CDS is both Cheap and Dangerous…
When looking across the credit space, CDS looks cheap.
Looking at the CDX index it is hard to argue that 92 bps is “rich”. Sure, over the past few years that seems expensive, but it has been much tighter. I am still scarred by the days when the 5×10 roll traded wider than 5 year CDS. That was at the height of CPDO silliness, and I’m not sure we get back to 30 bps again, but in a longer term historical perspective, 92 bps isn’t “rich”. Again, this is in the context of a market (or economy) that has incredible support from the Fed. While I don’t think the Fed will be particularly successful in getting unemployment down, I do think they will continue to buy credit instruments and to keep short term rates at zero, all of which should keep the investment grade companies making enough money to handily cover their debt.
Even in high yield, HY19 with a spread of almost 480 looks better to me than HYG or JNK (which are representative of the bond market indices) at 5.5% or so yield to worst. Drifting lower down the liquidity spectrum was incredibly interesting earlier this year, there was value there, and while there still might be more value in illiquid positions, a lot has been sucked out.
JPM CDS is trading at 85. It has a $167 billion market cap, it didn’t lose money in any quarter in 2008, and even the whale trade barely put a dent into its earnings. The Fed is there to support it. While I think the stock may be overvalued here, and earnings growth might be limited, in part because of the Fed, it seems hard to argue that the CDS is rich. 10 year bonds yielding 2.85% or T+105 seem less attractive to me, but even there maybe there is room for further tightening.
So, looking through the credit world, there are lots of reasons to think CDS can go a lot tighter:
- An okay economy is enough for more companies to do perform on their debt
- Banks are under pressure to lend more (both from a public policy standpoint and from a NIM standpoint) and to hedge less
- CLO’s are in demand as high grade investors search for spread product, ensuring access to loans for weak companies, further reducing likelihood of default
- The Fed is buying $85 billion a month of mortgages and treasuries, and would be happy to add if they think it is necessary, and as I wrote in our more detailed look at the treasury market, every sign is they will add more to keep yields on credit products low
- Clearing may ultimately help, especially on the bank CDS spreads because there should be less need for counterparty hedging
There are so many reasons to like CDS, so what is the issue?
We know the Cheap, why Dangerous?
Hedges are the first to move. I think the fixed income markets, credit markets in particular are very crowded longs right now. Positions range from long, to longer than usual, to wow, I can’t believe I’m so long. Not a single person seems concerned about being too long. Even today, the sense I get is that most investors are concerned about not being long enough coming into the new year. Crowded trades don’t always end badly. The “pain” trade doesn’t have to occur, especially when the Fed is your friend, but…
But it is often tested. Something happens that shakes the foundation of the reason to be so long, and CDS is the weapon of choice.
Investors aren’t going to sell the bonds they cover, they will short some CDS. That will be the first leg, and with so few people hedged or needing to cover shorts, that leg could be meaningful, and it won’t matter for a minute whether CDS is cheap to bonds, it will underperform.
The roll and year end both play into this as well. Year end for credit is generally quiet so there is no need to be very short. With the single name roll, anyone who wanted to be short would be tempted to hold off until after the roll to buy single name protection. So it isn’t just the indices that have the possibility of a move wider, the single names themselves are likely under hedged.
It Really is a Dilemna
In my ideal world, we get one good move wider. Markets get nervous and we get a day or two of weakness that provides the right entry opportunity. Although it is hard to articulate what the catalyst would be (a fancy way of saying I have no clue), the catalyst is often a surprise that only in hindsight is obvious.
So the other side of the paradox of CDS being the cheapest thing in credit land, but the most dangerous, is the belief that since no one can see a catalyst for a move wider, we must be close to getting one.
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