The T Report: From Idiosyncratic to Idiotsyncratic. Greece and HY ETF’s

The idiosyncratic risk is really coming from two sources and the fact that at the margin they collide is adding to the confusion and the volatility in the market.

Right now the problems in Europe are directly tied to Greece. Spain and Italy continue to have problems, and nothing is close to being resolved, but the real next catalyst in Europe is Greece. All this talk of a “Grexit” seems somewhere between premature and dangerous. I think Greece is likely to leave at some point, but several things have to happen before it can leave without causing a tidal wave of destruction across Europe and the global economies:

• Determine what will happen to the money owed to the ECB and the IMF. They too need to be redenominated at the very least, and possibly defaulted on in order for the new Greece to have a chance. What does that do for the reputations of those two institutions? How will the ECB make up for the loss? Will the IMF firewall remain intact after losses? Real issues that cannot be dismissed, and addressing some worst case, rather than best case reactions needs to be dealt with.
• Will Greece have the natural resources stockpiled to survive the immediate after effects? I see the risk of spiking energy costs as being one of the biggest risks. If the Drachma trades poorly against the Euro, and the Euro trades poorly against the dollar, how are people and businesses going to be able to afford items that need to be imported. For all the bizarre ways in which the bailout has been done so far, Greece has the luxury of not being forced into an immediate devaluation, so has time to prepare for some of the obvious risks.
• Portugal, Spain and Italy. I don’t see anything in place that would stop these countries from being immediately dragged down. Currency controls and a force redenomination in Greece will scare people in these countries. Capital flight at all levels will become a big issue. Trade in Europe could grind to a halt. How will contracts with Greek companies be dealt with. People will assume the worst in other countries and there is a real risk that trade dries up because even short term credit becomes completely unavailable. The ECB is likely to have to take unprecedented actions such as guaranteeing repo lines, and even settlement risk.
• The EFSF incubates contagion. Now maybe the EU will realize what many of us have being saying all along. The EFSF (and ESM) ensures that contagion will spread. If the EFSF is to be a source of money for anyone (notwithstanding its own losses on Greek loans), they will either be relying on Spanish and Italian guarantees, adding to the misery in those two countries, or, far worse, those countries will become “stepping out” members as well.
• Target2? Bank debt? Bank debt guaranteed by Greek central bank? So many other questions, so few of which have been addressed.

I don’t know what will happen if Greece leaves. I am not certain that we will see contagion quickly spread and Europe grind to a halt, but that scenario, given the current level of preparation, and the precarious situations in Spain and Italy, I find it impossible to believe politicians will ignore that risk in the end. The other issue here is that the entities that you would normally expect to see step in after a default, like the IMF, have already stepped in. The IMF, ECB, and EFSF, all of whom would be relied on to help after a big event, are already part of the big event. That is unusual and makes the situation far more difficult to contain.

The Greek drama will play out, but Grexit will not happen yet, and both sides will find enough ways to claim victory that some concessions will be made to give Europe and Greece more time to prepare. At this stage, that would be a big positive for the markets which right now are largely ignoring that most logical outcome.

You cannot mention idiotsyncratic risk without talking about JPM. Whatever the trade was, in all of its iterations, it is clear that it got so big relative to the liquidity in the market, that it was driving prices. Too tight at one point in hindsight, and possibly too wide right now, but that is yet to be determined. Every part of the fixed income world is being affected by the alleged unwind. It really doesn’t matter at this stage what position JPM has or doesn’t have. Whether they are unwinding or adding, whether they are being front run or not? The only thing that matters is that liquidity has dried up. No one wants to be the other side of a trade if they think it can be part of some alleged massive unwind. Liquidity, already limited with everything going on in Europe basically disappeared after the JPM announcement. The swings in CDS and now cash have been large. It takes very little trading to move the market. At certain prices, for whatever reason, big volumes go through, but the gap to the next “clearing” level seems random and large.

You cannot ignore these moves, but being dragged around by a battle that is occurring on a higher plane has its own risks. The markets will revert quickly and in ways that don’t let you get back in if you want. Not one to say “close your eyes” and ignore it, but to some extent you have to “close your eyes” and ignore it. It is impossible to separate out what is technical and specific to the JPM from the usual technicals. Games are being played and pictures are being painted on a scale that rarely occurs.

IG18 is trading at fair value. IG17 is actually trading cheap to intrinsic value. MAIN is trading cheap as well. This means that the indices are trading wider than their components. Since part of the allegations against the whale were that their trading drove indices to trade extremely tight to fair value, that has over corrected (it can over correct further, but that part of the problem is now out of the market). To me, this is a clear sign that the desire to put on “liquid” hedges has gotten more extreme and weak shorts are being created. Then looking at single name CDS versus the cash bond market, and it looks like CDS has underperformed here as well. So single name CDS, another “hedge” vehicle has done worse than the cash, and the index has done even worse. We have again a typical situation where rather than selling cash, some people have bought protection at prices wide relative to bonds. That often ends in a big gap where either bonds underperform or CDS outperforms. I’m leaning towards CDS going tighter, but cannot discount the potential for bonds to do worse.

Which brings us to HYG and JNK and their weak performance. There are two key drivers here and both are somewhat strange. The ETF’s are effectively a representation of the bond market and they tend to trade to either the “offer” side of the market in good times, or to the “bid” side of the market in bad times. What does that mean? It is relatively safe to say that the average high yield bond is quoted in 1 point markets. So if a bond was quoted as 98-99, in a strong market, the ETF tends to trade closer to the “99” price as the offer getting “lifted” is the likely trade. As the cash market weakens, two things tend to happen. The one is obvious, the price drops, the other is that the bid/offer spread also widens. So this same bond that was quoted 98/99 will now be 97/98.5. In spite of the bid dropping faster than the offer, that is the more likely side to be executed on, so the ETF, reflecting market sentiment, will drift to the bid side, and now reflect a “97” level. So the ETF could drop 2 points while the fair value, based on “mids” only dropped 0.75%. This move, while large, is as much a function of how high yield bonds trade as it is a reflection of real weakness. Remember the ETF’s are only a proxy for the underlying market, so this move from the offer to bid side explains a lot of the relative weakness of the ETF’s.

I’m seeing both HYG and JNK trade “cheap” to fair value. They are trading at a discount. That means the “reverse arb” comes into play, which can put added pressure on the ETF’s. It doesn’t surprise me, that JNK which generally is more lenient on the share redemption (and creation) process is experiencing more outflows than HYG, because the arbs will focus on it.

Be careful, but also don’t forget, that although we get lulled into a sense of liquidity in the ETF’s, at some level, the poor liquidity and wide bid offers in the underlying bond market come into play, and we are seeing that now.

I think the U.S. credit markets are attractive, I continue to like them, and am looking at adding more. I am not sure the time is right, but the price action in the U.S. is starting to become encouraging, and I’m seeing some signs that the whale feeding frenzy is over, which is encouraging. I would like to see some more evidence that Europe understands they aren’t ready to kick Greece out and that they will lose more than Greece, but for the first time, I’m seeing much more balanced comments and not everyone is on the Grexit bandwagon.