Credit markets are off to a pretty crazy start this year.
On January 3, Goldman Sachs was already closing out its #2 trade recommendation for 2013 – a long position in high-yield debt – on account of an astonishing rally that began in November.
Goldman strategists weren’t the only ones surprised by the swift move. Citi strategist Matt King expressed a similar sentiment in a note to clients on January 4, writing, “While CDS has already shot through our 2013 year-end targets (!), cash still has another 20 basis points to go.”
Société Générale credit strategists Juan Estaban Valencia and Suki Mann reflected on the strong demand for credit that has underpinned the January rally in a recent note as well, writing, “We’ve had one of the best starts to a year in the primary markets for investment grade, the best ever for high yield, and the best month for senior financials since January 2010, which underscores just how strong appetite for credit remains, even at the current pricing levels.”
The chart below, via BofA Merrill Lynch, shows the size of the rally in credit – and how it has mostly tracked that in other risky assets like the S&P 500 that began in November.
The big spread tightening in the credit space that occurred when a deal was reached on the “fiscal cliff” is what caused so many Wall Street strategists to blow through their year-end targets only a few days into January.
Photo: BofA Merrill Lynch
However, that uptick circled in the chart above – a significant sell-off in corporate debt at the end of the month – has people talking.
(A quick primer on credit investing: the “spread” refers to the difference between the yield on a corporate bond and that on a government bond. Yields on all bonds are inversely related to bond prices. So, when the spread “tightens,” it either means investors are buying up more corporate bonds, sending yields on those bonds lower, or they’re selling government bonds, sending yields on those bonds higher.)
The “Great Rotation” Versus The Real Threat
At the end of January, there was a sizeable correction in credit that was not reflected in equity markets.
The correction was to be expected after such an astonishing run. Now, Valencia and Mann at Société Générale write, “the bigger question is whether we are witnessing a healthy correction or a more sustainable shift out of credit and into other asset classes.”
There certainly has been a lot of chatter on Wall Street lately about a “Great Rotation” out of bond funds and into equity funds, talk of which was spurred on by big equity inflows in January that actually appear to be the simple byproduct of a raft of special dividends paid out to shareholders last year.
Other banks are getting the question a lot, too. Citi strategist Stephen Antczak writes in a note, “Many corporate investors are increasingly worried about a rotation from credit into equities, particularly one that is prompted by higher Treasury rates.”
While a rotation may or may not be happening – at least, not yet – it’s undeniable that Treasury yields are rising. Last week, the yield on the 10-year Treasury climbed past 2 per cent for the first time since April.
Antczak says regardless of the flows, rising Treasury yields in and of themselves are a big deal for investors in corporate credit. His latest note to clients sports a rather ominous title: “How Afraid of Rising Rates Should We Be? More than usual.”
In the note, Antczak stresses how exposed investors in corporate debt are to rising Treasury yields and points to a few major causes for concern.
The Rise Of Mutual Funds
The first thing to remember, writes Antczak, is that mutual funds and ETFs together are responsible for a big portion of the marginal flows into corporate credit markets in recent years. Mutual funds now account for $1.7 trillion of the market, up 69 per cent from the first quarter of 2009, and ETFs are responsible for $200 billion – up 328 per cent in the same time period.
The chart below should offer a sense for the importance of mutual funds and ETFs (along with life insurers, which have also piled into corporate debt in recent years).
Photo: Citi Research
Antczak explains why the rise of mutual funds and ETFs in the corporate debt market – reflecting increased access for retail investors – is so important (emphasis added):
The problem is that these investors tend to be backward-looking and sensitive to total returns, particularly negative total returns. And if 10-year Treasury rates were to rise anywhere near what our economists expect (again, 2.5% by year end) total returns in the corporate market may very well be negative. And if returns do in fact turn negative, we would expect investors to scale back mutual fund investments, creating forced sellers.
Forced selling is a problem when there is no one else to take the other side of the trade. Making the situation worse is the amount of risk investors in corporate credit have taken on as of late.
Record Levels Of Duration Risk In Corporate Debt Markets
Mark-to-market risk in corporate debt – as measured by DV01 – is at an all-time high.
Note: The term “DV01” – short for “dollar value of an 01” – refers to a bond’s dollar duration, which simply measures the amount of money a bond investor will lose on a $1 million bond investment for every 1-basis point rise in the yield on the bond.
Zero interest rate monetary policy in developed economies has pushed investors to take on more and more duration risk in their portfolios. With lower interest rates across the spectrum of maturities, investors move to longer-term debt to collect yields previously available from shorter-term debt. The problem is that the value of longer-term debt is more susceptible to changes in interest rates – hence the duration risk.
In other words, corporate bond prices are extremely sensitive right now to a rise in interest rates. The amount of money an investor stands to lose on his or her corporate debt investment for every uptick in yields (remember, yields and bond prices are inversely related) is at historic levels.
The chart below shows DV01, which Antczak characterises in his note as “WAY above its long-term average.”
Photo: Citi Research
Antczak writes, “Extreme mark-to-market sensitivity and extreme mark-to-market risk in a rising rate environment can’t be a good combination.”
Credit markets have undergone a substantial metamorphosis in recent years as a world of ultra-low interest rates has forced more and more investors – searching for yield opportunities – into investment grade and high yield corporate debt.
Now, everyone is on the same side of the trade. The changes in corporate bond holdings among various types of investors charted above lead Antczak to conclude that “essentially everyone that has been adding risk is real money, long-only investors.”
This leads to an important question, says Antczak:
“If mutual funds and ETFs are forced to sell, particularly given that the Street is still not willing to boost risk positioning, who will take the other side?“
The answer: “Perhaps no one, at least not until valuations cheapen meaningfully.”
For their part, Valencia and Mann at Société Générale don’t see the recent pull-back in corporate debt as “anything more sinister than some heightened nerves following a tightening that was overly aggressive as we kicked off the year.”
However, according to the two strategists, the sell-off does highlight a major concern – the same one hinted at in the question posed by Antczak above.
The Street doesn’t really maintain much inventory of corporate bonds anymore.
Valencia and Mann write, “the difficulties the Street faced to absorb one way flows recently highlights how vicious a more structural unwind could become (when we get sustained growth) given the lack of accommodation of emerging bonds from the Street when we get a sell-off.”
As mutual funds have bought up debt in recent years, dealers have seriously pared back inventories.
Citi strategist Matt King highlighted this dynamic recently in one of four “charts of the year” submitted to Business Insider:
Photo: ICI, NY Fed, Bloomberg, Haver Analytics, Citi Research
King put it this way: “Second, market liquidity. Since 2007, credit mutual fund assets have doubled, while dealers’ corporate bond inventories have halved. So while in 2007, it would have taken a 50% outflow from mutual funds to double the size of the street’s inventory, now if there were to be a 5% outflow it would double the size of the inventory.”
Valencia and Mann point to this as a sign that “the dynamics of the market have changed in that sense,” and conclude with a warning for clients:
…for now, while the going remains good for continued tightening in credit spreads, the exit will be messy. Hopefully, that’s not something we need to be concerned about for some time yet. So, for the moment, we have a correction, the entry points look/are better although few will be tempted to add – until, of course, someone else goes first.
All of this assumes that interest rates continue to rise in 2013 – but that’s exactly what many are forecasting right now.
In the “forced selling” scenario described above, Citi’s Antzcak thinks corporate credit spreads would eventually tighten “once the dust settles,” but cautions that the path to that end state could be a rocky one.