a while and the implications clear, i.e. the new contracts should trade at a wider level. The old contracts can still be useful, especially as we believe that bail-in will trigger a restructuring event (as was the case with SNS), but the existence of sub deliverables is uncertain and therefore they are less valuable to a protection buyer than the new one. This information was previously available but the market reacted last Friday.
Can the magnitude of the move be justified by relative recovery expectations between senior and sub contracts? Chart 1 shows the implied Sub/Sen ratio (for the existing contracts) as a function of the senior expected recovery rate for different sub recovery rate assumptions. In most cases the sub recovery rate has been in the 0-20% range. At current market pricing, this corresponds to a senior recovery rate of 30-40%. This does not strike us as too low, especially when we consider that (i) the Moody’s average historical senior corporate recovery rate is around 38%; (ii) further developments towards resolution regimes and senior bail-in should increase the senior credit event probability relative to the sub probability; (iii) depositor preference, if forthcoming, would reduce the senior expected recovery rate; and (iv) the recent SNS event highlights a growing likelihood of events with a significantly higher sub recovery rate (for the existing contracts) than 0-20%." - source BNP Paribas.

We disagree with BNP Paribas on the implied recovery rate of 30-40%. It is not too low, it is not low enough at least on the "old contracts" because it relies on Moody's average historical senior recovery so this analysis is backward looking. The senior expected recovery rate due to the evolution of resolution regimes and senior bail-in implies lower recovery rates and wider spread levels in the new contract.

Why the new contracts should trade at a wider level you might rightly ask? 

We have touched on that subject previously in February 2013 in our conversation "Promissory Hope":
From EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":
"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 
bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

As we repeatedly pointed out, the importance of liquidity is paramount, particularly in the credit space, given the low level of inventories on dealers' book that can accommodate large selling movements. The lack of liquidity in the financial CDS space without a revamp of the 2003 ISDA Credit Events definitions would exacerbate potentially the movements in financial bonds. 

The liquidity in credit is already impacted by the poor liquidity in the secondary space, in this low yield, and yield hunting environment as described in a recent presentation made by Wells Fargo Credit Strategy team:
"Anecdotal evidence from our trading desk suggests the performance of secondary bonds is lagging that of new-issues. In addition, trading flows point toward more investors buying new-issues “on switch” rather than outright from cash. This is particularly true at the long end of the curve and for frequent borrowers." - source Wells Fargo

Since January the price action has been more volatile in the Investment Grade than in the US High Yield ETF space, which has mirrored much more the price action of equities, namely the S&P 500. Investment Grade is therefore a more volatility sensitive asset, whereas High Yield is a more default sensitive asset, as indicated in  by the price movement of the the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (AMEX: LQD) versus the US High Yield ETF HYG and the S&P 500- source Bloomberg:
Looking at the latest minutes from the FOMC and the discussions surrounding the Fed's QE stance and the possibility of a reduction in bond purchases in coming quarters provided an improvement in the employment data, it does make Investment Grade corporate bonds highly more volatile to interest movements in this "Japonification" of the credit markets courtesy of global ZIRP.
As per a recent Wells Fargo credit presentation, we agree with them in relation to the key risks for Q2 2013 given that:
"Lower coupons and longer maturities increase a portfolio’s duration/interest-rate sensitivity. The duration of the entire HG corporate bond market has extended 1.0 year to 7.0 years over the past five years. In maturities of greater than 10 years, duration has extended 2.0 years to 13.6. With the Fed signaling a potential shift in policy this year, long-duration corporate bond prices could be at risk of falling sharply and quickly." - source Wells Fargo Credit Strategy.

We are not surprised that the price of "stability" courtesy of massive liquidity injections from global central banks has come at a cost of increased "instability" as per Hyman Minsky's definition:
"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity." - source Wikipedia.

You might want to read again, Irving Fisher's book "The Debt-Deflation Theory of the Great Depression" published in 1933. Because in this book Irving Fisher dealt extensively with "business cycle theory".

For Irving Fisher, the two big bad actors in great booms and depressions are debt disturbances and price-level disturbances. We have both...but that's us ranting:
"Debt Starters
Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was the prime cause leading to the over indebtedness of 1929." - Irving Fisher

Just a fact:
Investors borrowed $384.4 billion in April, a 1.3% gain from the previous month which was at $379.5 billion and conveniently the second highest in the history of the NYSE going back to 1959. The April surge was a 29% rise from the same month last year. The highest level was $381.4 billion recorded in July 2007.  We have an all-time record for margin debt and it exceeds the previous high mark. 

And what else did Irving Fisher wrote in his 1933 book?
"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debt tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts."

So no "speculation" going on, it is all going well...

As far as credit is concerned, the rapidity in the tightening movements in credit spreads is reminiscent of the warnings given in 1933 by the wise Irving Fisher. 

A recent note from Societe Generale on the 22nd of May is clearly indicative of the rapidity of how this time around the credit bubble is being blown by our "omnipotent" central bankers:
"When the music stops, we pause and then just add another chair. It's usually the slightest of breathers and the market isn't waiting too long before that relentless grind and lifting of paper resumes. Clips, blocks of paper and new issues are managing to get taken down without much fuss, and we're not seeing any contagion from the volatile stocks impacting the cash market. We're well poised here. Of course there's plenty of apprehension and it is understandable that we all need a little convincing that still adding risk at these levels is the right thing to do. It is. In the meantime, the low/high beta compression continues and was clearly evident from yesterday's deal from Plastic Omnium. The unrated - but implied non-IG - French borrower managed to raise €500m for seven years, paying just 3% for the privilege. Add in a premium for being unrated and one has to concede that the level is a funding coup for the borrower! For the broader market, the iBoxx cash index closed below B+133bp yesterday and will be lower again today after the tightening seen in today's session for corporate spreads. Even taking into account the massive February/March wobble (when the index widened 22bp), credit is tightening faster than even we - the most bullish of observers - would have expected. Hitting our original 2013 target of B+120bp is now a case of when not if, and we can only expect investor nervousness to rise even more as a result. As long as money continues to come into the asset class and supply remains at these (low) levels given the size of the demand, then the current tightening/compression dynamics will stay in place. Position for it." - source Societe Generale.

