Corporate CDS tightens to multi-year lows; bonds lag

US corporate CDS are tightening to new lows, as the Fed continues to pump liquidity into the market. The JPMorgan CDX indices which measure spreads for the "on-the-run" CDX (and include rolling into the most current series) are showing the tightest spreads in years. In fact the HY CDX spread is now at levels not seen since 2007.

Source: JPMorgan

Bond spreads have been tighter as well, but have not kept up with the action in the credit default swap market. The chart below shows how HY bond spreads performed over the same period (compared with the chart above).

Part of the reason for cash bonds' underperformance vs. their synthetic cousins is the unease with fixed rate products such as corporate bonds. Selling CDS is a way to increase corporate credit exposure without taking on rate risk (as opposed to buying corporate bonds).

The same trend is taking place in the investment grade universe. The JULI spread is JPMorgan's investment grade bond index spread, which is regressed against the 5-year IG CDX below. CDX spreads have tightened considerably more than bond spreads.

Source: JPMorgan

In the past, market participants would close this gap by buying corporate bonds, buying cheaper CDS protection and entering into a rate swap.  But with rate swaps expected to move onto the clearinghouse, there is risk of having to post margin on both the bonds (at the prime broker) and the swaps (at the clearinghouse) - making it less appealing to for traders to execute this arb. Regulation is creating a bit of a market distortion.

The upshot of the latest market moves is that credit risk appetite continues to increase, approaching the pre-crisis frothy levels. At the same time investors remain cautious on interest rates.

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From our sponsor:

Credit is finally getting back to reality

After months of frothy conditions, credit valuations are finally beginning to correct. High Yield has traded down materially, as investors have had enough of ridiculous pricing in this market (see discussion).

HYG (HY ETF)

HY CDX traded down to 97.5 after being as high as 101.5 a month ago - a material move even for this market.

Black line & RHS represents HY CDX price

Investment grade spreads widened as well, with IG CDX increasing to 108bp from near 90bp a month ago. Some managers are taking chips off the table before the impending political mess of the US fiscal budget fight. It's finally time to get back to reality.

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Six observations about index CDS markets

Once again it's time to clear up some misperceptions about the CDS markets. In particular, let's take a look at CDS index trading. The chart below shows one-month daily trading volume averages for the various CDS indices.

1-month daily average CDS index volumes ($bn; source: JPMorgan/MarkIt) 

Here are some observations:

1. CDS index trading is dominated by corporate unsecured credit, particularly investment garde: IG CDX and iTraxx Main.

2. European corporate credit trading is dominated by banks (followed by telecoms), while the US actively traded credits tend to be non-banking firms. That's why iTraxx Sen Fin (senior EU bank credits) is so popular. Barclays and Banco Bilbao Vizcaya Argentaria for example have been at the "top of the charts" in Europe, while the US market shows the highest volumes in GE and HP.

3. Sovereign indices, such as SovX are a fraction of the corporate market. Emerging markets CDX has more volume than the Western European SovX.

4. The market for CDS on senior secured debt (corporate loans), the so-called LCDX, is dead. This market was popular in 2007/8 when people sold protection on LCDX and bought protection on HY CDX thinking that in a crisis secured paper will outperform unsecured bonds - which would be reflected in the spread between the two. But these investors were wrong, as LCDX protection widened out just as fast as HY CDX as leveraged loans took a major beating. Since then the market on loan CDS has all but disappeared.

5. The municipal bond CDS index, MCDX never really took off and shows little improvement. As much as Markit wants this index to be used to hedge municipal bond portfolios, that is just not happening on any material scale.

6. Asset backed indices are mostly the left-over structures from the pre-crisis era. These include ABX (see discussion) and CMBX. They are used for spec trading as well as to hedge ABS and mortgage books. But even in that space users prefer corporate credit indices such as CDX IG and CDX HY to hedge their portfolios. Liquidity trumps increased basis risk these days.

