Rates and Duration, Credit and Value

I’ve been silent for a while. No need to talk about matters until the thesis “credit will be tighter in further into 2016 compared to yields we are seeing now” played out. There was a year-long awful grind down punctuated by a proper hammering in February, credit spreads are now in tightening mode. We made it.

There is no need to talk about rationales or quant models. This is how credit markets work—long grinds up and down. In equity, you see vol spikes with quick drops and slow grinds down. Credit moves like an avalanche slow, grinding and hard to reverse.

There are rationales of course. The ECB is dedicated to buying off-the-run corporate debt in a reasonably open-ended way (barring becoming a majority owner of any given name). They materially reduced funding cost for banks. The BOJ remains committed to easing. Perhaps most importantly, the Fed backed off a perceived hawkish stance. You don’t need a model to anticipate way improved sentiment.

So you have seen credit swap spreads as well as cash crush down. Senior financials peaked at 140 bps and revert back to 80 bps. CDX and Japan compressed to locally “normal” levels. Main, likely due to ECB intents and purposes, moved even lower. Have a look.

Forget rationales: this compression creates some major duration risk in rates. It is only natural that credit will benefit.

Allow me to explain. Duration is the time it takes until all cash flows from a bond are paid. An alternative way to explain it is to look how much a change in yield will adversely impact the price. When yield are ultra-low as you see in rates markets right now, a mere 30 bps change in yields will wipe out the entire annual income in Treasuries based on the current duration of 6.2 years. Eurozone sovereigns have an aggregate duration even higher than Treasuries at 7.22 years. This means a 13 bps change in yields will wipe out the entire annual income in this paper.

Imagine we see even a shadow of EU periphery troubles. Yields that even inch up one tenth of one percent will create carnage. This could spell a disaster, especially in the long end.

At the same time, stressed in high yield credit markets based on collapsing energy prices created some great long set-ups. Prices were so depressed in the energy and exploration sectors that the yield levels would cover loss severities of 50% even under minimal recovery scenarios. And correlations—always an enemy of a credit investor—actually created deep value opportunities in other sectors. Since then, Crossover (Europe) and EM credits mean-reverted the same way that investment grade did. North American high yield, while still elevated, should be.

Given the level of central bank support, across the board the credit complex has broadly reached fair value.

I wouldn’t see much more room for tightening except in one place: Japan. You have seen the same big compression in JGBs and tightening in Japanese corporate credit. But spreads remain elevated.

Only one problem: with nominal yields so low in Japan, duration risk is everywhere. Talk about picking up pennies in front of a steamroller.


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