Moving back to the subject of the evolution ISDA Credit Events and the impact of expected changes recovery rates on financials, the impact of the new CDS contracts would make the CDS market in the financial space more relevant as per a note from Societe Generale from the 24th of May on the subject:
CDS protection may be more valuable should reported proposals for amending credit derivative definitions be accepted. The proposal is to amend credit derivative definitions for banks and comprises three main points. First, it adds a credit event to capture government enforced bail-in. Second, it expands the list of deliverables in the new credit event and keeps current deliverables available for old events, despite their potential loss-absorption ability in the future. And third, it improves successor provisions to keep CDS protection attached to the debt. Taken together, these may help to avoid a repeat of the CDS insurance failure of SNS while capturing the increased tool-kit available for governments to restructure banks out of bankruptcy. We do not expect these provisions to be retrospectively applied to existing contracts; however the amendments suggest much less value in outstanding sub contracts.
ISDA’s proposed changes would make CDS protection more robust and, therefore, valuable. First, a new ‘hard’ credit event would capture government-enforced bail-in. This would be broadly defined as an action taken by government authorities that alters creditor rights under bank restructuring and resolution laws. By our understanding, this does not include the institution triggering Tier 2 contingent capital (CoCo) clauses, as this is an action undertaken by the entity itself, but it would capture Bankia-type events. If the new credit event trigger is a write-down, the event would not occur until the write-down is permanent or there is nonpayment under prior contract terms. A ‘hard’ event eliminates the maturity buckets of restructuring events. Second, deliverables in the new credit event auction may include the written-down or conversion/exchange proceeds. Again, this is Bankia-event type protection. In the event of complete write-off, à la SNS, par payment would be received by the protection buyer. In addition, deliverables under a current or new credit event could include Tier 2 or more senior securities with write-down provisions as mandated by legislation, provided they are not yet written down. This would enable most Lower Tier 2 debt to be deliverable even if it is loss absorbing Basel III-compliant via legislation. CoCos could be delivered in the new credit event provided they have not yet triggered. This captures many bail-in eventualities. Third, successor provisions would track the debt, enabling subordinated and senior CDS to succeed to different entities. This would keep CDS viable in a good bank/bad bank situation. Also, importantly, the new credit event could occur on subordinated CDS without triggering senior CDS. This may have implications for sub/snr trading levels once the new amendments are in place." - source Societe Generale

On a final note, the US equities market is increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally as indicated by Bloomberg's chart, great for CEOs and stock options and their shareholders but probably less so for the health of the balance sheet:
"Repurchases are becoming a bigger source of demand for U.S. stocks, and shares of the companies that carry them out may have an easier time beating benchmark indexes if history is any guide.
As the CHART OF THE DAY shows, the Nasdaq Buyback Achievers Index has more than tripled in the current bull market and has left the Standard & Poor’s 500 Index behind. The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months.
“Corporations have been aggressively buying back shares,” Jeffrey Kleintop, chief market strategist at LPL Financial Holdings Inc., wrote two days ago in a report. He added that the repurchases are largely designed “to boost earnings per share as revenue growth slows.” - source Bloomberg

"The public psychology of going into debt for gain passes through several more or less distinc phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible". - Irving Fisher.

At some point the Fed will have to normalize, probably not now, but the more they delay the adjustment, the more painful it is going to end up.

Stay tuned!

Saturday, 25 May 2013

Japanese Whispers

"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill 

Japanese Whispers is a 1983 singles album by British group The Cure. Looking at how the markets hope were slightly dented this week with the plus 7% drop on the Nikkei index, we thought we would use this reference to British group's album title and also given their convenient name in our "Abenomics" case namely "The Cure", given everyone and his dog have "delusional" hopes on Abenomics success in reviving Japan we think.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

This week's Bayesian lesson comes from Japan given our Japanese Chuck Yeager has indeed reached record altitude in true jet pilot fashion when one looks at the "Bayesian" surge in the Nikkei index which, apart from the recent stall, has passed the Dow for the first time since 2010 as indicated by Bloomberg:
"The CHART OF THE DAY shows the Nikkei 225 soaring 80 percent as the yen plunged after then-opposition leader Shinzo Abe said in November the Bank of Japan should carry out unlimited monetary easing. That allowed the Japanese stocks gauge to close a gap that was about 4,000 points. Abe became prime minster after his Liberal Democratic Party won a landslide victory in parliamentary elections. The BOJ, led by Abe’s nominee Haruhiko Kuroda, unveiled plans last month to double the money supply in two years to end deflation." - source Bloomberg.

More importantly we watched with interest the move on the Japanese VIX equivalent on Thursday at the same time of the sell-off, in true "sucker punch" fashion - source Bloomberg:
From 25 to as high as 48.35 in one move, or that's what happen when you have over confident central bankers/pilots pushing the envelope so to speak, as we discussed using Chuck Yeager crashing his NF-104 Lockheed Starfighter on the 4th of December 1963 as an analogy in our conversation "The Coffin Corner".

And does this move compare to 2008? It is indeed a fairly large movement in volatility as indicated in the below graph from Bloomberg displaying the VNKY index from May 2007 to today:

While reading the excellent FT Alphaville on Japan's mini crash we came upon an excellent comment from one of their reader:
"This equity mini crash is all fine and well, but what about the rise in JGB yields? I would be grateful if somebody could enlighten me how this whole allegedly Superman-like Abenomics plan can possibly not end in tears for all involved. The math just doesn't add up.