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Credit markets reversing post-QE3 euphoria

In a sharp correction during the past couple of days the HY bond market erased most of the post-QE3 announcement gains. As discussed before (see post), it was clear that the HY marked was frothy going into the Fed meeting, and now asset allocators are starting to come to grips with the fact that it's gotten even richer. HY CDX and HY ETFs (HYG, JNK) sold off sharply (HY CDX is down 2% in the past 2 days).

The realization is setting in that the Fed bringing mortgage rates to new lows (national average is now at an all-time low of 3.46%) is going to do little to improve the US economy (see discussion) and corporate profits. And some of the Fed members agree with this assessment.

MarketWatch: - “We are unlikely to see much benefit to growth or employment from further asset purchases,” said Charles Plosser, the president of the Philadelphia Fed Bank, in a speech to financial market trade groups in Philadelphia.

The reversal in the credit markets is also visible in the investment grade space. IG CDX has reversed most of the QE3-driven tightening.

IG CDX spread (Bloomberg)

No matter how much MBS the Fed buys, monetary expansion is unlikely to help Caterpillar for example. And markets are starting to get the point.

NASDAQ: - Caterpillar Inc. (CAT ), the world's largest manufacturer of construction and mining equipment, recently joined the bandwagon of companies who have trimmed their revenue and earnings expectations in the wake of weaker-than-expected growth in the global economy. This news led to a 2.4% fall in Caterpillar share prices to $88.73 in after-hours trading.

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IG CDX diverges from S&P500; JPMorgan advocates mean reversion trade

As discussed a few days back, the Investment Grade (IG) CDX has underperformed High Yield (HY) CDX since the announcement of JPMorgan's recent loss. On a relative basis, investment grade CDX widened faster than HY. That underperformance is also visible when comparing IG CDX spread levels to the US equity markets.

SP500 vs IG CDX (Bloomberg)

Ironically JPMorgan's research (they do excellent work by the way) views this divergence caused by their firm's announcement as a trading opportunity. Their scatter chart shows that based on recent levels, SP500 and IG CDX are in fact out of sync.

SP500 vs IG CDX recent levels (source: JPMorgan)

That "reversion to the mean" would help JPMorgan's portfolio, assuming it has not changed directionally since the announcement. The problem with this trade recommendation however is that this IG CDX relative widening may persist for a while. IG's underperformance may be around at least until the market is convinced that JPMorgan's "big unwind" of the CIO book is not imminent. And that may take some time - possibly a couple of quarterly earnings releases or the year-end balance sheet statement from the firm.

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JPMorgan's VAR model did not capture liquidity risk of the massive IG vs. HY position

As discussed earlier, we've had a substantial divergence between investment grade (IG) and high yield (HY) CDX spreads that started this year. These two indices historically move in tandem. There has been speculation in the market place that the JPMorgan CIO's activities may be behind this trend. Based on the recent article by Euromoney, that indeed seems to be the case. Euromoney indicates that not only was JPMorgan selling IG CDX protection, it was buying HY CDX protection causing the two to diverge. Effectively JPM was long investment grade credit and short HY credit.

Euromoney: - It is clear that JPMorgan’s CIO sold substantial amounts of investment-grade credit default swap index exposure in the first quarter of the year; market participants maintain that it also bought high-yield default swap protection, with total notional trade sizes running to tens of billions of dollars.

Those trades were unusually large for the credit derivatives market, despite their concentration in indices, which are more liquid than single-name default swaps. The JPMorgan activity helped to fuel the global rally in investment-grade credit spreads in the first quarter and contributed to a widening in the ratio between investment-grade and high-yield spreads, taking the latter to a multiple of roughly six times the former.

This is not necessarily a bad position to hold, except for it's size. The thinking probably was that if the economy stumbles, HY companies will get hurt first and their spreads will widen much faster than those of IG companies (making the spread between the two to widen). But liquidity in CDS markets has not been great in recent years and these large trades began to move the market earlier in the year - initially helping JPMorgan's position.

