We have recently discussed (with clients and media alike) the growing sense of euphoria that exists in the high yield credit space. Whether it is fund flows or the extremely bullish sentiment seen in AAII surveys on stock investors, the Fed’s decision to push investors to reach for yield may have unintended consequences as holding back the specter of global deleveraging and the tightening of global credit standards lead to one inevitable conclusion – rising real defaults and slower growth in the real economy. Below we highlight the six main canaries-in-the-coalmine that make us nervous to add HY exposure at these levels.
This week has provided a great deal of activity and rather abrupt shifts in many of the most active bond ETFs that we follow and utlize for individual (and many professional) investors. Furthermore, the interactions with other asset classes and between OTC and exchange traded products also offered some unique insights. In this post we discuss several of our ETF-based relationships in more detail and point to some interesting opportunities.
Ironically though, we start the discussion with one of our better known relative-value indications – the risk basket – which has been surprisingly well-behaved all week. The upper chart shows that the relationship between the risk basket and S&P futures has generally held very well with periods of clear OTF buying and selling pressure that have led or lagged the risk basket’s moves. What we find most intriguing is that wehave not adjusted the framework since early Monday and for once the S&P and its basket proxy have comverged over a slightly longer time frame.
We were rather surprised at the shifts in stock markets late in the day yesterday relative to all the other asset class contexts that we track and based on this strongly suggested entering the ETF Arb position to take advantage, in a relatively risk-reduced way, of that view. This morning, we see the window-dressing bid removed and another set of weak macro data to drive equity prices back into line with our risk basket and directionally in our favor in the Arb trade.
We would take off half the position here for a fast 7-8% gain, never one to look a gift horse in the mouth, shift stops to breakeven (around $18) and look for a $16 target in the short-term. Our other ETF-based position (weighted HYG-LQD), entered on May 6th is also doing well as our view of HY-IG decompression cont-nues to play out. The 1.2xLQD vs 1x HYG position is up around 4.5% and half way to its target.
The dismal ADP print and somewhat expectedly (at least by many of us that bother to look at it as opposed to the 82 economists that blindly forecast it) weak ISM data has taken away all of yesterday’s equity gains holding S&P at around Friday’s closing level (slightly below intraday). HY is also back to the same level, Friday’s close but IG remains slightly tighter – implying more up-in-quality risk aversion from investors even as non-financials in Europe underperform relative to financials on the day.
Credit spreads decompressed modestly today in IG and HY as almost every other asset class saw dramatic moves and equities saw their largest day-to-day underperformance of credit since 3/10 (based on our relative-value models) – even more so than last Thursday’s underperformance.
We commented earlier in the day on the velocity of convergence today and exited half our ETF Arb position by lunchtime and hit our adjusted target of $16 mid-afternoon for a very rapid ~12% return (unlevered).
We have been aggressively discussing our view of equity being over-priced relative to credit and why we did not think this was entirely due to any capital structure shift (intentional releveraging) for a while now and it is certainly the case that recent events have converged this relationship but there is still a considerable way to go. We remain short-term traders of the ETF Arb position (opportunistic) but from a tactical asset allocation perspective up-in-quality and up-in-capital structure are the way to go still.
Our late day entry into the ETF Arb position we have been so active in has rapidly moved into the money as equities have underperformed handsomely this morning. We were slightly anxious at the entry’s time given the relatively quick re-entry post our last profitable result, however, we were proved correct.
The velocity of this morning’s move however does warrant not looking a gift-horse in the mouth and we suggest taking half off for a 7.5% profit and shift stops to $17.5 (from $18.1 entry).
If we hit $16 today take it all off for a very nice profit.
For more color on this trade (and the rest of the successful trades we have undertaken using this approach – see our bonds section)