A Tale of Three CDX Curves

What follows is a very brief parsing of the US high yield credit market based on CDS index curves based on the swap level quotes. Swap curves are liquid analogues of cash bond yield curves except they are based not on individual names, but rather on a credit index.

Curves are telling metrics. Just as with cash, synthetic curves can be steep, flat, or can invert. Just as with cash, you don’t want a synthetic curve to invert. It is indicative not only of higher credit risk, but also reflects immediacy to this credit risk—default is not only highly likely, it is more likely now than later.

The spread curve analysis is limited to the sectors with the highest swap spread premia: energy, material and mining, and financials. The other subindex premia are lower than these three on a spread basis. So the other sectors have a lower credit risk that these, but their respective curves are also gradually steep.

Energy is bad. What is shown is a fully inverted HY energy CDX curve, at an extremely high aggregate yield to maturity. The sector is pricing in high probability of default. It is unclear without drilling into the underlying names in the sub-index how recovery on assets is priced.

Materials and mining curves invert at the 3Y maturity. This is indicative of balance sheets (or maturity profiles) than can handle a year or so of unprofitable operations (or repayment of principal and coupon) from cash and cash equivalents on the balance sheet, but maturities at the 3Y-5Y belly of the curve are likely not serviceable given sustained weakness in metals prices. The market also doesn’t think there will be metal weakness further out than five years, or alternatively, the names issuing longer dated underlying bonds are stronger than the rest of the pack. Again, it will take a deeper dive into the specific names in the subindex to tell.

Financials are not priced for panic. At all. Protection is bid at sub 400 bps for 1Y maturities and sub 600 at 10Y. This is a healthy curve, albeit at high spread levels than seen a few years ago. In 2011, protection was 40 bps less than it is now. That is a solid and potentially painful move for levered money, but utterly manageable.

The curves encapsulate the fundamentals of the synthetic situation, but not the price action in cash, which is to be totally loved at this point. Here’s why.

In cash, retail is fleeing from the high yield market in droves, because they hear about energy bond stress. Retail fleeing high yield really means that they are exiting high yield credit funds in droves. This in turn makes closed end high yield funds trade at super-steep discounts to NAV. Looking at spread premia in non-energy makes these discounts appealing on a carry basis.

You just have to endure the contagion effects that are dominating a credit market in transition and convince yourself that downside in prices do not reflect default. IF you do not agree, or if you are levered, stay out.

A phase transition to be precise. Under a market phase transition, mean-reversion is replaced by trends and momentum emerges as the dominant investment factor. So throw your fair valuation models out the door. Stresses simultaneously occur at all time-scales. So you see the entire curve shift up as well as change shape.

Correlations get stronger across the market, so an energy industry in thorough default impacts other sectors. This happens every half decade or so. It is the market’s way of clearing out the excesses and making everyone involved feel foolish.

After the system has gone through a phase change, old favorites become irreversibly nauseating for an extended time. So post-transition, arbitrage bounds cease to hold. CDX and iBoxx relationships—never overwhelmingly strong, really break down. Adapting to this new state means becoming interested in balance sheets more and less on the liquidity/illiquidity driven moves.


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