IG vs HY CDX (Bloomberg)

But now that the market participants got a rough idea of what JPMorgan's exposures are, they started putting on the opposite trades in anticipation of JPMorgan unwinding this book (which may already be taking place). The spread between HY and IG CDX has narrowed substantially since JPM's announcement last week, causing the firm further pain (remember, JPM needs the spread to widen). The vultures are circling...

Euromoney: - The exact details of the trades put on by the JPMorgan CIO have not been disclosed. JPMorgan is understandably unwilling to shed additional light on its holdings, while its market counterparties such as hedge funds have limited visibility on offsets to individual trades, along with a strong motive to talk their own books by speculating about potential eventual deal unwinds.

And now everyone is asking the same question. JPMorgan had fairly thorough VAR models that should have shown a potential for a large loss on these positions. Why was this risk not flagged?

If you look at the chart above (IG vs. HY spreads), it is clear that the historical relationship (on which VAR models are based) has been broken by these outsize trades. Once you have a sudden change in correlation, the model needs to be re-calibrated. For spread positions this large and correlation that starts out close to one (which masks risks of large long/short positions), even a small change in correlation will have an enormous impact on the perceived amount of risk.

Illustration of how a spread position between two assets responds to changing correlation

As the mass media begins to pore over the issue of JPMorgan's VAR models, the reporters will surely miss this one critical point. VAR models generally can not capture liquidity risk. In particular it is difficult to model how outsize trades can impact correlation. Once positions become too large and liquidity declines, even the most effective VAR models break down. And once others learn about your concentrated positions, no risk model stands a chance.

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IG CDX continues to trade tight on a relative basis

Based on recent history, the investment grade (IG) CDX is still outperforming high yield (HY) CDX. That is on a relative basis IG spread is tighter - now back below 100bp.

IG vs HY CDX

Portfolio managers who bought IG protection as a hedge or simply to bet that spreads will widen are bleeding premium without the reward. Just as was the case with VIX earlier in the year, CDX IG has become a poor generic hedge against spikes in risk. Part of the reason may be that banks such as JPM are hedging their own bonds (DVA). Note that CDX IG has a substantial financials component. That means even if dealers sell financials protection against their bonds (and not the whole index), it will still keep CDX IG relatively tight. And betting against JPM or other dealers may be a losing battle.

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The "London Whale" is likely hedging JPMorgan's own bonds

The financial media has had a field day with the recent story about the so called "London Whale". Apparently a trader out of JPMorgan's office of the CIO has been a seller of the Investment Grade (IG) CDX (an index of investment grade corporate CDS).

WSJ: Mr. Iksil has taken large positions for the bank in insurance-like products called credit-default swaps. Lately, partly in reaction to market movements possibly resulting from Mr. Iksil's trades, some hedge funds and others have made heavy opposing bets, according to people close to the matter.

According to the story these trades have been so large that they are distorting the market. A few comments on this situation:

1. The story of large sales of protection are in fact true as evidenced by the recent divergence of the IG CDX and the HY CDX spreads which are generally highly correlated. The selling pressure from the "Whale" or whoever has tightened IG spreads disproportionately to HY CDX.

IG anf HY CDX spreads (Bloomberg)

Note that the spike in both spreads today is due to the relatively bad employment numbers out of the US, as we continue to see more negative economic surprises.

2. The story about hedge funds taking the other side is probably true as well, simply because hedge funds use IG CDX as a general hedge against negative market events. And given the relative divergence here, they saw this index as a fairly cheap hedge/market short. But they clearly have not traded enough to bring the two indices back in line.

3. As IG CDX widened today, it is premature to conclude that JPMorgan has taken a large loss. Let's just put some numbers on it. Let's say JPM is short $5bn of  IG CDX protection. The index has widened 15bp from the lows (85 to 100). That translates into $37mm of losses, barely a blip for JPM's earnings.

