Credit Markets: When the Chase for Yield Becomes 'Offered Without a Bid'
When the chase for yield becomes an exodus.
Over the past four years, investors of all types have migrated into bonds in search of safety and yield after being burnt on losses in stocks. According to ICI, mutual fund flows alone have seen $1 trillion move into bond funds while $235 billion have been pulled from equity funds. During the past nine months especially, bond funds have seen increased demand as investors "search for yield."
As this demand has increased over the past four years, corresponding yields have decreased. According to the BofA-ML US Corporate Master Index, yield has declined from 7.98% to 2.76% in the present day. Today, demand has never been higher, with yields near historical peaks nonetheless. Issuance over that time frame has also increased. For the month of November, corporate issuance in the US has surpassed $100 billion, well ahead of seasonal norms. At the end of October, year-to-date corporate issuance had already reached $1.3 trillion, more than the entire year's issuance in 2011. This has been the case throughout 2012. However, in 2013, according to the research I have read from a number of the large investment banks, net corporate bond supply should decline on a year-to-year basis.
Something else that gives me pause is the sheer lack of volatility, or rise in complacency, in the overall bond market. From a pure supply standpoint, you would expect demand for interest rate swaps (or hedging) to increase as issuance for corporate bonds increases. However, swap spreads across the curve are near record lows. This means that rather than buying Treasuries or interest rate swaps to hedge their exposure in corporate bonds, they are either finding nontraditional sources to hedge or not hedging at all. To put it in its equity form, it would be the opposite of the S&P 500 (INDEXSP:.INX) making new highs, and the VIX spiking as everyone buys puts. If everyone thinks something will happen, odds are it won't. You can see historical examples of 2-year swap spreads and 10-year swap spreads below:
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Additionally, Treasury curve weighted options volatility, as measured by the Merrill Lynch Options Volatility Index (MOVE) is also near record lows.
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What I am describing is exemplified by the action in closed end bond funds over the past two months. Starting in early October on the Buzz, we identified a number of closed end bond funds such as Western Asset High Income (NYSE:HIX) and PIMCO High Income Fund (NYSE:PHK) that were running extreme premiums to NAV (in the range of 15% to 30%), suddenly begin dropping 10% in price. In a sense, this also embodies the bond market as a whole.
While befuddling, we assumed at the time that it was institutions or "smart" money getting out while they could. A month later, the selling intensified, as the desire to get out of these funds spread to retail investors. This is the typical cycle with many asset classes; retail is unfortunately the last to know. I think we will likely see a similar sequence play out in the credit markets. Unfortunately, once retail is selling, there are no bidders left, or the only bidders left aren't at attractive prices to the seller.
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The rub is that that there will be no bidders when that point is reached. One of the major unintended consequences of the increased regulation of banks from the Volcker Rule is that banks, via their desks, are only able to carry 10% of the inventory they were able to in the past. This in turn has caused liquidity in everything but the most liquid or safe bonds to vanish, creating extreme trouble for investors and institutions when attempting to source "off the run" or illiquid bonds.
By definition, these desks are supposed to be market makers, meaning that they stand to step in to stabilize markets in times of distressed selling, and take the other side of trades. But in that circumstance, they are also likely sellers. Or in this case, the whole credit market would become "offered without a bid" or a one-sided market.
There is another issue to consider as well. As corporations have been able to issuer lower coupon debt at longer maturities, investors have correspondingly reached for duration by investing in longer-term debt to generate larger returns. However, as coupons have decreased, convexity has also accelerated -- meaning that if we see a major turn in the credit market, it will be that much more painful. For example, a 10-year note that carries a 2.5% coupon will fall about 1 point for every 10bps rise in rates. On the other hand, a 5% coupon 10-year note will only fall 1 point for every 15bps rise in rates.
The last facet of this troubling superstorm is the fact that the major central banks' tools to lessen the damage of this type of move have largely been diminished. I believe that the Fed will not be able to raise rates for the rest of this decade. Because the Fed owns $3 trillion in interest rate sensitive securities (Treasuries and agency MBS), these purchases will start falling in price if the Fed begins raising rates; thus it will begin to lose money on its purchases if rates surpass a certain point.
My rough calculation is that the Fed's purchase price is the 10-year equivalent yield of 3.5% in Treasuries. We can reasonably suspect that if the Fed stopped maintaining its large position in MBS, the portfolio would run off in five years. However, the Fed must allow its Treasury purchases to also run off, about 75% of which matures by 2021. Thus, the Fed must keep rates low to prevent any loss on its holdings. It is possible that the Fed could "afford" to lose money and ask the Treasury to make up the difference, but that likelihood seems almost unrealistic. I could never imagine the Fed Chairman going to Congress to ask for money to bail out the Fed.
Unfortunately, there is no way of predicting when this type of true "risk off" moment will happen, and I will not venture any guesses. However, if I were running a large fund (which I am not), given what I know, I would be in the position of taking little to no credit risk.
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