Night Diving

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The-Great-Blue-Hole

There’s little difference between deep faith and night diving. At the very least, the former is required to do the latter. This I discovered the hard way when my flashlight failed to provide even a glimmer of light after my descent into a pitch black depth of 60 feet. What had I gotten myself into? It certainly had sounded like the getaway of getaways for the young thrill seeker that I was then – 17 dives in 7 days off Long Caye in the crystal clear waters off the Belizean coast. The good news is I found my guide before a creature of the deep night found me. This thankfully helped to stifle the hyperventilating, which is never recommended when oxygen is a finite tanked resource. The better news is I was able to take in some of the wonders of nocturnal nautical nightlife which left me with some mean midnight cravings for crustaceans. Luckily such delicacies can be easily procured in the Caribbean. As thrilling as night dives can be, it was just as well that most dives were set under a blazing tropical sky.

Over the last seven years, debt issuers of all stripes have likewise basked in an idyllic, sunny setting, pampered by investors’ seemingly insatiable hunger for any security offering a yield north of nothing. What were once hyperbolic headlines are now so very ho-hum. Consider Exhibit One: Monday’s front page Wall Street Journal’s, “Corporate Bond Market Heats Up.” The newsworthiness gets stale after seeing the same explanation year in and year out – that issuance is surging thanks to “efforts by corporate treasurers to lock in low interest rates before a possible Federal Reserve interest-rate increase in December.” The end result of four consecutive years of record-breaking sales catalyzed by a perma-possibility is that outstanding U.S. corporate debt is closing in on the $40 trillion mark, which dwarfs the $27 trillion U.S. stock market.

These lofty figures have led market watchers and policymakers alike to angst about the true depth of the pools in which trades are executed in the vast fixed income markets. The truth is dangers may be lurking in what are perceived to be the safest waters. I can’t help but to bring Deutsche Bank’s Oleg Melentyev, who’s graced these pages in the past, back to help explain. A report he published a few months back came to mind as I read the Journal’s latest warning on the potential hazards brewing in the bond market. While the market is indeed “alarmingly fragile and increasingly subject to volatility,” the fragility is not necessarily as brittle as the headlines would have you believe.

Doom-and-gloomers relish in repeating the 80-percent decline in dealer inventories because it just sounds scary. While it’s true that dealer inventories are a fifth of their $250 billion 2007 level, if you clear your face mask you’ll see that while the numbers in the aggregate are kosher, sensationalistic claims should be taken with a generous pinch of sea salt. Generally speaking, there are two culprits blamed for the decline in reported liquidity – the financial crisis itself and the regulations that have made holding bonds more onerous for traditional dealers. But there is a third component to the equation that must be factored in so as to not mislead – the virtual disappearance of an entire class of fixed income securities – namely the reviled collateralized mortgage obligation, many of which harbored those toxic subprime mortgages. The absence of a rebound in these securities exaggerates the reported decline in fixed income inventories. Looked at a different way, the denominator has shrunk so it’s not fair to also not shrink the numerator before making any calculations.

Also in the not too bad news category is that liquidity disruptions are unlikely to originate in the much-feared junk bond market. Don’t get me wrong. Junk bond underwriting standards are rotten; but that’s always been the case as credit cycles mature. Along the same lines, there’s nothing new about the expectation that a fifth of CCC-rated bonds, the junkiest of the junk, will default within five years of being issued. Nor should the latest headlines out of Moody’s shock – that junk debt liquidity is at the lowest level in nearly five years. Despite the price of oil’s refusing to bounce back as the punditry commands, liquidity is hovering near its long-term average and remains two-thirds more abundant than it was in March 2009, when financial markets worldwide troughed.

The real revelation in Melentyev’s analysis is that junk bond, or high yield (HY), liquidity should not be what’s keeping investors up at night. The proportion of outstanding junk bonds that are trading hands these days equates to 0.7 percent of the market size on an average day over the past year. Before calling out the Coast Guard, consider that that is only a 30-percent loss of trading depth since onset of the crisis.

Would it surprise you to learn that junk’s Ivy League-educated older brother, Investment Grade (IG), has seen a greater degree of deterioration? At 0.4 percent, IG trades appreciably less of its outstanding market on a given day representing a 50-percent decline in trading depth. That’s saying something considering that both markets have more than doubled since 2007. But size really does negate comparing the atrophied liquidity in the two markets: At $5 trillion, the IG market dwarfs that of HY’s $1.4 trillion, which demands that IG needs more, not less, when it comes to turnover in its market.

In the adding insult to injury department, the deterioration in liquidity has worsened for IG over the past year, falling from 0.6 percent to 0.4 percent while that of HY has improved from 0.6 percent to 0.7 percent. Pardon the death by numbers but sometimes it’s critical to appreciate what it looks like under the surface of the now-calm waters of these markets.

