Monday’s T-Report: 10% Returns in a 4% Yield Environment

Sorry for the delay today, but just getting used to mountain time (and the extreme cold morning right now).

What caught my eye today was story that funds are more leveraged then they have been in awhile.  I take all these with a grain of salt as I don’t think the numbers mean as much as people think.

When everyone talks about “cash on the sidelines” but ignores that funds can be “fully invested” with margin on regular assets or futures or OTC derivatives, it is only natural that they have cash lying around, to meet margin calls, and because they are fully invested (synthetically).

So before I go into any warning signs about “leverage” let’s throw some caveats out there.  As we move into a lower volatility world, and move a little away form the “risk on” / “risk off” mentality, funds should have more positions.  They should have more longs and shorts.  With lower volatility and more longs/shorts the net risk to the funds may not have gone up much, but “leverage” would have appeared to.

So without knowing a firm’s exact positions, I don’t get too excited about the leverage number being thrown around.  It is far too simplistic to be too useful.

But what I do know, is on the credit side, pitching 10% annual returns in a 4% yield environment is tricky.  Maybe some funds out there are succesful pitching 5% with minimal volatility, but I suspect many clients still want at least the potential to get 10% out of their investments (pre-fees).

So, one way is to be short credit, but I don’t think many (any) funds have gone that route in the effort to be set up for a 10% year.  It was hard enough to be short credit in front of the fiscal cliff because of the deluge of liquidity supplied by Ben, buying from retail, and a lack of supply, and post cliff, it seemed less rational to many to be short credit.  So funds were not set up to be short credit to get 10%.

What about short the long bond?  That had some more appeal.  Many investors could see the long bond backing up to 4%.  Being right on that would generate the requisite 10% return.  On the other hand shorting what Ben is actually buying with no evidence that a bad fiscal cliff outcome was being priced in by actual businesses seemed risky.  I think more and more we should see Bunds and Treasuries converge – Germany is on the hook for a lot of rescue debt, and redenomination seems unlikely; whereas, Ben sees low yields as the key to any recovery.  I think “equity” investors were more prone to setting some treasury shorts than more traditional fixed income players.  The 15 to 20 year point still seems ideal to me as the “free float” is so low and isn’t really growing with new issue.  Having said that, we added the long bond to our list of “best ideas” late last week.

So what is the other strategy to generate 10%?  Buy a bunch of junk bonds and lever them up 2 to 3 times?  It sounds so “unsophisticated” but there are people who bought into that strategy.  Lets find a bunch of high yield debt we like, a little “cuspy” providing 6% yields and lever it up 2 times.  Net of some funding charges, voila, 10% annual return.  It may actually work.  If you have the position on now, shut down your screens and don’t look at them the rest of the year, that strategy may well work out.  The “problem” is that isn’t how we are trained to manage money, particularly not in the hedge fund space.

So at first the manager deals with it, maybe even adds some risk, but any weakness starts to get nerve racking.  A 2% move down in high yield bond prices (hardly an anomoly) suddenly puts the fund down 4%.  If it is hard enough to raise money in a low yield environment, I imagine it is even harder if you start the year down.  This is what would potentially create the selling, but doesn’t.  The manager (hypothetical of course) most comfortable running a 2 or 3 times leverage junk bond portfolio (or leveraged loans, or 7 times leverage IG bond portfolio) loves bonds.  If “love” is too strong a word, they have a high propensity to own bonds.  It is what they know best and like most.  The recent struggles to source bonds are too fresh in their memory to want to sell bonds.  So what do they do?  They short credit via CDS.  It doesn’t matter whether or not IG19 is cheap, or that HY19 offers far more upside than the bonds they hold, that is the first step.  The intermediate step will be shorting the ETF’s (so be early).  The investment grade ETF, LQD already has some outflows, so be careful thinking retail is still adding to their fixed income exposure.  So IG19 remains on our “best idea” list as a short position for precisely this reason.  On this we will be looking to cover at some point and will actually reverse into a long, because we will see another “squeeze of a lifetime” which is now a semi-annual event.

So I’m not particularly concerned (or overjoyed) by the stories of high leverage in funds, but I think it continues to support our near term bearish view.  Our target on S&P still remains 1,400 to 1,425.

Apple is going to be all over the news as people prepare for earnings.  I am not sure what I think of the stock at $500, but my working premise remains the same, a blowout quarter leaving the bulls partying in the street, until they realize everyone expected a blowout quarter and it isn’t enough to get the stock back on a trajectory towards $600.

Our “best idea” that isn’t working today is long spain/italy debt vs bunds, but I think that remains a great trade and I would add, becasue it is underinvested, particularly by hedge funds, so shouldn’t feel quite the same pressure.  Spain in particular, has most of its bonds owned by Spanish banks who aren’t selling.  Owning the stock market there and banks in particular remains our call for outperformance, but should only be owned with a nice short in DAX/SPX.