Credit is Sick and Going Synthetic. Weinstein Offers a Solution.

Once upon a time, real money like insurance cos and mutual funds and pensions were interested in a particular bond issue come up, but they needed a place where they could get their money to work while they waited. It had to be in their mandate—bonds. It had to be short-term like a couple of months or so of lock up. And it had to be liquid. So real money started dropping cash into short iTraxx Main, just to collect premium until those cash bond issues came around. Indices outside of iTraxx Main were pretty much verboten for this twerk, used almost exclusively for hedging with the dealer collecting premium on the other side.

Now that the Volker Rule and the regulators have largely killed the secondary market for cash bonds, the story has changed. Bond only AMs, pension funds, real money accounts, have sought out credit derivatives. Investors are using credit swap indices or bond-linked asset swaps to invest in credit on a meaningful time horizon. Let’s get real: the liquidity on cash bonds is dismal. Added to this is that investors can’t get their hands on cash bonds unless the bid-ask is as wide as the Grand Canyon. Going synthetic is the solution to access liquidity which has been stripped from the bond market.

I see this is as a perspsitent and long-term trend in the credit ecosystem. Total return and cash-linked swaps like iBoxx IG and HY and credit swap index products will grow while cash bonds and single name CDS will diminish. The note claims that there is increasing interest in bespoke and iTraxx Crossover tranches, while investor positioning is definitely long in the iTraxx Main and Xover. In HY, hedging is still prominent, but that is more due to the energy names in the index than anything else. That said, even in HY you are seeing compression between iBoxx and iTraxx indicating (the spread is on the right hand side). The spike in the middle is just the roll where three names dropped off. Based on the “normal” spread being around 70 bps, the market is now in the 40s. Either the CDS names are very representative of the universe, or credit is looking at synthetic possibilities for relative value.

Credit Trends I.jpg

While bond issuance in Asia is healthy and pretty bid, but if liquidity dries up, it is only a matter of time before CDX.EM and iTraxx IG Asia ex-Japan indices get some product tweaks so that investors can strip out the FX risk and make the product more amenable to “short CDS and hold”. I use that goofy phrase on purpose, just to highlight the need to take an honest appraisal here. Instead of complex responses to challenged liquidity, needed are simple solutions.

There is something to be said for some simplicity to contest this trend. Following the path of least resistance, although and easy, lazy way, isn’t always the best way.

Boaz Weinstein gets it and I think he has a hot hand again. In recent filings, you see him buying high yield credit closed end funds—because they are trading up to 10% cheap to NAV. So he is long value and decent carry. He also has big put positions on energy exploration stocks as the hedge on high yield. This is simple and straightforward. Unless you expect to see WTI over $80 then it sure makes sense.


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