Japan has about 990 trillion yen in JGB outstanding. There is even more public debt (local, regional, SOE etc), but let's focus just on the JGB's, which already amount to some 180% of GDP, so there is aplenty. They have been able to finance this very cheaply (nominally speaking) and largely domestically at about 0.50% pa nominal yield for the past two decades. This was largely possible because of deflationary pressures, meaning that real yields were not so bad at all (1.5~3%, depending on where, when and how you measure). So this system more or less worked, at least for domestic parties, who hold 95% of the JGB's. 

But now, Monsieur Abe has got it into his head that he is going to end those deflationary pressures, and the BoJ is with him. It looks like the latter is succeeding in credibly promising 2% pa inflation, to be delivered within 2 years. And they have the means, it is more of a matter of will indeed, so why not indeed. Now, if I am a Japanese domestic investor (say a pension fund), why on earth would I continue to hold and keep buying JGB's at below 1% pa nominal yield for 10 years while I know the BoJ is going to do everything it can to ensure at least 2% inflation, and thus meaning a real yield of -1%. 

And in fact, let's not forget that the whole point of Abenomics' grand inflation chase is precisely that effect: driving individual (in aggregate) and corporate savers out of safe-haven investments like JGB's and getting them to invest in more productive assets. Now you may say, no worries, you don't need to have those parties to buy JGB's, or they won't have a choice but to accept negative real yields, since the BoJ will just 'financially repress' yields anyway. But this is where the maths go off track. What works for the Fed, does not work for the BoJ in this case. The average maturity of the JGB debt is relatively short (about 6 years). The Japanese government therefore does quite a bit of rolling over, and is still running a huge deficit as well, so lots of issuance going on. In FY2013 alone, they are scheduled to issue JPY 170 trillion in JGB's. The BoJ has specifically committed itself to buy some JPY 70 trillion of JGB's this year, which makes sense given its commitment to double the monetary base in two years, and which was originally JPY 135 trillion when they made that commitment. 

So we have JPY 990 trillion (and growing) in existing outstanding JGB's, JPY 170 (of which) being rolled over/newly issued this year, and the BoJ will buy 'only' 70 trillion of that (even assuming they only buy primary issues, which is by no means a given). At the same time, we have the possibility that the domestic investor base that has been diligently buying JGB's in the past 20 years will stop doing that (and even start selling existing holdings too): because they don't want to bear negative real yields (and again: this is precisely the purpose of Abenomics, to get that money working rather than just gathering paltry JGB yield). Foreign investors? No way. They wouldn't want the negative JPY yields either, and with a declining yen (at the very least a all-but-certain side-effect of Abenomics), they would want them even less.

I can only see three possible scenarios here, but would be very pleased to be proven wrong by a flaw in my reasoning:

(1) Abenomics and the BoJ's efforts don't work. Inflation does not materialise. Deflation or 0% price stability is here to stay. Nominal JGB yields remain low (or go back to even lower). Real JGB yields thus remain more or less attractive for domestic parties. All stays as it was. The JPY strengthens again. Abenomics fails, but nobody gets really hurt. 

(2) Abenomics and the BoJ's efforts do work. Inflation picks up and gets to 2% like the BoJ wants. Nominal JGB yields therefore go up as well, since the BoJ is not buying nearly enough to successfully keep yields down (10-year JGB at 3%? 4%?). At this point, the BoJ even stops the bond purchases and/or may even tighten. This will mean the government cannot sustainably (or at all) finance its deficit and the debt it needs to roll over. It will either have implement the kind of austerity that would Greece seem like child's play, which it can't/won't for it would kill the recovery, or it will have to consider default/restructuring. Abenomics fails, and has brought the Japanese government to the brink of an IMF-bailout, or worse. 

(3) Abenomics and the BoJ's efforts do work. Inflation picks up and gets to 2% like the BoJ wants. Nominal JGB yields go up with it (10-year JGB at 3%? 4%, see above). At this point, the BoJ continues to buy debt, for the government has no other way to sustainably finance itself, and Abe has already de facto ended central bank independence. It will have to even buy a lot more than it is currently planning. A whole lot more. The monetary base continues to grow. It's effectively debt monetisation. Inflation gets out of hand, even into double digits. Debt-to-GDP is getting healthier, but the JPY goes to hell. Exports are good, but resource-poor Japan can barely afford its oil and gas imports. Japan becomes the first developed nation to move back into a middle-income trap economic situation. Abenomics fails and has brought economic misery for the Japanese people, especially the asset-rich pensioners who see their purchasing power destroyed. 

In short: Abenomics and its three arrows perhaps are not such a bad idea if your debt-to-GDP ratio is well below 100%, your debt maturity profile is long-ish, and you're running a government surplus (or at least just a modest deficit), and you can therefore handle an uptick in government debt financing costs, especially if it also comes with a gradual nominal increase in tax revenue. When your debt-to-GDP is closer to 200%, and you run a huge deficit, you can't. You will be back against the wall very quickly and face a stark choice: either your central bank will have to begin monetising debt and let inflation get out of hand, or you will have to implement some form of austerity with/without debt restructuring that will have an economic impact that is the polar opposite of what you were trying to achieve." - source FT Alphaville comment from j.v.e 

We could not agree more with the above great comments. Yet, foreign investors continue to buy Japanese stocks to the tune of JPY 716 billion versus JPY 879 billion as reported by JP Morgan, from Japan's MoF released weekly update of portfolio flows:
"Foreign investors have bought a total of JPY4.6trn in Japanese stocks in April and May so far." - source JP Morgan.

