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Credit Default Swaps (CDS) are not evil.
Now I know that many of you will stop right there shaking your head in disgust at me for arguing that CDS are not evil, but you shouldn’t.
CDS are an integral part of the market. The HY CDS index still seems to trade in the $5 billion to $10 billion range daily. Even after accounting for the fast momo accounts that are merely trying to whip and drive the street and catch someone “off sides”, there is legitimate volume that goes through, more than in the ETF space. The investment grade CDS world still has large flows, particularly the IG index, even if they are less important than they once were.
Too many people choose to ignore CDS, or worse, just right it off as some inherently dangerous product. There is no other subject in the financial world where you can say whatever you want about something, but so long as it is bad, someone is happy to treat it as gospel truth. Anything you say bad about CDS attracts followers with less fact-checking than a Fox News Skit on Saturday Night Live.
There is nothing inherently good or bad about CDS. It has problems, but it also has uses. Understanding it and figuring out what is driving the flows in that market may sometimes provide an edge in the broader markets. There will be lots of times it adds no additional value and sometimes it throws off false signals, but it is useful often enough that it shouldn’t be neglected.
Much the same can be said about ETFs.
Less Liquid Asset ETFs
ETFs covering less liquid asset classes are suddenly under fire; whether gold, or some EM stock markets, or high-yield bonds, the world is suddenly taking real notice of the associated ETFs and their potential impact on the market.
This will create opportunities, but only for those who are willing to dig a little deeper into what is going on. We were early in describing how we saw the ETF Spiral™ potentially playing out, both positively and negatively.
No one cared when the impact was positive, but now that it is potentially having a negative effect, everyone's paying attention.
Notice we used the word “potentially” because what we are seeing in the rush to condemn ETFs is a lot of analysis that is mostly self-serving rather than aimed at figuring out what is really happening and how to trade around it.
Heisenberg’s Uncertainty Principle and Fixed Income ETFs
The “uncertainty principle” states that "the act of measurement always disturbs the object measured”.
I don't know much about science, but I think this is an important concept.
We all know fixed income indices were designed more as “marketing” tools than as indices that could actually be replicated in real-world trading..
They have assumptions that are nice for “tracking” purposes, but are completely unrealistic for actual replication.
No transaction costs as names get upgraded or downgraded in/out of indices.
All new issues that qualify are brought in at the new issue price, assuming a full allocation.
Accrued interest tends to be rolled monthly into the index, which has a compounding effect that can’t be matched.
So unlike equity indices that can be exactly replicated, in fixed income, we start with something that cannot be matched.
This adds another level of complexity to the situation and has led to this belief that there are such things as “ETF bonds”.
There Were Index Bonds Long Before There Were ETF Bonds
The term “index bond" has existed long before the creation of ETFs.
Bonds of the same issuer, but which for some reason (usually issue size) don’t qualify for the index can trade at a discount to the index-eligible bonds. Part of this is just an excuse to bid down smaller issues, but this is not new to a world with ETFs.
There were similar upheavals when Lehman changed their ratings criteria to include Fitch.
Over time, there has always been this concept of “index” bonds which impacted their pricing. It isn’t new and it isn’t entirely specific to ETFs.
But you can start seeing how Heisenberg’s observation applies to the bond world when we try to “measure” the indices through ETFs.
Note the following:
Being in the index can affect prices of individual bonds.
The ETF, trying to replicate the index by proxy, affects the valuation of the indices they are measuring.
So things become interconnected, but just like with CDS, it isn’t necessarily bad and it takes time to understand the dynamics to trade them well.
Three Big ETF Myths
1) ETFs Are Driving Redemptions
No, redemptions are hitting mutual funds as well. It isn’t isolated and the reason someone is selling an ETF is at its core the same reason someone is selling a mutual fund – they no longer want to be in that asset class.
ETFs do have more stop-loss day traders making the moves hit faster, and mutual funds are generally held longer, so at the margins, the sellers are slightly different, but to think someone wakes up one day and decides to sell their high-yield mutual fund because SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) is getting crushed is a stretch.
The reasons for wanting to sell are there regardless of the instrument. It is just as easy (and probably equally incorrect) to argue that people want out of their longer-term assets but sell the ETFs because the liquidity is there and the fees are lower and they have no barrier to buying back in.
So as a whole we do NOT view ETFs as driving the redemption process for an entire asset class.
