Where is the value in the market?
Where is the value in this market? What looks cheap? What has good risk/reward? That is a constant complaint. The high yield market is trading at pretty tight levels. Big liquid names have been picked over, so you have to go for less liquid names or story credits to find value. But you should be looking at high beta high yield CDS.
Who is the buyer of HY CDS?
There have been 4 primary sources of credit protection buyers of high yield names:
- Correlation Desks and Tranche Traders. These desks take risk on a “slice” of an index and can trade some single names around it. The whale is legendary for having bought lots of short dated protection on high yield CDS indices both outright and in tranche form. The tranche shorts put a lot of pressure on the high beta single names. That trade is over with the CIO office shuttered. And its not just JPM, as firms like Barclay’s and Morgan Stanley get added to the list of banks pulling back from CDS correlation trading.
- Loan hedging desks. Hedging desks have been a big part of the bid for high yield names. Banks make loans and then try and win bond underwriting business. But the Fed has been pushing to change that. Stress tests reward banks who put the loans in banking books. That should relieve some of the pressure to buy CDS. Whether or not that is good long term is debatable, but it was a source of protection buying that is diminishing. With the CLO market gaining momentum, and leveraged loan ETF’s starting to show decent inflows, there is no shortage of outright buyers of loans if banks want to reduce risk in a more “traditional” way. There is an ever growing taint to companies that announced “hedged” positions rather than small outright positions.
- Index Arb activity. There remains decent activity in index arb, and since the high yield index is notorious for trading cheap to fair value, the trade is typically to sell protection on the index and buy protection on the single names. The overall strength in the high yield market is reducing the demand for index hedges (and more investors are shifting to using ETF’s for their hedges) so the index is less likely to be as wide as often. Then there is the issue that single name liquidity for high yield is abysmal. The index can be “cheap” on a theoretical basis, but the ability to execute the arb is very low in high yield. That again removes a potential buyer.
- Shorts, relative value, cap structure arb, etc. This source of buyers of protection remains.
Who is the Seller of HY CDS?
You? This is a serious question. There has been a shortage of investors willing to sell protection on high beta names. Lots of reasons are given:
- It’s too illiquid. Yes, many of the same hedge funds that complain all day long about how the ETF’s are driving the liquid bonds too tight, turn around and buy those same bonds. The liquidity premium is too high, and given a lot of returns I see, maybe the strategy should be to find good investments priced with the most attractive risk reward. The inflow into cash continues, which supports bonds, but soon the only “alpha” left will be finding “beta” that has been ignored.
- I hate CDS as a product. Tougher to argue with that one, but hating something to the point where you choose not to use it, isn’t a great investment philosophy. High Yield CDS, for all its short coming, has at least never really had a disputed Credit Event and the settlements on Credit Events have all made sense. There will be volatility, and there will be days that you want to punch the screen because some “26 year old quant jockey” is driving CDS higher while bonds are performing, but as a risk/reward over a longer period that problem should go away.
- The technicals are bad. Back on April 9th I wrote about IG9 10 yr as a good basis trade short. I had conversations with some clients even before that. The response I got over and over was “The technicals are awful”. “Big bad JPM keeps selling it, I’ll get crushed”. “It might be rich but it can stay rich longer than you can stay liquid”. “The technicals are awful”. Nothing changes technicals faster in CDS than a catalyst that triggers the P&L stop loss dance.
Defaults Are Harder to Come by with a strong Loan Market
Companies can be bad, but if the leverage loan market is strong and CLO’s have a need for loans with high spread, then companies can survive much longer than otherwise. It might subordinate some of the debt, that is a risk, but with CDS, particularly short dated protection, the availability of new senior secured loans tends to be a help because the decreased probability of default far outweighs the decreased subordination in event of default.
HOV had a catalyst today. Positive news from a credit perspective, but where is the value and what is moving?
The 10 5/8’s bonds moved 5 points so far today. They went from 97.5 to 102.5. Not shabby, but at that price they are starting to trade to their 2015 call date rather than their 2016 final maturity.
5 year CDS on the other hand is 11 points better. From 38.5 points up front to 27.5 points up front. It is unsecured versus 1st lien, so some of the outperformance is that, but also, where is the bid? Who really know this credit so well and wants to short it? Maybe a cap structure trade?
What if people really believe that more of these high beta companies will take advantage of a decent stock market, sluggish but okay economy, and strong demand for credit to continue to repair their balance sheets?
AK Steel Tomorrow?
AK Steel is another reasonably active high beta name. Bonds are trading at 87, but CDS is 22 points up front. The bonds are all trading “special” in that there is no borrow, so all shorts have gravitated to the CDS market. If China can stop the GDP slowdown and produce numbers in the 7.5% range, will investors still want to be short this name? They won’t be able to buy bonds versus the CDS since the float is small and tucked away (hence no borrow). So they need to buy CDS that is already cheap in a name that would be feeling good. This is definitely a risky play, but is something investors need to be looking at, especially if the real value is in the CDS and not the bonds. Certainly at 22 points up front vs bonds at 87, the jump to default risk is in favor of selling CDS, and I think the squeeze risk to the upside is also in favor of selling CDS.
Chesapeake, everyone’s favorite short
Who doesn’t know that Chesapeake needs to borrow? That they have issues? The stock has stabilized, and the credit is improving, but the next leg, where is the value likely to be? It seems more and more than the CDS offers better value than the bonds.
The list of potential names is long. Each one has its issues, but in tight credit environments, you make money by finding the best opportunities, not just riding the beta wave.
What and When and Who
I’m not sure the exact credits – it is still a name specific risk market. I’m not sure when the “capitulation” will come. On the other hand, the JPM news helps. Catalysts like HOV put some fear into shorts. With so much liquidity premium built into bond prices, finding a source of credit risk that is paying you for the lack of liquidity is key. Also, with many reasons to suspect the base of potential credit protection buyers is shrinking there is another reason to take a very close look at selling CDS on high beta High Yield names, if not actually executing.