But more interestingly was the following:
"Japan’s MoF released the weekly update of portfolio flows. Japanese net sold JPY804bn in foreign bonds last week (May 13-17), more than undoing the net buying in the three weeks prior (which totaled JPY692bn). Japanese sold JPY137bn of foreign stocks last week as well, which is also more than the net buying amount in the previous two weeks (which sums up to JPY47bn)." - source JP Morgan

In conjunction to the heightened volatility in the Japanese JBG market, we have been looking with interest at the roller coaster moves in the 30 year Japanese bond space versus the Swiss equivalent - source Bloomberg:

So while equities our enjoying the Japanese show, even after the following recent stall of the Japanese "Starfighter", we have been busy watching with interest the credit space given we still believe Japanese financials CDS to be "cheap" as displayed in the below graph from CMA, part of S&P Capital IQ:

Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control...

We would therefore like to re-iterate what we said in Last week's conversation "It's a Wonderful Life":
"Given that for these Japanese banks profits are tied up to substantial trading and "unrealised" investment bond gains from abroad and looking at the recent rise of JGB yields since the arrival of Mr Kuroda at the Bank of Japan, and knowing the very large size of JGB portfolios for these Japanese banks, in the absence of investment bond gains (which would mean selling some European government bond holdings...yikes!), unrealised losses on their JGB portfolios will not doubt put pressure, not only on their shareholder's equity and regulatory capital, but on their CDS spreads as well and their earnings. The CDS for these Japanese banks is trading closer to the more highly rated Australian banks but also Korean counterparts such as Kookmin according to CreditSights. Therefore, should "Abenomics" disappoint, there is indeed some room for these Japanese banks CDS to widen "significantly" at some point...(sorry we are not paper fortune tellers)." - source Macronomics

Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since January 2010 until today - source Bloomberg:
Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials.

"If at first you don't succeed, try, try again. Then quit. There's no point in being a damn fool about it." - W. C. Fields

Stay tuned!

Sunday, 19 May 2013

Credit - It's a Wonderful Life

"It is best to avoid the beginnings of evil."- Henry David Thoreau 

Watching with interest Moody's savage six notch down-grade of the Cooperative Bank (from A3 to Ba3) on late Friday 12th of May made us wander again this week towards are much beloved cinematographic analogies for our chosen title. The Co-Op banking story sounds a lot like a replay of 1946 great Frank Capra movie called "It's a Wonderful Life" starring James Stewart. In the movie George Bailey after giving up on his childhood dreams, decided to run the Building and Loan community bank founded by his father and faced early in his banking role a collapse. Earlier in his banking life, Georges Bailey witnessed a bank run on his establishment and to avoid the fateful rout of the financial institution used the money for his honeymoon trip to avoid the demise of his local bank. Later in his life as a local banker, Georges faced another liquidation moment when the Building and Loan's cash funds are snatched, and the bank is only saved by the flood of townspeople donations to save George (facing prison) and the Building and Loan institution. Of course, any resemblance between the analogies used in this blog post and real events are purely coincidental...

In these days and ages it seems that, after all, sub-investment grade ratings at European banks, are no doubt, becoming more the norm rather than the exception, given Italian Bank Monte dei Paschi di Siena founded in 1472, the world's oldest bank, was given as well the multiple downgrade treatment by Moody's, falling three notches in the process (from Ba2 to B2). They have just lost 100.7 million euros in the first quarter compared to a profit of 89 million euros in 2012 and have lost 7.9 billion euros in the past two years with an outstanding market cap of 2.48 billion euros.

This multiple downgrades from a trigger happy rating agency is definitely one of the first results of the Cyprus effect, namely the "unintended consequences" of the recent talks surrounding an earlier implementation date for senior debt bail-in.

In its Co-Op decision, Moody's highlighted the "risk of write-downs on junior debt instruments and, potentially, the need for external support to maintain regulatory capital levels".
In its Monte dei Paschi di Siena (MPS), Moody's declared it "is concerned that the risk of burden sharing with creditors in order to ensure its adequate capitalisation has risen and would be significant under an adverse scenario".

We have been warning for a long time and on numerous occasions the risk of total wipe-out for subordinated bond holders, leading in many instances to debt-to equity swaps for some (Portuguese bank Banco Espirito Santo in October 2011), and numerous capital increases for others (Commerzbank in the market this week for its fifth capital increase in four years, this time around for 2.5 billion euros and probably not the last one...). 

While the case for the Co-Op could eventually lead to the first test of a bail-in of subordinated creditors in the UK, the SNS case and the acceleration of the implementation of "bail-in" are as well putting significant pressure on the ISDA to come up with new "credit event" definitions to save not only the Sovereign CDS market, which has been impacted by the Greek saga, but to conjure the potential demise of the subordinated CDS market if it doesn't take into account the "expropriation" trick from the SNS case as a "credit event" given the lack of deliverable subordinated obligations thanks to the total wipe-out. 

Therefore, in this week's conversation, we will look at the complacency in the subordinated market in this "Wonderful Life" of credit, where spreads are tightening at lightning speed, and credit risk is so much a "thing of the past", but, there we go, rather than rambling, you find us grumbling. Oh well...
But first our quick market overview.

Credit wise Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities)   have marked a pause this week with Itraxx Crossover rising 5 bps to 387 bps and cash credit was also flat following four consecutive weeks of uninterrupted tightening  - source Bloomberg:
While credit has moved significantly tighter in 2013, following "whatever it takes 2" courtesy of "Abenomics", we have yet to touch the lowest spread of 255 bps between both indices from 2011.

At the same time European Credit has marked a pause in their rally, European government yields have moved back from their lows with German 10 year Government yields moving towards 1.30%  - source Bloomberg:

Equities wise, the Eurostoxx which has lagged the continuous rally seen in the S&P 500 has catch up is now moving in synch with the US index, whereas Italian government bonds, indicated in the same graph have been trading below the 4% level - source Bloomberg:

Whereas are Japanese friends are still recording significant increases, in their successful art of deceit, enticing even more investors in the rally game while creating significant headaches to local Asian countries in the process - source Bloomberg:

What is increasingly stirring our interest, when it comes to Japan is, as we indicated last week, has been the disconnect between credit spreads and volatility, which has been rising in the case of Japan as of late - source Bloomberg:
As indicated in last week's credit conversation, the shorter 3 months Implied volatility has been telling a different story since the beginning of the year and has been rising significantly. We are wondering now if Credit Risk which has been significantly tempered by Abenomics as displayed by the significant rally in the CDS Itraxx Japan 5 year index is not going to reverse its trend and start surging again.