4. In general JPM would not do an outright trade like this. Most likely they have something on the other side of the trade that the market doesn't see. It is in fact highly possible that the bank is hedging the volatility in its own bonds. Well publicized accounting rules have banks mark their own debt to market. In difficult times their debt drops in value, and because the bank is effectively short its own debt, it records a gain. What JPMorgan may be doing is protecting itself from the rise in its debt value, which would force them to record a loss. If JPMorgan's credit spread tightens, the firm takes a loss on its own bonds but would make a gain on the bank's IG CDX position as an offset. IG CDX is highly correlated to the CDS of financial companies and is liquid enough for JPMorgan to execute in size. It is well known that Goldman for example has been quite active in hedging its bonds, and is therefore not unreasonable to assume that JPMorgan is doing the same using IG CDX.

Reuters: ... Morgan Stanley reported $3.6 billion worth of debt valuation gains in the last half of 2011, as its credit default swap prices more than doubled. The bank is likely to report a charge of hundreds of millions of dollars in the first quarter if its bond and CDS prices remain stable, analysts said. Goldman hedges its debt valuation risk, so its gains and losses are smaller and harder to predict.

For those interested in this topic, here is a great detailed write-up on the IG CDX recent dynamics and a discussion of the infamous London Whale from Lisa Pollack .

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Leveraged US firms faced headwinds in Q4

The relative health of the US corporate sector can be gauged by the metrics around leveraged companies, which tend to be vulnerable to fluctuations in economic conditions. Companies comprising the CDX High Yield Index make up a good sample for this analysis. These include firms such as TXU, Harrah's, Realogy, Royal Carribean, etc. The first metric that analysts tend to review is gross leverage (debt to earnings), which has risen somewhat in Q4 of 2011.

Source: Credit Suisse

Another important indicator is the level of corporate cash positions. And those have increased as well during last quarter.

Source: Credit Suisse

Subtracting cash holdings from the debt amounts, one obtains the "net leverage". In spite of higher debt levels, the large cash positions have brought the net leverage to the lowest level in years.

Source: Credit Suisse

Why would firms borrow more money (increasing gross leverage) when they have such large cash positions? The answer has to do with what these firms were experiencing in Q4 of 2011. The global economy, impacted by the events in Europe, looked like it may enter a double-dip recession,  So firms who had the opportunity to raise new debt did so, but kept a large portion of the proceeds in cash in preparation for rough times ahead. Companies also had direct reasons to become defensive, as they saw their free cash flow stay at depressed levels.

Source: Credit Suisse

The causes of lower free cash flow included increases in working capital, greater CapEx, lower gross margins, and higher inventory. Q4 was not easy for the HY CDX firms.

In spite of these headwinds, earnings have been coming in relatively strong with Q4 "beats" at roughly three times the "misses" (although a number of companies are yet to report). Going forward it will be critical to see how these firms perform and the metrics around their leverage, cash positions, and free cash flow, as these will tell us what risks the US corporate sector may be facing.

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Market Neutral Anti-Beta Index: an alternative portfolio hedging tool

Implied volatility based products have not provided the hedge effectiveness many managers were looking for in 2011. In some instances, particularly as implied volatility came off sharply, index options simply did not perform as expected for many portfolios.  

The chart below shows VIX futures versus the HY CDX total return index as an example of someone trying to hedge a credit portfolio with a VIX product. Having worked reasonably well through August-October, the hedge behaved poorly for the rest of the year.

HY CDX vs. VIX Futures

There are alternatives to using equity volatility products to hedge a portfolio.  One of those is the Dow Jones Market Neutral Anti-Beta Index.  It represents a market neutral basket of stocks which is long low beta stocks and short high beta stocks.  The idea is that during market uncertainty and risk aversion, high beta stocks will under-perform low beta stocks. The chart below shows that when properly scaled, a hedge using this index would be fairly effective.

HY CDX vs. Dow Jones Market Neutral Anti-Beta Index

There is in fact an ETF that seeks to replicate this index called QuantShares US Market Neutral Anti-Beta Fund (ticker symbol BTAL). It will work for a small investor but may be too illiquid for a larger institutional manager.  But the underlying stocks in the index a fairly liquid and the basket can be easily replicated.  It has to be adjusted on a monthly basis because betas for the constituent stocks change over time.  The index methodology is included below.


