Europe Nothing New to Say
You can read about Europe from a lot of other sources this weekend. I maintain that when a Grexit became a real possibility, they finally looked at what it would mean and became scared of the risk. Since then there has been a change of attitude. I saw it in the Spanish bailout, and I continue to see it. You can debate all day long about what Merkel says, or what the facilities can or can’t do, but if the EU has changed their approach, and has the will, they can find a way to give this one heck of a kick down the road.
High Yield is positive for the year no matter which day you bought it
Why would retail investors switch to equities when they have found a new and underinvested asset class that yields 7%? I’ve pulled up HYG here to show that there is now not a single purchase that would have a negative total return. Even if you top-ticked the market in February, the coupon income has saved you. This is true for the mutual funds I looked at as well.
We have had a long bias for high yield all year and continue to like it. The fact that the Fed is on hold for rates helps high yield. That high yield is more domestic and less reliant on the global economy than large cap stocks is another benefit as the default risk hasn’t been correlated with Europe. Finally, the Volcker rule means that banks don’t have big inventories so the downward pressure has been more a function of hedge funds caught off-sides than a mass exodus of hedge funds and bloated trading desk positions. With trading desks carrying smaller inventory we may see more volatility within a narrow range. Less capital and smaller inventory means that dealers can’t support existing prices so they will bounce around more to meet true supply and demand. That creates noise around existing levels, but it reduces the risk of a liquidity driven big move. Dealers can’t load up on the flows they are seeing so are less likely to get caught on wrong side of a reversal, meaning there is less pressure on the market.
With yields at 7%, a shift from beta products into managed products once again makes sense as much of the beta has been captured, and the next leg of returns will come down to credit selection and individual bond selection. If, and it is still a big if, we are entering into another full risk-on rally, look for small “illiquid” deals and weaker “CCC” deals to outperform. So much of a premium has been placed on staying liquid that the only way for a fund, and hedge fund in particular to outperform is to get down and dirty and make a reach for yield. We will revisit that idea in a bit when we look at credit hedge funds and their “goal-seeked” investment choices.
In Spite of What Your Read, Selling CDS is easier than Buying CDS
In spite of all the hype, being short U.S. credit in particular has been a tough trade and timing has been everything. Returns show that few have managed to time it well.
IG17 started the year as the “on the run” index. It was and remains part of the “whale” trade. This chart shows that it hasn’t been that easy to make money being short. Any trade done below the green line would be in the money from the short side, but any trade above the green line is in the money being long. The downward sloping line is a result of carry and duration. The longer the trade is on, the more carry comes into play, and the more trades that got it “wrong” benefit from reduced duration.
The single worst day to have sold protection on IG17 was on March 21st at 82 bps (we were recommending shorting it at the time). But at Friday’s close of 104, the loss is “only” 0.72% of notional. Not insignificant loss, but somehow not as bad as selling something at 82 and covering it at 104 would sound. If you sold IG17 the day after the JPM conference call, you would have sold at 103 and are now positive. So anyone who sold protection on IG17 into the close on the 11th of May is actually up money. Even if you were caught long on the 10th, the total return since then is -0.16%.
Clearly there have been trading opportunities, but by the looks of YTD credit hedge fund returns, most didn’t catch the moves particularly well, and if it wasn’t for the IG9 basis trade, the returns for many would look worse.
The Myth of 7% Yields Being the Death Knell
We have heard about 7% a lot. Everywhere you turned, someone was reminding you that 7% was the level that forced Ireland, Portugal, and Greece into bailout mode and deep credit problems. Almost no one mentioned that Italy had hit 7% and recovered. About the same number of people (and typically the same ones) pointed out that Ireland had breached 7% in the good direction.
Given the hype around 7% and everyone’s desire to create the “Paulson” trade and be massively short credit into a death spiral, last week’s price action may have been devastating to some funds. How many funds waited to see Spanish 10 year bond prices decline before growing their shorts, and how many got caught on the 4 point rise on Friday?
I am sure some funds traded this well, but too many investors (credit and otherwise) got sucked into the hype that the 7% barrier was truly devastating in spite of more recent evidence that in November, when Italy hit that, the EU and ECB acted. They acted again as we have expected and it is finally sinking into the market that this time they are serious.