For us Japanese equities and Japanese credits are indicating that investors are no doubt buying purely on hope. Yes, the three Japanese megabanks have reported an aggregate 11% rise in net profits for FY12 (+30% adjusted for prior year exceptionals) to a multi-year high of 2.2 trillion yen (22 billion USD). As reported by CreditSights in their 15th of May note entitled "Buying On Hope", the ROE ranged from 14% for SMFG to 10% for Mizuho and 8% for MUFG: "Profits were indeed helped in the last quarter by the lower yen which boosted overseas income and much reduced stock impairment losses as the stock market recovered; lower tax charges have also helped." - source CreditSights

Given that for these Japanese banks profits are tied up to substantial trading and "unrealised" investment bond gains from abroad and looking at the recent rise of JGB yields since the arrival of Mr Kuroda at the Bank of Japan, and knowing the very large size of JGB portfolios for these Japanese banks, in the absence of investment bond gains (which would mean selling some European government bond holdings...yikes!), unrealised losses on their JGB portfolios will not doubt put pressure, not only on their shareholder's equity and regulatory capital, but on their CDS spreads as well and their earnings. The CDS for these Japanese banks is trading closer to the more highly rated Australian banks but also Korean counterparts such as Kookmin according to CreditSights. Therefore, should "Abenomics" disappoint, there is indeed some room for these Japanese banks CDS to widen "significantly" at some point...(sorry we are not paper fortune tellers).

In terms of the recent poor macro data, and the continuous rally in risky assets with a fairly muted VIX (around 13), the recent move in the MOVE and CVIX indices warrant caution we think.
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
Graph - source Bloomberg:

"If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallied hard with the same type of cross-asset vols opposite moves.

Looking at the recent disappointing batch of macro data and the huge rally in risky assets in similar to the move we have seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space.

As we argued last week, Investment Grade is therefore a more volatility sensitive asset to interest rate changes, whereas High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened recently. Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD is more sensitive to interest rate risk  - source Bloomberg:

Moving on to our subject of complacency in the "Wonderful Life" of the subordinated credit space, the Cooperative Bank's capital gap is according to the FT at around 1 billion GBP, truth is their is 1.3 billion GBP in outstanding subordinated bonds, so as the saying goes "mind the gap", because the capital gap, is going to be filled and most likely in the first place by subordinated bondholders rather than  by a flood of townspeople donations like in the 1946 movie. On the complacency in the "Wonderful Life" of subordinated bond holders, we would have to agree with Bank of America Merrill Lynch takes on the subject from their 13th of May note entitled "It's all at the Co-op - now:
"A still complacent market – what next?
The precipitate decline of the Co-op’s bond prices highlights that bondholder haircuts are not in the price, even though the market ‘knows’ about bail-in. In spite of the recent chilling lesson from Cyprus, sub yields touch new bottoms and prices reach new highs. We believe there is no room for error in either. Our Credit Investor Survey last week saw more money going to subordinated financials, not less. We thought complacency reached its apogee last month when we saw Unicredit, a bank with 20% NPLs in its core Italian business, place sub bonds in the USD market. Capital is king in a bail-in world." - source Bank of America Merrill Lynch.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

As far as the Co-op's sub debt bonds are concerned, get ready for some "Bayesian learning", dear subordinated bondholders:
- source Bank of America Merrill Lynch.

Can you smell bond tenders or debt-to-equity? Because we can and so does Bank of America Merrill Lynch in their note:
"Liability management
Ironically, the precipitate fall in the bonds of the Co-op has increased its optionality with respect to using its subordinated bonds to bridge its capital gap. We estimate that the current gap between the face value of the Group’s tradeable subordinated bonds and their market value as of Friday close is £416m (there are other bonds which are much less liquid too in addition to this number). The monetization of this could be a key part of the solution, assuming that the bonds don’t jump in value next week as bottom fishers may come in.

That would be risky, we think, because all forms of liability management are potentially on the table, in our view, both coercive and voluntary. We can even see the possibility (though admittedly unlikely) of a debt-for-equity swap – the bank is a PLC after all, so it does have shares. The Group would resist this, we would expect, as it would hardly want to share ownership of the bank with sub bondholders, but it depends on how truly desperate the situation is and how the UK authorities decide to address it." - source Bank of America Merrill Lynch.

Of course the "unintended consequences" of Cyprus and "Abenomics" make us believe that in the "Wonderful Life" of the financial credit universe, no one is really prepared to "face the music" when the music, will stop, because at some point, with the implementation of "bail-in" it will!

It looks like Bank of America Merrill Lynch is facing our rather "sanguine" views as well on that matter:
"Is it priced in?
In our view the price action of Co-op bonds on Friday shows that the market is ill-prepared for bail-in of bank bonds, which rather undermines the idea that the concept is so well-known and talked about that it is ‘in the price’. It is not in the price in our view.
Our investment case for European bank bonds became much more cautious post-Cyprus. In summary, we think that the positive investment case for European bank bonds has faltered as a result of Cyprus. However we believe that has not been reflected in spreads or positioning. In fact, our recent investor survey shows that investors have been consistently increasing their allocations to subordinated debt and moving away from senior debt. Whilst we understand the concept that you don’t get paid for bail-in in senior debt, we have to underline that you don’t get paid for bail-in in subordinated debt either." - source Bank of America Merrill Lynch.