Dow Jones Market Neutral Anti-Beta Index

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ICE is asking CFTC to allow CDX and CDS in one account

The CFTC is seeking industry comments on the ICE Clear Credit request for "Commingling" and "Portfolio Margining". As a bit of background ICE (the Intercontinental Exchange) is preparing a platform to clear credit default swaps (ICE would become a "clearinghouse"). It's a slow and tedious process because so many regulatory and "plumbing" (process/technology) issues need to be worked out for CDS.

In their infinite wisdom US politicians have split the regulatory oversight over CDS clearing. Index CDS (such as CDX) are to be regulated by the CFTC, while the SEC is to regulate "single-name" CDS (for example CDS protection on Ford). The rationale here is that the SEC regulates public companies - therefore "single names", while the CFTC deals with futures, many of which are indices. It is quite common for industry participants to have both types in the same portfolio, for example selling protection on one or more single names while buying protection on the index.

Of course neither the politicians nor the two regulators have fully thought this out. After all the futures industry lobby that has been pushing for CDS clearing does not fully understand how CDS is used in practice. Realizing the problem, ICE is trying to get permission to do the following:

1. Keep both single-name and index CDS in a single customer account (separate accounts for different customers of course) in order to allow clients offset gains on one with losses on the other. This is particularly helpful if the strategy is some sort of a spread trade or one type is used to hedge the other.

2. Allow portfolio based margining in this single account. That is if the long and the short CDS have significant risk offsets (short single name CDS vs. long CDX for example), the margin requirement would be reduced. That is the lower the risk, the lower the margin. Obviously there would be the "jump to default" margin charge for each position that can't be "hedged", but portfolio diversification would help reduce that charge.

This is a sensible way to structure CDS clearing and should be permitted. If the CFTC does not accept this request, it will put a significant damper on CDS liquidity, making it that much harder for institutions to hedge credit portfolios and reduce risk.
ICE Exec Summary Portfolio Margining

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Retranching a credit index after defaults

We received several requests to explain how some major synthetic tranches of credit indices such as CDX and LCDX get adjusted when defaults take place. The best way to go over this is to look at an example. Consider the loan index LCDX-12 (if you want to brush up on credit indices, please see the primer in this post). Here are the original tranches of LCDX-12:

0-8% (equity)
8-15% (junior mezz)
15-30% (senior mezz)
30-100% (senior)

That means that on $100 worth of the index, the tranche notionals are:

$8
$7
$15
$30

Each tranche can be traded on its own, allowing someone to go long or short a specific part of the capital structure of this loan index of 100 credits. But since the index was launched, 7 names have defaulted. One key parameter needed here is the average recovery rate, which in this case was 80%. Note that such high recovery is a fluke for leveraged loans this year, but it just happened to be the recovery for these specific names.

Note that as names drop out of the index due to defaults, the equity takes the full loss, while the most senior tranche is reduced in notional. This is equivalent to a static cash CLO deal, where recoveries from defaulted collateral go to pay down the most senior tranche.

With 7 defaults (each name representing 1% of the index) and an 80% recovery rate on $100 index notional, we would expect $7 of defaults, $1.4 in losses, and $5.6 of recoveries. The easiest way to think about this is that losses reduce the most junior tranche, while recoveries reduce the most senior tranche notional. The tranches in the middle stay intact. So here are the new amounts:

$6.6 (8 - 1.4)
$7
$15
$64.4 (70 - 5.6)

But the total notional is no longer $100; it is now $93 (7 names defaulted). Thus the tranche percentages of the lower notional become as follows:

0 - 7.1%
7.1 - 14.6%
14.6% - 30.7%
30.7% - 100%

This index capital structure has changed due to defaults as well as names taken out of the index, and can be significantly different from the original structure.