There will be a lot of temptation to downplay the EU summit. There will be attempts to downplay the ECB’s actions this week. Investors may even be tempted to push the envelope and see if they can drive prices lower again, but some of the excitement will be gone. Investors buying CDS at 600 and already booking mental profits from when the country starts getting quoted in “points up front” are all gone. Not only didn’t we get the massive spike higher, the shorts took a serious beating. Will anyone really want to push it? To test the resolve of the EU, ECB, and Fed, without some new indications of deteriorating economies and no follow through on the apparent change of heart within Europe?
It was one thing to ignore that Italy had made it back, but what to do about Ireland? The view that any solution was temporary and would eventually result in a Greek outcome may also be in doubt. Ireland probably can’t tap the public market yet, but at 6.3% yield on the 10 year, the view that bailout equals collapse is less obvious. Even the Portuguese 10 year is under 10% and the 2 year is back to 7.4%. Still ugly yields, but the steepening is encouraging and another seed of doubt in the thesis that the markets can drive all the countries into a Greek like outcome.
The 7% Hedge Fund Dilemma and Goal-Seeked Returns
I was looking at the HSBC report on hedge fund returns. Some credit funds have done well year to date, but a lot were sitting around 2% YTD. Those who took the other side of the IG9 basis trade had a particularly good quarter – or at least that’s what the return numbers indicate. We don’t know how well any did in the last week or so, but my guess is that the ones with better YTD numbers played it better.
The problem with 7% for hedge funds, is that is the return you need before investors at 2 and 20 get the same amount of money as the hedge fund manager. It is a key number for a lot of investors, even more key for many than the 10% target returns.
So if you are halfway through the year, have underperformed plopping money into a HY mutual fund, or the 10 year treasury, you are thinking about how to generate a big return in the next 6 months.
Thinking about the return needed rather than what are your best trading ideas can generate is a subtle difference, but often leads to bizarre consequences. How many Monday morning meetings will start with – “how are we going to generate 6% between now and year end?” I suspect there will be a lot of those meetings. They need that to keep existing investors happy and to have any shot of getting new money. Those funds that are having good years won’t be having those meetings, and those that have good process and solid track records, won’t have those meetings, but there are enough funds that will be having those meetings, that it is worth taking them seriously.
If your goal as a credit hedge fund is to get 6% in the next month you have 4 obvious choices.
Aggressively trade and capture the flows
- Easier said than done, and most have failed YTD trying to do that
Short Europe since it’s going to crack
- Still a crowded trade, and far less obvious than it was a week ago that Europe “won’t act”, so tricky, and even stability hurts you as negative carry is painful on a big short when it’s not moving
Buy High Yield and lever it up
- You can buy high yield and lever it up, but at these prices, it will take a lot of leverage as most of the potential return now is coupon return, with relatively little price appreciation – especially for the better quality credits which have significant rate risk now. Do you go “all-in” and buy the illiquid stuff and the story paper?
Buy Spanish and Italian Bonds
- You know you hate Europe. You know that you don’t believe in their plan, but what if it does work? What if they do a 5 year LTRO? Spanish 5 year bonds are 7 points off their highs and pay a 4.25% coupon. The old Italian 5 year has a 4.75% coupon and is still almost 6 points off the highs. You know the banks aren’t selling, you know that most people don’t believe it will be fixed, and the reality, you don’t even need to get back to the best levels of the year. A little leverage and with carry and duration, if yields just move halfway back to their March 1 levels, we can get the 6%.
I think this is the decision facing a lot of funds. They have the capital to move markets, so guessing what they will do is key. They are more than welcome to trying to capture the momentum and kill it that way, but it has been hard, especially since the dealers no longer let themselves get picked off all day long by the funds who have made a career out of picking off and crossing dealers rather than being right.
That leaves the short Europe bet, which I think is far harder to go into right now, or the go long Europe bet. I think many will make the “go long” Europe bet. It is easier to convince yourself of that. The EU and ECB have some work to do, to defend Friday’s move, but if they can, it might not be hard to push the return chasers into the bullish camp.
Finally, I think more funds will look at the illiquid and “story” credit names in high yield. Chesapeake CDS has moved a lot more than the stock – that could be a name to focus on. Names, like Harrah’s, which have done a lot of right moves on the credit side and haven’t been rewarded, may also catch a bid. I have to look closer, but the short dated CDS market had been bid up by the whale, particularly high beta names. That might be another area where funds come in and push the markets tighter.
Monday will be a key day. It will be important to see the progress from Friday hold. The market doesn’t have to go higher, it just needs to hold and I think you will see money come into Spanish and Italian bonds (emphasizing 5 years and in), with a growing interesting in buying weaker and less liquid high yield bonds.