The T Report: LIBOR, Spain, and High Yield Bonds
LIBOR
This FSA report is a must read! Page 18 is where it gets really interesting. That is where it starts talking about “external” requests to manipulate the LIBOR fixings. The FSA clearly has the e-mails and chats and will go after the other counterparties. Some are contributors. I don’t see this story getting smaller, the Barclay’s story is just the tip of the iceberg. We will continue to put out detailed reports on this issue as we dig deeper into it, but think the importance of the LIBOR scandal is not yet priced into the market. We have liked financials, particularly JPM ahead of their earnings but this LIBOR issue is making us seriously reconsider.
Europe
The market is reacting positively to yet another announcement of the Spanish bailout. While still lacking any details, it looks like money might actually be made available by the end of this month. I am not sure why it is taking this long, as EFSF has been available and am extremely tempted to sell this rally.
Spanish bonds and stocks are doing well, which makes sense to me. They remain at low levels and will directly benefit from the bailout.
Other than the fact that more people got short U.S. markets following the weak NFP report on Friday and ahead of the expected weak earnings season, I’m not sure why stocks are responding positively at all. I remain long but am less convinced that Europe will truly take the steps necessary in a timely manner, so will be looking to cut and possibly go short. Unfortunately, it seems like everyone else is still looking to “sell the news” and put on shorts, so may have to remain patiently and nervously long for a bit longer.
U.S. Credit Markets Remain Strong – Don’t Ignore Coupon Flows
While I’m near the end of my range on U.S. stocks, I remain comfortable with U.S. credit. IG18 was very strong yesterday and is 2 bps tighter already this morning, trading at 109.5. High Yield has performed well and seems set to continue to do well.
There were many people who were questioning why credit was so strong yesterday even with stocks being weak. One big component is the coupon flow. The monthly coupon that bond investors receive is meaningful. While some of that money is taken out of the market, much of it has to be reinvested. That is a form of “inflows” just not seen in equities. When the market goes a period with little new issue – like the 4th of July week, money accumulates that needs to be put to work.
While the jobs data was weak for stocks, it wasn’t a disaster for fixed income investors. While stocks will need signs of growth to rally significantly from here, bond investors can live with stability. Enough growth to ensure companies can pay back their debt while the Fed is forced to keep rates low is a good environment for high yield bonds.
How many “pundits” are out there recommending dividend stocks and talking up a 7% to 8% return scenario? It seems like a lot. Why take the stock price risk when high yield offers those returns with potentially much lower volatility?
The ability to capture profits from price appreciation is diminishing. The market has bifurcated into rich “liquid” bonds and cheap “illiquid” bonds. Investors have bid up the liquid bonds to a point where the risk/reward is skewed against them. Although many like to blame the High Yield ETF’s for this phenomena, the hedge funds and trading desks bear just as much responsibility. The desire to stay “liquid” has meant that too many people are chasing these same bonds. The ironic part is not only are these bonds trading rich, the liquidity is a curse. All these rich bonds are held by fast money accounts that tend to want liquidity in the same direction at the same time. These bonds are trading with a higher beta than the “less” liquid bonds. Investors, particularly hedge funds, need to rethink the strategy of buying the richest and most volatile bonds.
Look for more fixed income investors to capitulate and look for less liquid bonds and weaker credits. I don’t like the strategy of moving into ever riskier bonds. The economy is fragile enough that many of the “story” credits won’t make it. Those bonds are cheap in many cases because the problems are real.
Moving into less liquid bonds makes sense. The volatility is actually reduced because the “fast money” crew doesn’t own them and isn’t looking for a bid on every 10 point move in the S&P 500. They look like they are trading consistently cheap compared to similar companies with “liquid” bonds.
High Yield CDS might be another option. Several names look cheap, particularly at the front end of the curve. Lost in the crescendo of information about the Whale trade and IG9 is the view that JPM was short many of the high yield indices, particularly at the front end of the curve. Finding good names that are mispriced in CDS is another avenue to “alpha” generation. That market isn’t particularly liquid and if JPM really was the support for the front end bid, it would be an attractive risk/reward trade that could actually see some quick price appreciation since it has been relatively neglected by investors looking to go long credit exposure.