So, sorry to spoil the 'credit party mood', because current subordinated bond prices do not reflect the fundamentals and the underlying credit risk we think and we are not the only ones:
"We maintain our view that a more cautious stance is warranted, especially in the periphery where European bank asset quality problems are concentrated. We saw the recent USD 6.375% subordinated bond of Unicredit as the apogee of complacency in the market. This bond is currently trading well above 102 (a yield of nearly 5.9%). We can see the attraction of the yield but it is not normal for a bank to have NPLs of 20.1% in its domestic business. On a consolidated basis, a 14.1% NPL ratio (up from 13.6% at year end) with 44% coverage should not be considered normal either. It represents a significant risk to bondholders, in our view." - source Bank of America Merrill Lynch.

On a final note, given a few days back we pointed out that Air Traffic is pointing to additional economic activity weakness, we would like to add there is indeed a high correlation between passenger air traffic and GDP growth - graph source Bloomberg:

"Passenger air traffic correlates with GDP growth at a 1x multiple in developed countries and about a 1.5x to 2x multiple in developing markets. Consensus GDP forecasts provide insight to the trend for air traffic growth in the coming years." - source Bloomberg.

"It's not what you look at that matters, it's what you see." - Henry David Thoreau

Stay tuned!

Thursday, 16 May 2013

Chart of the Day - Too many European banks and why the deleveraging has only just started

"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning." - Winston Churchill 

This chart of the Day extracted from Bank of America's note Banking on the Banks from the 16th of May clearly illustrate why the deleveraging has only just started in Europe:
"Meanwhile, Europe continues to lag the improvements seen in the US economy and markets. Quite simply, Europe's economy struggles with too many banks, too much debt and too little growth. A long history of empire, trade, war and commerce means a long history of banking. The world’s first state-guaranteed bank was the Bank of Venice, founded in 1157, and the world’s oldest bank today is also Italian, Monte Paschi di Siena (founded 1472). In many European countries, bank assets dwarf the size of the local economy and are far in excess of other regions in the world." - source Bank of America Merrill Lynch.

Why the credit crunch in European countries?
Because this deleveraging was as well accelerated by the fateful decision taken by the European Banking Association  of imposing European banks to reach a Core Tier 1 capital ratio of 9% by June 2012. It has not only broken the credit transmission mechanism to the real economy in Europe but as well caused a credit crunch:
- source Bank of America Merrill Lynch

"What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from." - T. S. Eliot 

Stay tuned!

Wednesday, 15 May 2013

Air Traffic is pointing to additional economic activity weakness

"Rashness belongs to youth; prudence to old age." - Marcus Tullius Cicero 

A regular economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Over the past 13 years’ monthly data, there has been an 84% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months (second graph). In turn, this has translated into a clear relationship between air cargo and chemical industry volume growth" - source Nomura:
"Our air cargo indicator of industrial activity came in at -7.4% (y-o-y) in April, following -3.8% in March and -7.8% in February. As a readily available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth." - source Nomura

Air cargo volume growth vs global industrial production growth, y-o-y, % - source Nomura:

In addition to Air Cargo trending down, as far as Air Traffic is concerned, demand growth remains weak as indicated by CreditSights in their April 2013 European Airlines Traffic Review. YTD demand in Europe has been flat and April demand was only up by 1% for Air-France-KLM, whereas April 2012 had been up by 5%. Overall demand by regions including Americas was up 2% in April 2013 against up 3% in April 2012 for this European operator. It was worse for IAG, the combined British and Spanish operator (British Airways and Iberia) with Spanish demand particularly weak in April in its domestic market, down 16% whereas it had been up 3% in April 2012. Iberia's traffic is down by 19% due to the weak Spanish economy sapping the demand.

Looks like we are indeed moving more into a soft patch...just saying.

"It's not what you look at that matters, it's what you see." - Henry David Thoreau 

Stay tuned!

Saturday, 11 May 2013

Credit - What - We Worry?

What - Me Worry: "As an interrogatory, indicative of a nonchalant attitude towards potential criticism, not caring about what other people think, confident and self-possessed." - source wiktionary

For a fourth week in a row, we have seen the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds, tightened by 5 bps in the cash market every week, as the "grabayield" game goes on or as Bill Blain, a senior fixed income broker from Mint Partners recently put it recently to a interview referred to as an asset "grabathon":
 "This is going to become an asset 'grabathon', put your buying boots on".

This week's title is a reference to one of one of our great teenage years read, namely Mad Magazine Alfred E. Neuman's motto. After all the "grabayield" nonchalance in the credit space, not caring about the macro outlook, and with the credit markets being confident and self-possessed, made us venture this week towards this idiomatic analogy. We would have used "Dumb and Dumber" as a title looking at the issues being thrown out with such a pace and abandon (Unbounded enthusiasm; exuberance, being more likely), but, we did use this title before. Unlike some "goldfish memory span" investors out there, we do not suffer from Anterograde amnesia, which has been created it seems, by the use of "powerful narcotics", namely massive liquidity injections by our favorite Central Bankers.

On that subject of credit investors suffering from Anterograde amnesia, we could not have agreed more with our old friend and sparring partner Anthony Peters' column in IFR (International Financing Review) entitled "Investors queue up for perp walk":
"On Tuesday last week I tweeted (@therealadmp, should you wish to follow): “Enron announces zero coupon perpetual, convertible into WorldCom – book expected to be six times oversubscribed!”

My outburst was prompted by the ever-increasing slew of bond issues that defy logic and that seem to be bought by investors, to quote George Mallory out of context, because they’re there.

What caught my eye was the €1.75bn Hutchison Whampoa perpetual issue, which attracted a book somewhere in the region of €6bn.

I couldn’t help but wonder whether investors have a clue what distinguishes subordinated from senior corporate debt and what they are thinking when they pile into corporate perpetuals.