2) The ETFs Own Only the “Liquid” Bonds and are Hurting the Market
Most hedge funds and trading desks sit on the exact same sort of “liquid” bonds. Allegedly, ETFs own these bonds because they follow dumb replication strategies but certain managers sit on them because they will see the turns in the market and berate dealers into giving them good bids so they can flee the market early, while those same dealers own the bonds because there has been a “street bid” at which they can sell.
Investors and traders of all types own similar bonds because they are attracted like moths to the flame by the perceived liquidity. At least ETFs have to own these bonds; whereas many market makers and some momentum accounts have chosen to own them. Now that they have been burned by the flame as liquidity was more abysmal than they thought, all they can do is write articles blaming the ETFs for their own folly.
So the “liquid” bond phenomena is not an ETF one, it is just easy to blame them when the strategy didn’t work as expected.
3) The ETFs Distort Market Prices
In the good old days of high-yield bond trading where good-looking people swaggered around desks negotiating bond prices over the phone, doing everything in their power to protect the desk, maximize value, and not upset the apple cart, here is how a typical down day would work.
Trader sends out a morning price of 99.50/100.
Phone immediately rings.
Sales knows they have a trade.
Trader knows he is too high and tries to flake.
Sales rolls their eyes and demands a bid.
Trader bids 99, sales tells client in a voice that is both apologetic and completely demeaning to their own trader that the best the trader can do right now is pay 99 (his tone conveys that the homeless person across the street would have made a better bid).
The client has to seem annoyed that the trader flaked, that he could have gotten that bid from 10 other firms and that by going to their "go to relationship”, they just cost themselves money, even though the client is now seeing the market go offered without.
Blah, blah, blah, after some more back and forth and asking about more variations on how to work an order than you thought possible, the dealer takes down $2 million at 99 to work 3 million more.
They spend the rest of the day flogging those bond, and dodging the client who is trying to grow the ticket to $5 million.
At the end of the day, the dealer is still 98.5/99.5 better seller.
The client tries in vain to get the dealer to upsize the ticket to $5 million, then asks the dealer if they would take $3 million more at 98.5. The dealer says “they would rather not” as the TRACE print would hurt the overall position and they are sure that they are developing a buyer in the 98.5/99.5 context – which translated means, that the dealer would hit a 98.5 bid so fast it would make your head spin and only once he got off the original position and a small short off would he come back to take you and your bonds along.
So in those days, everyone would go home with bonds marked at 99, where they last TRACED and centered around the last market the trader had sent out, in spite of knowing the real market was probably 97.5/98.5. The sad thing is those good old days were yesterday.
In this world, the ETF, like Index CDS, probably moves to the right price faster than the “index” it is benchmarked against. More often than not (but not always), the ETFs reflect reality that the quote-only bond market and its associated indices don’t reflect.
What We Watch For:
1) Real Discount/Premium to NAV
When there is a real and monetizable discount or premium to NAV, you will see trading that tends to push markets in the direction of the discount or premium. The pure arbitrage activity has this impact, in spite of the fact that in theory, it should act to close the discount/premium rather than reinforce direction.
2) Late Day Clean-Up Activity
When you get the sense that dealers in particular, but even clients, resort to the ETF market to manage risk late in the day because they couldn’t get execution in the bond market, that also puts the spiral into play.
3) Capitulation Bond Selling
When you finally see bonds coming out and bids getting hit rather than simple screwing around with ETFs, you are getting close to the bottom
4) ETF Snap Rallies
The recent snap rallies in many fixed income ETFs were a clear sign that they are dominated by shorts and susceptible to a squeeze. The cheapness will attract buyers too, especially in the early stages of a rally where someone already long bonds might not commit to yet more bonds, but will increase their beta through the ETF. We saw this early last week, and think we will get set up to see again this week.
5) When My Mother Knows Something
By the time my mother knows something, the trade is usually just about over. While my mother hasn’t called yet to complain about ETF’s, it cannot be far away. That will be a good indicator that it is time to buy again as everyone has gone overboard and forgot the value proposition that ETF’s offer.
Not Evil but Far From Perfect
These past few months have highlighted some of the shortcomings of the ETF products, particularly in less liquid spaces. ETF providers will do well to work on improving what they can. Investors will do well to make sure that they fully understanding both the benefits and limitations of ETFs.
I suspect the ETF discussion will get far more interesting than it already has but don’t get caught up in the hype as not everything you read is right; there are agendas at play, and the real signals and opportunities that present themselves in this market are more likely to be caught by paying attention to this corner of the market, rather than ignoring it, or worse yet -- endowing it with a “morality” that it just doesn’t have.
Editor's Note: This article is a free edition of Peter Tchir's Fixed Income Report. For a two-week FREE trial, click here.