Corporate Bonds, Derivatives, and How They Wag the Equity Markets

By Fil Zucchi  AUG 29, 2012 11:40 AM

To more accurately guess the primary direction of equity markets, there are better places to look to than stocks themselves.

 


MINYANVILLE ORIGINAL Full disclosure: Much of what appears below I learned through the years from the writings of Brian Reynolds, now at Rosenblatt Securities, who is without question the sharpest bond market watcher I’ve ever run across.

Forgive the wonkiness of this piece, but I thought it would be helpful to explain why I often post on Minyanville's Buzz & Banter (subscription required) about the daily moves in the Credit Default Swaps (CDS) of large financial institutions and EU countries, the issuance of new corporate bonds, high-yield spreads, the two-year swap rates, the CDS on US debt, and other arcane derivatives.

These measures are always helpful to track the mood of the credit markets, but have been particularly critical over the last several years because the corporate bond market has been the primary source of funds to companies for buybacks, dividends, and M&A.

In addition, the bond derivatives market is where macro traders have been heavily involved to protect and/or press the downside of equity markets. Corporations have been the steady, relentless “bid” under equities absorbing the "sells" by institutions managing individuals’ money.  Pull up the quarterly Flow of Funds data by the Federal Reserve, and you will see what I mean.

So given the importance of fund flows from corporate bond sales, and considering that the S&P 500 (SPX) is at a juncture where an upside break could lead to more short covering in both equities and credit derivatives, it is useful to look back at some long-term charts to get a feel for how bullish/bearish corporate bond players are feeling. In other words: Is the bond/derivatives backdrop conducive to corporate bond buyers continuing to throw money at companies, which in turn can use it to defend and/or run up their stocks?

The place to start is the corporate bond market itself, and here we consider two questions. First: Is there good demand for new issuance and at what price? The first two charts show total corporate bond issuance and high-yield issuance since 2002.  I have “crudely” annualized YTD data for 2012, even though the period from September to December tends to see more issuance than the other months.  Regardless, all things being equal, 2012 should be a record year for issuance.


Source: Bloomberg LEAG Tables


Source: Bloomberg LEAG Tables



The next chart shows one of many available HY indices, and it is a good indicator of how aggressively buyers are bidding for bonds.  Econ 101 would suggest that as supply increases, prices should go down (i.e., yields up).  But that has hardly been the case. 

Blips aside (mostly EU crisis related), supply has begotten demand and even junk yields have been on a steady downward path since Q1 of 2009. (You can’t see it in the chart, but the junk market came back to life in January 2009, two months before equities bottomed.  Not a coincidence.) Currently, yields are at some of the lowest levels since 2003, and for investment grade debt, they are at all-time lows.


Click to enlarge

So these three charts suggest that the core of corporate credit is as healthy as it has been in a decade.

The next question is: Can these happy days continue? 

The first place I look to for an answer is the secondary market for recently issued bonds. If the buyers of new issues see their new purchases hold their prices, or even rise, they tend to be happy and to come back for more, even incrementally more.  If secondary trading is weak, it is a major red flag. Here is why: Much of the supply of new bonds is absorbed by bond funds on a leveraged basis. These funds use leverage because they are expected to provide returns to their investors (pension funds, insurance companies, etc.) far higher than what is offered by current coupons.

If prices of bonds newly acquired on margin start falling, the funds are faced with the equivalent of “margin calls.” But unlike a margin call on equities, where the holder can come up with new cash or liquidate a position at the push of a button, forced selling of bonds often occurs in a vacuum and at much lower prices than the last trade. This in turn creates additional margin calls, or forces the fund to shore up the position with new cash. Either way, capital that could have been leveraged for new purchases is now tied up in existing holdings. If this dynamic repeats in a widespread manner (as it happened in 2007-2008), next thing you know, the buyers of new issues disappear.

(As an aside, the illiquidity of the secondary market has been exacerbated in the last couple of years by banks having to shed leverage, reduce their inventory of bonds, and get out of the market-making business. This is likely to be one of the harshest unintended consequences of regulatory reforms the next time the bond market hits the skids.)

I am not aware of an easy-to-follow indicator that illustrates how secondary trading is doing, so I’ve resorted to keeping a rolling watch-list of recently issued bonds, and I simply track how they are trading. Not surprisingly, many of these three to six month old issues are now trading well above par -- so from that perspective, there is no inkling that the corporate bond party is about to end for good.



Next, we must worry about what could throw the corporate bond market off its tracks.

The risks are only limited by your imagination, but my two primary concerns are the obvious ones: Number one, China, and number two, Europe.  I won’t spend any time on these because there’s certainly no lack of discussion on the topics. I will point out, however, that some analysts (Brian Reynolds among them) are of the view that these kinds of exogenous concerns can temporarily influence the US corporate bond market, but are unlikely to be the catalyst for the end of the current credit boom.