I never had too much of a problem with banks issuing perps – from a regulatory capital perspective it makes sense – but corporates don’t have reg cap requirements and therefore the entire process of issuing such structures perplexes me.

In the case of default the subs rank below the seniors and all that jazz, but is it really necessary and are investors being rewarded for the subordination or for the strip of call options that are embedded in the structure and which they are selling to the issuers?

I’m sure that there are plenty of syndicate managers who could easily argue the point, but they also argued, not so long ago and very convincingly, that CDOs were failsafe, that Libor plus 30bp was cheap for Triple A tranches of subprime mortgage bonds and that government bonds were risk-free. Caveat emptor, in other words."

Or caveat creditor, we would add to the wise words of our estimated friend. So in this week's conversation  we will look at default rates and their predictive ability in forecasting a turn in the credit cycle as well where we are in the credit cycle, as a follow up to last week's conversation where we focused on the releveraging taking place in the US market and the Global Credit Channel Clock. But, first our quick market overview.

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has been growing in strength. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:
In trading on Friday, shares of the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (AMEX: LQD) crossed below their 200 day moving average of $120.77, changing hands as low as $120.46 per share. Since January the price action has been more volatile in the Investment Grade than in the US High Yield ETF space, which has mirrored much more the price action of equities, namely the S&P 500. HYG and JNK are the two largest investment grade ETFs accounting for 80% of assets. These two ETFs have seen 1.1 billion USD of outflows highlighting the demand towards shorter duration ETFs such as High Yield ETFs SJNK and HYS, which according to CreditSights have taken in over 1.8 billion USD in combined AUM in 2013.

Investment Grade is therefore a more volatility sensitive asset, whereas High Yield is a more default sensitive asset. We will look further into this in this week's conversation.

Although the Eurostoxx have been much more less prone in breaking records than the S&P 500 and the Japanese Nikkei index, and has been struggling to break the 2800 level, the latest rise in the German 10 year Government yields towards the 1.27% yield level makes new issues in the European Investment Grade space much more sensitive to rising interest rates due to convexity factors than European High Yield. In the financial space the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) has continued to  perform towards 120 in the last couple of weeks while volatility remains muted at 17.3 for the V2X index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

In similar fashion and as displayed by the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge), high beta credit such as financials and European High Yield have indeed continue to perform with the Itraxx Crossover falling below the 2008 levels - source Bloomberg:

At the same time, the absolute level of core European government yields has somewhat reversed with German yields rising towards 1.30% level, and non-core peripheral bond yields for Italy and Spain have stabilised following a very impressive rally induced last summer on the back of the first episode of "whatever it takes" which was led by Mario Draghi and which was followed in 2013 by "whatever it takes" episode 2 courtesy of Kuroda and the Bank of Japan leading to another raft of "grabayield" - source Bloomberg:

The continued meteoric rise in the Japanese Yen, the Nikkei index and the receding pressure on Itraxx Japan credit spreads courtesy of Abenomics continue to validate the aeronautical analogy we made in our conversation the "Coffin Corner" - graph source Bloomberg:

But, we have been following as well with much interest the relationship between credit spreads and volatility in the Japanese space, a tale of growing divergence we think - source Bloomberg:
Whereas the 1 one year Implied volatility has remained relatively stable, the shorter 3 months Implied volatility has been telling a different story and why the relationship with credit was stable until 2011, it remained fairly muted throughout 2012 but since the beginning of the year, while the Itraxx Japan index has continued to perform in similar fashion to equities and the US dollar versus the Japanese yen, 3 months implied volatility has been surging. Something, we think, warrants monitoring.

Moving on to the subject of defaults rate and US HY, as indicated by UBS in their recent Global Credit Navigator from the 8th of May, global defaults rates since 2010 have remained stubbornly low:
"Since the end of 2010, global default rates have remained stubbornly low, oscillating in a narrow range of 1.5% to 3.5% (Chart below). 
The trend has been broadly similar in the US and Europe despite a bumpy economic recovery post the ’08-’09 Great Recession and the Eurozone debt crisis. Exceptional liquidity provisions by central banks (QE from the Fed, LTROs from the ECB) as well as “amend and pretends” in Europe have arguably kept default rates artificially low, at least below levels consistent with economic fundamentals. The thesis that the credit cycle may be reaching an inflection point is becoming a growing concern to many market participants and policymakers (please see “Overheating in Credit Markets: Origins, Measurement, and Policy Responses”, J. Stein, February 2013). Over the past 12 to 18 months, HY issuance has set new records and average credit quality has deteriorated. In particular, annualized rates of PIK bond issuance and of covenant-lite loan issuance in the fourth quarter of 2012 were comparable to highs from 2007. 
These recent trends do not bode well for prospective credit returns. Default rates in the 5% area (currently 3%) could cost about half an investor’s annual carry on his/her HY investment (US HY indices currently yield c6% per year). From a rating agency perspective, Moody’s baseline forecasts for default rates in one year’s time suggest some upcoming upward pressure on European default rates but on balance no material change to the latest global trends. However, while the agency’s optimistic forecasts do not imply a significant improvement in current default rates, the agency’s pessimistic forecasts underscore material downside risk. In their “black sky” scenario, default rates could reach 7% in the US, 8% globally and 9% in Europe." - source UBS

And, as we indicated in November 2012 in our conversation "The Omnipotence Paradox", zero growth should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults:
"The empirical relationships between lagged economic indicators (e.g. global PMIs) and defaults suggests zero growth should move default rates up towards the 5-8% context over the next 12 months."
- source UBS

What credit investors forget in this deflationary environment, is that, 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, not inflation as per Morgan Stanley's 2011 note:
"While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - source Morgan Stanley

So, what is driving default rates you might rightly ask? 

For us and our good friends at Rcube Global Macro Research, and also UBS, as per their recent note, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):
"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.

