Corporate Bond Yield Spreads - Unbelievable!!!

RGE: The comparison of cash bond and CDS indices shows that the real action in corporate credit markets is taking place in the cash bond markets, in both the investment grade and the high yield segments. After Lehman’s default, a heavy selloff in both investment-grade and high yield bonds took place that sent cash bond spread higher than their CDS counterparts (‘basis’ definition = CDS spread – asset swap spread rather than bond spread, but results are similar) in a reversal of fortunes since the start of the credit crisis. A negative basis used to be common in the good old days when the building up of leverage in structured products required the sale of large amounts of credit protection. The unwinding of these structures instead sent CDS spreads higher than cash bonds during the crisis. Until mid-September.

Going forward, will bond yields eventually converge lower as investors take advantage of distressed prices and arbitrage opportunities (negative basis trade includes buying both a bond and protection on the same to lock in risk-free profit)? Or are bond prices reflecting a fundamentally worse outlook that is not captured in CDS spreads?

It depends on the reasons for the jump in bond spreads. Market commentators offer two explanations:

1) deteriorating credit quality;

2) technical bond demand and supply factors.

Overview:

Graph 1: iBoxx $ Domestic Corporates AAA Spread to Libor (white) VS. 5-year Investment-grade CDX Spread to Libor (orange)

From EIU: Better-quality investment-grade corporate bonds (company bonds rated triple-A to triple-B) suffered negative total returns of more than 7% for a second straight month in October. This is an astounding development. For Merrill Lynch indices dated back to 1989, there had not previously been a loss in excess of 4.25% in any given month, let alone a loss of more than 14% on a two-month basis (see Graph 1)

For high-yield or “junk” bonds (company bonds rated double-B or lower), the loss was more than 16% in October alone, after a more than 8% loss in September. Each, at the time of release, marked a record monthly loss for the category (see Graph 2.)

Graph 2: BLP Active High Yield US Corporate Bond Price Index (orange) VS. 5-year High Yield CDX Price Index (white)

The reasons for this sell-off are twofold:

1) Deteriorating Credit Quality:

The high-yield market is entering the up-leg of the default rate cycle with a far worse credit quality mix than the last time around. In particular, as a percentage of the total high-yield universe, triple-C issues ended October 2008 at about 27% of the total, a record high for the index and up about five percentage points year on year. During the last credit cycle collapse in 2001-02, the triple-C share topped out at less than 25% in the fourth quarter of 2001, presaging the looming default cycle well into 2003.

Graphs 3 and 4 compare the share of low-quality debt (B3 or lower) and defaults in previous cycles. The results are stunning.

Graph 3:

Source: Moody’s

Graph 4:

Source: Moody’s

Fitch says in a recent report that, including bonds affected by Lehman Brothers’ bankruptcy filing and Washington Mutual Inc.’s collapse, the par value of corporate bond defaults exceeds $100 billion already, a level comparable to 2002 when total default rates reached over 12%. In October, Fitch warned of the worst default rate on record in this cycle. Currently, high yield spreads imply a default rate of nearly 21% (see Graph 4) while corporate downgrades have been accelerating in Q3. In other words, what is investment grade today may soon not be anymore as the economy worsens. Moreover, commercial paper funding conditions remain tight.

2) Technical Demand and Supply Factors in the Corporate Bond Markets:

Among the major factors which have caused these steep price drops in the bond markets are the heavy selling volume on behalf of hedge funds and other institutional investors in need to raise cash to meet liquidations requests, margin calls, and deleveraging pressures. An additional factor is sheer risk aversion with investors shifting out of risky assets into safe Treasuries (see Graph below)

Graph 6:

So are these firesales indicating the presence of buying opportunities? Kiessel from PIMCO is cautious. “Now, with credit spreads at all-time wides, we are more positive on credit valuations, simply from the standpoint that investors are finally getting paid now to take selective credit risk. Nevertheless, the real effects of the credit crunch will be felt throughout the overall economy over the next year, and near-term deleveraging is likely to continue with near-term negative market technicals with more risky bond sellers than buyers.”

p/s photos: Jiang Yu Chen

US Treasury Yields Near Zero

WASHINGTON - THE panic in global financial markets has sparked an unprecedented rush into safe US Treasury securities, driving yields on short-term government notes down to almost zero.

Due to stampeding demand for safe short-term investments, the US Treasury's four-week and three-month bills on Friday yielded an effective rate of 0.01 per cent - down sharply from 1.515 per cent and 1.785 per cent, respectively, in early September.

Other Treasuries are also showing record low yields. The 10-year bond yield fell as low as 2.505 per cent and the 30-year bond yield slid to 3.005 per cent at one point on Friday. The six-month bond yielded a mere 0.20 per cent.