I tend to disagree for two main reasons.

First, the only tool available to Europe to try to keep things from unraveling is the printing of fiat money, which entails confidence on the part of the recipients of this currency that it is indeed worth its stated value. By definition, printing of fiat money dilutes confidence, so what’s holding Europe together now is also laying the foundation for its demise. (The same can be said about the US, of course.)

Second, problems in Europe and/or China risk the worsening of “societal acrimony” to a point where, in lesser stable areas, it can flare into violence rather quickly. If that happens, all bets are off.

So how do I track the ups and down of China and Europe?

China’s official data is a sketchy as it is unreliable; as a “command and control” economy, there is nothing that the government can’t manipulate. I find the most useful information to be anecdotal. Images of ghost cities built for millions of people, and empty office towers with enough space for a 100-square-foot office for every man, woman, and child is about all I need to know about China’s “economic miracle.”

Tracking Europe is easier. Aside from the generally available economic data, sovereign CDS and bond spreads speak volumes on the ebb and flow of confidence vis-à-vis specific countries and the euro currency as a whole. Bottom up, the countries currently in focus are Italy and Spain (but I am not ignoring Greece, Portugal, and France), so those are the most important 10-year bond rates to watch. I find it more relevant to focus on levels rather than the daily up and down moves. For example, the 7.50% area on the Spanish 10-year is where the ECB last freaked out and verbally “intervened.”

A similar level for Italy would be the 6.50% area.  Should yields blow through those rates, not only would it make it prohibitively expensive for the countries to service their debts, but it would signal a broader collapse in confidence and an increase in systemic risk. Currently, the Spanish 10-year trades around 6.5% and the Italian 10-year trades around 5.8%.  Neither country can bear these rates long term, but they are buying  time to figure out a solution (if there is one).  Conversely, the German 10-year yield is a reliable indicator of “flight to quality.”  At 1.34%, it’s pretty close to the 1.2% area, which might trigger an even deeper crisis in Europe. 



Moves in sovereigns’ CDS are also a general precursor to swings in the underlying bonds, partly because they insure those bonds, but also because CDS offer macro funds a leveraged way to express directional positions. I’ve put together my own little index of CDS, which includes both shaky nations as well as Germany. You can see from the chart below that in the aggregate CDS, levels are higher than pre-2008 crisis, but well off the highs, and they are generally stable.


Click to enlarge

So, in the aggregate, EU bonds and CDS don’t look healthy nor do they look terminal.

Of course, the EU spasms concern us only to the extent that they impact our financial system or our economy.  To monitor if that is happening, I track an index of CDS on bonds of large US financial companies.  Our big banks --  JPMorgan (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Bank of America (BAC), etc. --  is where EU problems would metastasize first. Of course, these CDS would also warn us of any renewed “homegrown issues.”  Broader non-financial CDS indices such at the Markit CDX.IG 18 can also add color.  As you can see below, things remain boringly steady for now.


Click to enlarge

Lastly, the two-year swap spread and CDS on US debt represent the “contagion warning system.”  While at times macro players have attempted to mess with US CDS just to spook the markets, bona fide spikes have occurred only during times of true stress, and have been concurrent with jumps in the two-year swap spread.  When these two measures start “misbehaving,” they tend to signal that not only are there stresses within our financial system, but those stresses have the potential to become systemic.  As one may predict by glancing at our “boring” big financials’ CDS, US CDS show no signs of concern and two-year swaps are trading remarkably tight.


Click to enlarge


Click to enlarge

 

So, to sum up how I use the aforementioned tools to gauge which way equities may be heading:
Taking a snapshot of all of the above, I would conclude that there currently are marginally serious problems in Europe and in China, but these problems remain localized.  Our financial institutions are perceived (remember, in finance perception is 90% of reality) to be in decent shape, and their post-crisis lingering problems are of no consequence to corporate bond buyers, which seemingly can’t find enough bonds for all the (leveraged) buying power they have. Within this backdrop, equities always run the risk of hitting earnings or headlines related air-pockets, but ultimately the drops are likely to be backstopped by shareholders' friendly actions funded by ongoing sales of corporate debt.
 
Editor's Note: At Minyanville we often argue that markets and stocks are driven by four primary attributes: the fundamentals, the technicals, the structural, and psychology. In this weekly piece, trader Fil Zucchi will attempt to digest these four measures to come to actionable recommendations, but with a couple of twists: Rather than relying on standard technical analysis, he will examine the technicals through the lenses of “DeMark” indicators. And rather than highlighting straight entry and exit points for stocks, he will use options to gain long / short exposure, control risk, and generate cash flow. Investors should note: This column will be written 1-2 days prior to publication, so by the time it appears the prices of the securities mentioned may have changed.
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