Another factor used by UBS is Nonfinancial leverage:
"Average leverage of non-financial corporate sector (Nonfinancial Corp Debt/Nonfinancial Corp Earnings, source Federal Reserve)." - source UBS
"In terms of predictive value, the SLO survey and Non-financial leverage are two clear winners and these two factors alone produce an R^2 of about 0.6 in the best two-factor model." - source UBS

And as UBS rightly indicated:
"The 2008-2009 financial crisis brought the banking sector to an abrupt halt, resulting in a significant deleveraging of dealer balance sheets and contraction in bank lending to large and small firms which found themselves unable to refinance their debt." - source Bloomberg

This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will use it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg:
"Positive investor sentiment combined with an excess of demand over supply pushed the average price of S&P/LSTA Index loans up a quarter-point to a fresh post-credit-crunch high of 98.4 cents on the dollar in April 2013. In response, the Index gained 60 bps during the month, bringing loan returns for the first four months of the year to 2.7%." - source Forbes

As displayed in a recent note from our good friends from Rcube Global Macro Research in relation to the US economy:
"While demand seemed to have eased a touch in the survey, actual commercial and industrial loan growth remains robust and should stay that way"
"With all major surveys on credit availability having now been released, we can draw several
conclusions on the health of the global credit channel. Following the 2008 subprime meltdown and
the 2011/2012 European sovereign crisis, the global bank credit channel weakened substantially. It
seems that it is normalizing fast now." - source Rcube

Rcube also added in their note a very important point relating to Europe and the difference with the US economy:
"Europe remains the only place where the credit channel is malfunctioning. But even there the trend is positive. The % of banks tightening loan supply and terms is becoming smaller. As we said in yesterday’s Monthly Review, coming ECB actions will be centered on this issue, potentially improving substantially the credit transmission mechanism." source Rcube

Where we slightly disagree with our friends is that we wonder if the damages which have been caused by lack of credit in Europe, courtesy of the rapid deleveraging imposed on banks by the European Banking Association (EBA) to reach a Core Tier 1 capital threshold of 9% by June 2012 can be reversed. Looking at the credit crunch which happened in peripheral countries in Europe leading to a surge in both unemployment and nonperforming loans plaguing peripheral banks, it still hindering bank lending, hence the dislocation in rates between core European countries and peripheral countries:
- Source Datastream / Fathom Consulting.
- Source Datastream / Fathom Consulting.

Therefore a future rebound in private loan demand in Europe is questionable.

In terms of where we are in the credit cycle, as posited by Bank of America Merrill Lynch in their recent Credit Market Strategist note from the 10th of May, we agree with their stance namely that the previous credit cycle might indeed be shorter this time:
"With vanishing systemic uncertainties one of the key questions is - Where are we in the cycle? Compared with the previous cycle credit spreads are currently relatively “early cycle” at 2H 2003 levels – high grade non-financials around August and, following the recent rally, high yield a little later (December). 
However, due largely to extreme monetary accommodation certain indicators have us at later stages of the cycle. Thus, while spread-wise we are still at an early stage, the duration of the cycle may be shorter this time. Indicators displaying “late cycle” behavior include the very steep spread curves in high grade as well as the high percentage of CCC rated issuers that are accessing the primary market in high yield.
In terms of fundamentals, although leverage has been increasing over the past two years, we are still not seeing the downgrade pressures that are typical later in the cycle. Share buybacks are running at 2006 levels while M&A and LBO announcement volumes are consistent with earlier cycle 2004 levels. 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. While previously dealer inventories grew to almost 5% of the market through the cycle, this time they are unlikely to expand meaningfully from current levels. That limits the potential for spread tightening as investors require more compensation to hold off-the-run bonds. Given this, the difficulties investors face becoming completely comfortable with financials post the financial crisis, as well as likely more binding constraints on leverage this time we think potential cycle-tight US high grade spreads are 100bps this time, compared with 79bps in the previous cycle. For reference the current spread level is 143bps and our year-end 2013 target 130bps." - source Bank of America Merrill Lynch.

As we have argued in so many conversations, while the credit space is enjoying a "sugar rush" courtesy of our Central Bankers", and to quote again our friend Anthony Peters from his recent column:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk

We could not agree more with our good friend, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". 

If you think liquidity is coming back in the credit space, then you are indeed suffering from "Anterograde amnesia" caused by the liquidity induced "sugar rush" as indicated by Bank of America Merrill Lynch recent note:
"This one is not coming back. Dodd-Frank leads to less liquidity in the corporate bond and CDS markets, as the ability of dealers to make markets is permanently impaired by the new restrictions on balance sheets. For example dealers now hold less than one percent of outstanding corporate bonds – but during the previous cycle they were able and willing to expand their holdings to as much as almost 5% in 2007 (Figure below).
In contrast, for the present cycle we do not expect inventories to expand materially from current low levels. The natural consequence of this development is – as we have seen – that liquidity becomes more concentrated in on-the-run maturities and names. Thus investors will require an increased liquidity premium to hold off-the-run bonds – the vast majority of the outstanding corporate bond market. We estimate below (Figure below) that the difference between spreads on off-the-run and on-the-run 10-year HG corporate bonds is about 15-20bps, up from 1-5bps prior to the financial crisis.
Obviously this cuts both ways as the liquidity of off-the-run bonds has declined, while on-the-runs may actually have become more liquid.
However, still one of the most straightforward impacts of Dodd-Frank is wider credit spreads for the corporate bond market as most bonds are off-the-run. While the precise magnitude of this effect is difficult to estimate it could easily amount to 10-15bps for the average bond in high grade, or about 10% of overall spread levels." - source Bank of America Merrill Lynch.

As we posited in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

"So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door" - Macronomics - Pain & Gain

What - We Worry?      
"The circulation of confidence is better than the circulation of money." - James Madison, 4th American President.

Stay tuned!
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