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Credit Spread Compression


Starving artists are painting a dangerous picture.


Credit spreads are essentially the difference in interest rates an investor demands for corporate bonds over treasury bonds (corporations are riskier, so an investor rationally expects to make a higher rate of interest on corporate bonds). The less risky those corporate bonds, either due to an improving balance sheet or improving economy, the less those investors will demand in the spread between the two. As the spread narrows, the financing costs for companies goes down; the less cost, the better the company can perform.

So generally improving credit spreads usually indicate improving conditions. Those improving conditions are good for nominal equity prices in varying degrees, the magnitude depending on where in the cycle we are.

There are many ways to measure credit spreads due to new "synthetics" or derivatives and things can get confusing. Suffice it to say that credit spreads in general have come down over the last several months to historically low levels as investors are demanding less and less of a risk premium for corporate bonds of all types.

Brian has spoken much about the effects of this, but we both think it is crucial to understand the reasons behind it, for the effects may look and act healthy, but if the reasons are mostly technical, then these effects are potentially severe long term negatives. We have had a good idea for some time what has been driving the narrowing of credit spreads. We recently hired an independent research group to verify our view and they have confirmed our thoughts.

The primary buyers of credit (those choosing to invest in corporate bonds instead of treasury bonds despite less and less of a spread) over the last several months have been pension funds and insurance companies. We offer that the reason they have been so aggressive in buying credit is because they are simply starving for yield. In other words, it is out of desperation that they have been willing to increase their risk, not out of a perception that that risk is lower.

Insurance companies through their activities issue products like whole life insurance contracts which guarantee a rate of interest. As interest rates have come down, if they have not properly locked in a positive differential between what they earn on their investments (equities and bonds) and what they pay out on these contracts, they will have a mismatch between what they are earning and what they are paying. It may sound ridiculous, but insurance companies take this risk and have gotten themselves into a situation. To compensate for this negative gap, they have been "forced" to buy riskier and riskier fixed-income assets (and in some cases increase their equity exposure as well).

The pension fund liability situation with many companies has been well documented. Pension fund accounting is dark and mysterious and we have written on it before. A pension fund simply makes an assumption about what they will "earn" on their investments going forward and gears all appropriations to the pension fund accordingly. The higher their assumed investment rate the less the company has to contribute in order to pay off their future liabilities (they have also recently gotten relief in the calculation used to approximate their liability as well). For example, General Motors (GM:NYSE) is still assuming it will earn around 8.5% on its investments in its calculations. The ten year treasury yield is 4.19%. This is called a negative liability gap: if GM were to assume that it would only earn the 4.19% on its investments, their pension fund would require a massive infusion from the company. So just like the insurance companies, pension funds have been "increasing their risk" to get a higher return in order to try to close this gap.

So instead of the driver of lower and lower credit spreads being expert credit analysis, we feel in these two cases it is more a function of chasing yield. In 1999 in order to close the liability gap, many of these entities went into higher beta stocks. We all remember what happened in 2000 when that unwind occurred.

The third and perhaps largest buyer of credit spreads is being done by none other than hedge funds. In analyzing the flow of funds data it is revealed that a huge demand is coming from the Caribbean; it just so happens that most offshore hedge funds are domiciled there. If a broker has demand for a credit default swap from a hedger (perhaps another hedge fund buying a convertible bond wants to hedge out the credit exposure), a fixed-income hedge fund will step in and sell that swap, assuming the credit exposure. That hedge fund will then hedge it dynamically through a complicated basket of CDO's or just by selling a portion of the corporate bond itself.

There are two essential points here. First, since the hedge fund is essentially selling an option on the credit, it turns out that the swap will trade at a lower price than it would if it had to clear the market on pure sentiment (this is how option markets provide liquidity: options exchange price risk for convexity risk). Second, and as a consequence of the first, this process introduces short convexity into the system.

The crux of those two points is this: credit spreads are being sold using leverage by hedge funds.

This whole process is called compression and we have talked about it before: markets moving in one direction for the technical reason of "starving for yield". No one sees the unwind coming until it is too late because everyone is instead busy getting into the market.

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