The low yields reflect a surge in demand for these instruments, seen as the safest in the world during times of turmoil.

'Investors seem to be content to sell stocks and park into the bonds for now,' said Mr Greg Michalowski of the financial website FXDD.

Analysts say the fear factor has pushed up demand for Treasuries, since investors are virtually certain the US government will not default.

Other factors include worries about deflation and the overall trend in interest rates, with the Federal Reserve having cut its base lending rate to a historic low of 1.0 per cent, and further reductions possible.

But Mr Bob Eisenbeis, analyst at Cumberland Advisors, said the unprecedented low yields are a sign of 'dysfunction' in markets.

Eisenbeis said US municipal bonds are paying upwards of 6.0 per cent tax-free and corporate bonds even more, but that fears of default and a lack of knowledge about underlying bond quality have led investors to shun these alternatives.

One reason for the surge in demand for Treasuries, said Mr Eisenbeis, is the Federal Reserve's decision to flood financial markets with liquidity including through other central banks.

Many central banks and commercial banks are reluctant to use this cash for traditional lending, and are buying Treasuries to ride out the storm, Mr Eisenbeis added.

A big question for the market is whether the Treasury market has become a bubble that will burst.

Although the low rates allow Washington to borrow money cheaply, Mr Eisenbeis said such a scenario could be perilous for the economy and the dollar.

'When you have this huge flood of liquidity into the marketplace, that can't last forever,' he said.

A bursting of this bubble could mean a rush out of Treasuries, forcing the government to pay higher rates on an unprecedented amount of debt.

'We would have huge increases in our costs and people wouldn't want to hold Treasury obligations anymore because of the capital losses,' Mr Eisenbeis said.

'You could have a huge switch in interest rates very quickly.' Mr Mike Larson, an analyst at Weiss Research, says the long-term bond market could be 'the biggest bubble of all', worse than the dot-com and real estate bubbles.

'Treasury bonds almost never move this far, this fast. And interest rates, which move in the opposite direction of bond prices, almost never fall this far, this fast,' Mr Larson said.

Mr Larson said the yield on the 10-year Treasury bond plunged from a mid-October high of 4.08 per cent to nearly 2.5 per cent this week, 'yielding lows not seen since the mid-1950s'. 'There are lots of reasons to believe this Treasury rally is unsustainable, and that a day of reckoning is fast approaching,' he said.

Mr Sal Guatieri, economist at BMO Capital Markets, acknowledged that 'investors are throwing money at Uncle Sam with the same conviction that they bought houses and dot-com stocks in their heydays'. But he argued that if inflation is quashed and investors retain confidence in the US government, the dangers have not yet hit a boiling point.

'While Treasuries may be overpriced, they probably are not yet in a bubble,' he said.

Comments: The continued buying of US Treasuries indicates a few major conclusions:

a) the aversion to corporate bonds, the risk in corporate defaults is still high

b) the aversion to risk is very high, many are willing to accept 0% yield to be in USD

c) that the markets are unconvinced on the measures promoted by the government so far

d) the anticipation of more major corporate collapses, and maybe even more bailouts to come

e) the aversion to stocks of any kind, even US stocks, hence we are seeing no flow of funds to emerging markets for now

f) the zero yield is the most important indicator that financials and credit markets are not working properly

g) corporates will have enormous difficulty to raise funds or even renew their funding

h) the pressure has mounted significantly for governments to do a lot more to unfreeze credit markets

i) this will cause most companies to hoard cash rather than reinvest, in other words companies will be cutting back operations and capacity further, a priority will be to push down inventory

j) If investors are willing to hold zero yield Treasuries, its a telling sign that people want to be in CASH but not in a bank as they do not trust their money within any banks

doraiddd has left a new comment on your post "US Treasury Yields Near Zero":

k) this notion that us treasuries are also the safest asset class to be in will be soon proven to be the ultimate fallacy... and fantasy...

l) us treasuries are the last remaining asset bubble left. Expect the chinese, arabs and the japanese to unload soon....

m) when the panic stampede starts outta us treasuries, where u gonna hide? where u gonna run? who's gonna save you??

n) maybe perhaps king midas himself...?


