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Credit and Rates Update


It's time to take a look at high-yield credit spreads and other issues in the international credit markets.

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High-yield spreads have widened out by 20 bps in the past two weeks after tightening by 50 bps from the wides of the summer. A sensible reason is profit-taking. Additionally, investment grade spreads are also widening out by a few basis points after spending the past five months stuck in a 5 bp range. A large part of this is due to the avalanche of issuance scheduled for this week after a mostly dead August. There was $3 billion of HY issuance in the entire month of August, but almost four times that in the first week of September. Investment grade issuance was $58 billion last week -- the busiest wee of the entire year even though it was only four days!

A riskier short-term play would be to buy HY outright in about 10 days with the horizon of selling early next year. The expected total return is 4.9% if you keep an average duration of 7 assuming 45bps of spread tightening (from 395 to 350 - currently 388) and carry/rolldown over the 4.5 month term.

At that point, should the Fed still be on track for a mid-year 2015 hike, I am a seller.

Closed-end municipal bond funds have weakened significantly over the past five weeks, as much as 4% versus their underlying NAVs while the value of their portfolios has actually risen. Municipal bonds, on a spread basis, have the worst seasonality in September and that sentiment is being reflected in these funds. On average, these funds are running 3.64% below their annual median discount to NAV. Once negative Treasury seasonality ends in the second week of October, you can start looking at these funds from an investment perspective.

However, solely for the closed-end space, their weakest months of performance is December, but there most likely will not be tax-related selling this year.

Spreads on muni bonds are now fairly valued across the spectrum and even rich for the intermediate sector. For a similar level of liquidity, I'd prefer munis over high yield at the moment.

The differential between IG and HY spreads in the UK is now at a multi-year wide, as expected. This is purely a function of the portfolio balance channel. As the horizon on expected returns on cash begins to turn more positive, the investor class reduces its overall risk level and "rolls back in" on the risk curve. The easiest example is the IG/HY spread, shown in this chart:

Click to enlarge

The spread peaked a week after the bi-annual speech by Carney in June that shocked the UK interest rate markets. The lower-rated issuers, who have lower cash flows and higher debt ratios, are more subject to default-type events when the liquidity tap begins to tighten and investors move up in seniority or in ratings. I've found the best way to see this relationship in the market is looking at the spread between the 6th and 10th future money market rates to see how the market "tightens." If the Fed stays on the current course of a mid-year 2015 hike, then the interest rate markets predict that we'll experience this event near the end of January 2015.

That will provide an opportunity to buy HY CDS (even through the new ETFs) and sell IG CDS -- the easiest way to put the trade on. I have every intention of doing this trade, but we're still a few months away. A similar relationship is seen in UK small caps vs. large caps, which I assume will be present in the US as well.

A few clarifications/counterpoints that were brought up by a few people regarding the above on the UK. I don't know if the trade is due to the Scotland, but it would be extremely peculiar if it was since the trend has existed for more than three months. Also, I don't know the size of the UK debt markets (IG and HY) with regards to it being an idiosyncratic experience. I also am not sure if moving in along the risk curve will affect EM debt as well (dollars would be repatriated) because the correlation has not existed recently.

Twitter: @MichaelSedacca

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