Retail investors in particular should pay heed to the disturbing details. The Journal story points out that bond mutual and exchange-traded funds now own 17 percent of corporate bonds, nearly double their share seven years ago. The article goes on to warn that the rise of large bond funds places small investors at risk of the same groupthink that plagues stock funds, that is managers chasing the same stocks which translates into highly correlated losses across funds when markets decline. The best news mined from Melentyev’s data actually refutes this claim. Whether you look at the largest 10, 20 or 30 funds, the proportion of total assets under management (AUM), as a percent of AUM in all funds, has declined notably since 2007, by about half in fact. “A less top-heavy structure of the market is a clear benefit to liquidity as it breeds lower correlation of flows and higher diversity of views being expressed on both sides of each trade,” Melentyev reassures.

That’s about the nicest thing you can say about high grade bond funds. In the years to come, we will all grow tired of hearing the term, “fallen angel,” which refers to an IG credit that’s downgraded to HY. There are some $71 billion in IG bonds that are trading as if they’ve been downgraded to junk. A recent Morgan Stanley report noted that this distressed cohort’s addition to the high yield market would boost the size of the junk market by seven percent. For the record, Morgan Stanley is more bullish on HY than it is on IG.

One of the outgrowths of declining liquidity is bond fund managers becoming creative to gain adequate exposure to corporate credit. The first rule of law for any mutual fund manager is you can only sit on so much cash. Deploying cash into specific credits can prove challenging if the targeted bonds trade by appointment only. Enter the $14 trillion credit default swap (CDS) market. CDSs are effectively insurance on credit securities, whether they be sovereign, corporate or asset-backed. An investor can buy a CDS on any company that will pay out in the event said company defaults on its obligations to hedge their position. That’s all good and well.

But what about bond fund managers, thirsty for liquidity, buying CDSs to gain exposure to a given credit? A great friend of mine gives this skirting technique a two-word vote: “No Bueno.” The how to goes like this – if you sell a CDS, you are making an opposite statement to needing insurance against a default, i.e. bullish on the credit. Implementing this strategy, a manager synthetically replicates a bond investment. The problem is these critters are risky and highly unpredictable. It’s not just the credit of the underlying company managers are betting on, it’s the risk that the insurer is also solvent, also known as counterparty risk. AIG circa 2008 anyone?

Because of the immensity of the CDS market and its infrastructure, the widespread adoption of CDS strategies has largely been limited to marquee bond funds which can rationalize the costs via economies of scale (if it sounds expensive, it’s because it is). A 2010 FDIC study found that large fund families tend to use CDS with a third greater frequency than smaller funds. Five years later, with liquidity further depleted, the trend is sure to have been more extensively embraced. The problem is funds who use CDS tend to be more volatile and have lower absolute returns given the additional risk and cost required to more actively trade in their quest for yield. In the words of credit legend Michael Lewitt, “Large bond funds continue to be a triumph of hope over experience that offer virtual nothing in the way of real (i.e. inflation-adjusted) returns and less-than-zero in the way of risk-adjusted returns when you look below the surface and discover that they are investing in all kinds of derivatives and taking other imprudent risks.”

Thank heavens investors can fall back on their ultra-safe government bond funds if all else fails. Or can they? While U.S. Treasurys are still by far the most liquid of fixed income markets, hence their designation as the world heavyweight reining risk-free asset champion, their degree of post-crisis liquidity evaporation also takes the top prize.
Some four percent of Treasurys’ outstanding market size trades hands every day, ten times that of IG bonds. However, that relatively robust level represents a 70-percent decline over the last eight years, which eclipses that of both IG and HY.

In other words, investors’ cherished assumptions about the safest assets in their portfolios could be in for a nasty wake-up call – in more ways than one. The first inkling that liquidity in the Treasury market was not as deep as widely perceived arrived over a year ago, on October 15, 2014. First things, first. Rather than prices flash-crashing downwards, they spiked upwards to the tune of a seven-sigmas – yields move opposite price; they collapsed in the blink of an eye.

The other implication is much more nuanced. Because the severe bond market disruption erupted in the least likely place, Fed officials are realizing they’re in a tougher position than they’d imagined. Policymakers have always known that raising rates after nine years could upset complacent markets. After the flash melt-up, the Fed must also grapple with the fact that not raising rates could communicate that after all of the stimulus that’s been deployed, the economy is still too frail to withstand a quarter-point increase in interest rates. Maybe that’s why Yellen reiterated to Congress that December is the imminent launch date.

When I think back on my week in Belize, I remember that other than that faulty flashlight scare, my second most enduring underwater memory was made diving the Great Blue Hole, a huge submarine sinkhole just minutes away from Long Caye. Take my advice, if you do find yourself in a Belizean boat about to take the plunge into that world famous watermark, heed your guide’s warning not to dive deeper than 100 feet. This will prevent us exchanging notes about mind-altering 130-feet-down subaquatic experiences that deludes one into wanting to pet the cute and cuddly hammerheads circling the forbidden depths. All digressions aside, perhaps it’s time bond investors understood that the deep dive their portfolios have taken into what they think to be the protected waters could just be populated with sharks in guppies’ clothing.