Expect a trying week for stock markets globally. Not a nice way to end 2008.

p/s photos: Zhou Wei Tong

The Next Crisis Unfolding - Auto

On 15th October 2008, I posted on the upcoming demise of the US auto sector:


Watch for the auto sector - this is where the pain will shift to. Big companies will fail or be merged and job losses will be massive - the auto sector consolidation has been brought forward by the events over the last couple of weeks. The auto sector combustion will cause the media to focus away from the carnage on Wall Street to carnage on Main Street. Expect markets to be wobbled by this. Keep cash at least 50%, trade out on weak signs - the worst may be over, but the general conditions still shifty. Jobs is where we should really look at. We can expect more job losses in the coming weeks and even months. I forsee some industries will see MASSIVE failure - the first to go will be the US auto makers.... pension problems, no credit or loans for people to buy cars, consumers delaying changing of cars now, problems with unions... very difficult to refinance their lines of credit moving forward... watch for at least two of them being merged or absorbed by a foreign competitor at cut throat prices. The auto industry are big employers, and that will hurt employment, and drag property prices weakness in those states where auto industry is strong.
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General Motors Corp. stock fell to its lowest level since 1946 as concern intensified that the auto maker could run out of cash and be forced to file for bankruptcy protection. The stock's decline came as several analysts issued dire reports about GM and the company acknowledged in a government filing it could be at risk of violating the terms of some of its debt if it doesn't steady its deteriorating finances by year's end.

Should governments bail out GM? If GM is allowed to fail, what are the repercussions? How far does it spread in terms of employment and loss of business activity? How far do GM bonds reach, and what are implications of default? The size of bonds outstanding for the entire US auto industry comes to about $250 billion. The good news is that most of these bonds are already at very junk status, most trading at less than 25 cents to the dollar. The loss to bondholders have already been triggered way way before today. Hence if any of them were to go bankrupt, it would not have strong repercussions on the actual bond holders. The bad news is that over the past few years, there is the invention of Credit Default Swaps, which has been the bane of AIG's demise. When actual companies do fail, these CDS clicks into action. How many holders of CDS are actually able to pony up the funds to pay back these bond holders? Thats why they trade at just a fraction of their face value. The market does not think that the CDS will actually be able to come up with the cash to pay back the face value of the bond (which is what CDS is designed to do). The worse news is that if say one-third of these bonds crumbles due to bankruptcy, the actual $100 billion losses is manageable, but many of these holders (think AIG) will also be holding many other CDS - a payout to a GM bankruptcy will have cascading effects on the "validity" and "viability" of the other CDS these people are holding.

This might make CDS totally unworkable and will collapse. Hence many more insurance firms will have to file for bankruptcy as well to avoid paying many of these CDS. Thats also why AIG keeps needing more and more capital infusion. Thats also partly why the government needed to bailout AIG, and the likes, in order for a properly functioning credit market to continue. Is the $125 billion into AIG sufficient?

Hence in all likelihood, the government is UNLIKELY to risk having GM go into bankruptcy. You DO NOT WANT TO STRESS TEST the CDS market to see if it would hold up. It might also unravel all the hard work done so far to keep AIG afloat. If the government pump money into GM, how much money is required and what is the direct purpose? By purpose, what will the money be used for? Will the initial injection be enough? Can any amount of money make the company a strong, viable competitor again? Will other national governments pump money into their car companies too, further increasing competition? If you look at how the Big 3 auto companies are operating, they are not financially viable over the long term.

I suspect Obama will not allow GM to fail so early in his Presidency as its not just the car maker, its the supporting sub industries and flow on job losses effect which is not what he would want at such a critical time.

The chart above shows average hourly compensation for the Big Three ($73.20) and Toyota ($48.00), compared to average hourly compensation for Management and Professional Workers ($47.57), Manufacturing/Goods Producing ($31.59) and all workers ($28.48). The auto industry in the US has long been crippled by the unions. We can argue till the cows come home but unions can kill an entire industry. They now have pensions that the company cannot fund, which in turn put unbearable claims on the company's balance sheet. At the end of the day, unless you make a much much better car, you cannot justify operating at cost per hour that is 70% higher than your competitors. The $73 and hour includes legacy costs. Union member don't make anywhere near that much money in reality. That number is at least $15-$20 high and includes benefits like health care. Well, you know what, no matter how you cut it, its still $73 and counting.

I think Obama will inject money into GM in exchange for control, and then institute a merger with maybe a foreign car maker - its pointless to merge an American car maker with another, it just compounds the problem. A foreign car maker will come in but with huge concessions and with a union that is willing to make huge sacrifices. Unions will have to be controlled and ask to forsake a lot in order to keep the company afloat. Job losses will be severe but it will be a lot less than allowing GM to fail. Allowing GM to fail is not an option owing to the flow on effects on the CDS and hence the entire bond market and credit viability.

The danger for financial markets is IF GM is allowed to fail, then you could get another freeze up in credit and sent all markets much lower. You could see the 7,000 being tested. If GM is being bailout, its still not blue skies. Things are still fluid and I see huge volatility in the coming weeks til end of the year at least.

p/s photos: Iwa Moto