Inherent dangers in hedging with Index CDS

Credit Default Swaps are often thought of in terms of providing protection against credit events. However in many instances CDS are used to simply hedge against mark to market losses even if there is no default. Some use Index CDS to reduce volatility of portfolios due to spread fluctuations. The concept is that if the underlying portfolio spread widens, the CDS premium should increase as well, providing some cushion against losses.

However the basis spread between cash securities and CDS can widen dramatically, making the hedge fairly ineffective on a mark to market basis. In 2008 some investors wanted to take advantage of that spread, hoping for convergence. The idea is that if a bond yield, less the financing cost (to leverage the bond), is higher than the CDS protection, one can make a "riskless" return by owning the bond and the CDS.

The assumption however is that one has the ability to hold these bonds and the CDS to maturity. But in 08 that assumption went out the window, as banks asked for additional margin to leverage bonds even if they were hedged with CDS. In addition to that, hedge fund redemptions forced managers to raise liquidity. These two events combined to force the unwind of the basis trade, making the bond-CDS spread widen even more. The wider spread created mark-to-market losses for other basis trade holders, forcing them to unwind as well. It was a punishing cycle.

Those who hedged their portfolios with Index CDS saw their hedges fail, as the CDS premiums did not rise nearly as much as the portfolios got marked down. It was particularly painful for those who had to unwind the portfolios, crystallizing the mismatch.

The chart below tracks the value of the Credit Suisse High Yield (a diversified basket of cash bonds) index vs. HY CDX (index CDS on a basket of HY names). CDX here is shown in terms of price equivalent rather than spread (if premiums increase, the effective "price" drops). End of 08 spelled disaster for many who had these types of hedges on, particularly if they beleived their portolios were neutral. The hedge stopped tracking the portfolio completely.



A similar scenario occured with leveraged loan portfolios. The hedge (LCDX) broke down. In addition, during that period the loans and the LCDX became illiquid, making it even harder to unwind. LCDX performed so poorely as a hedge, it never really recovered from the "ineffective" image and continues to be illiquid.



"Neutralizing" credit portfolios with Index CDS hedges is no longer viewed as reliable strategy. Managers still use these products, but it's no longer considered a dependable hedging program on it's own.

For those who are interested in learning more about Index CDS, please see the Credit Indices primer from Markit (below):

Credit markets taking cue from the stock market

From Bloomberg:

Corporate bonds, loans and mortgage securities and asset- backed debt have all weakened or been stuck in ranges in the past three to five weeks on concern that markets strengthened too far, too fast. Yields on high-yield, high-risk U.S. company bonds rose to 9.69 percentage points more than Treasuries yesterday, after falling to 9.17 points on June 12 from 16.62 points on Dec. 31, according to Barclays Capital Inc. index data. Loans to the companies fell to 79.41 cents on the dollar, from 80.24 cents on June 12, Standard & Poor’s data show.

“It’s all sort of stalled out,” Jim Shallcross, who oversees about $14 billion of bonds as director of portfolio management at Declaration Management & Research LLC in McLean, Virginia, said in a telephone interview.

The credit markets in this story are viewed as somehow separate from the equity markets. But in reality the secondary credit markets look to 4 sources for "inspiration".

1. The primary markets: If demand for new issues picks up and new deals get priced differently from the secondary markets, the credit markets will respond.
2. Defaults and recoveries: Unexpected defaults, poor recoveries or unusual court actions will get the markets' attention.
3. Mutual fund flows
4. The equity market: Absent anything unexpected in 1 - 3, the credit market traders will take their cues from the most transparent/liquid proxy - the equity market.

One can give all sorts of explanations for the credit market rally, and recent sideways movement, but the reality is that the credit traders are mostly responding to the stock market. Here is a chart that shows the traded HY bond index (HY CDX), the HY loan index (LCDX), and the S&P500. Both the rally and the "sort of stalled out" part are simply following what the S&P500 has done.



This may be a sacrilege, but a possible way to think about the credit markets these days (particularly the heavily discounted non-investment grade) in a macro sense is simply as low beta stocks.