Chasing Yield Is Tiring Work – is the Market fit enough to keep going?

Well we got some chase for yield. High yield did well.  EM did okay, as did Munis and Investment Grade.  Closed end funds on the fixed income side did very well, benefitting from leverage and short memories, where once again investors want these at a premium (image of Homer Simpson repeatedly burning himself).

Treasuries actually had a good week in spite of the “risk on” mentality, but that was “confirmation” from Hilsenrath that the Fed is likely to continue to find ways to buy long dated treasuries once Operation Twist is officially over.

So it was a nice, and surprising combination for treasuries and risky bonds to do well, but this week was the first time in awhile that we saw some confusion in the broader market about corporate bond performance.

In times of stress, high yield can perform much like equities.  There is a lot of upside when you are buying high yield bonds with 8% coupons and a price of 90.  That is NOT the world we are currently in.  Specific bond selection is key to getting any further appreciate.  While that is primarily true for high yield, it is also true in investment grade.  We touched on the issue of yield versus spread in You look great in Blue, buy this Pink dress.

We will look more closely at the risk and problem in the individual sections, but this is a growing focus, particularly if playing the market through “indices” or beta plays like ETF’s.

My bigger question is how much more room is there to chase yield?  There is definitely more room to go, and my basic premise is that credit will continue to outperform, but there is time to be “patient” here.

Too many negatives were ignored by the market this week.

• The Greek deal is less of a deal and more of a plan than is priced in
• The market is pricing in a “successful” fiscal cliff negotiation, so the upside from a deal is mostly priced in, and the market too easily ignored the “posturing” this week, which, while I agree that it is posturing, sometimes posturing becomes reality, so concern is warranted
• Housing was generally good, and some real positives there, but away from that, the economic data seemed squishy, and there should be some concern that you can only blame so much on hurricane Sandy before someone gets nervous that the problem is bigger than that

So as a whole, it is time to dial back.  Be patient.  While the chase for yield is still the likely course of action, we are due for a pullback on risk assets, and fixed income will suffer.  I’m not so bearish that I like treasuries, just cautious for a little, that too much has been priced in, so downside is there, and for many fixed income markets, the upside is definitely capped.

Amazing what a Buyer with Endless Capacity Can Do for a Market

Treasuries did well for one and only one reason, more Fed purchases.  No one is buying treasuries in the “chase for yield”.  They are buying them for a trade.  If the Fed is going to buy the “belly of the curve” of 5 to 10 year bonds, then you might as well buy them too.

If you spend time this weekend reading about inflation expectations and their impact on treasuries you have just lost a few minutes of your life that you won’t get back.  At some time in the future, things like that may matter, but not now.  Pretending that treasuries trade the way they used to, is just wrong.  There is a big buyer and every fast money trader knows it, and will go along with what the Fed is doing.

That is why the Fed will never be able to exit by selling.  The moment they threatened to sell, yields would gap higher, regardless of anything else.  So for now, look for treasuries to do okay.  It is hard to sell off if the Fed is going to grow its balance sheet.  I do think it is hard to rally much further even in a risk off moment, so am neutral here.

Credit Spreads and Yield

Generally a good week for credit spreads.

LQD, actually performed relatively poorly.  It didn’t keep pace with treasuries.  We did see IG19 finish the week only unchanged, which was not great performance.  The reality is people had gotten too bullish on credit, then we saw spread widening in the “liquid” index, that quickly reversed itself.  I think the market is a bit too aggressively positioned from the long end here (mid week I felt the opposite), so I think we can pause.  The bonds may have underperformed as they dealt with supply (the new issue calendar was unexpectedly large for this time of year as companies issued debt to pay one time dividends).  The bonds also lagged because they hadn’t sold off as much as they should have during the post election fear stage, so some normalization is required.

High yield did well.  No complaints there but it is time to re-evaluate the strategy here.  Bond selection is meaningful.  It is easy to see a “risk on” market where generic ETF’s underperform.  Not all high yield bonds are the same.  In fact, high yield bonds are more complex than any other bond market, and many of the factors that make them attractive in general, aren’t so obvious right now.

Let’s take a peak under the hood of HYG.  I am not picking on HYG, since they generally do a good job of tracking their index, it is a matter that the index itself has problems here.

The biggest holding is the Sprint Nextel 9% bond due 2018.  Now that sounds good.  9% for 6 years, great!  Wrong.  It closed Friday at a price of 123 to yield 4.53%.  There is definitely some upside left.  The company has a new strategic partner, etc., but the upside gets capped.  Convexity and pull to par make it harder to go up (though here I’m willing to admit that the new strategic investor could help a lot).  The other issue facing this bond is the yield risk.  While high yield is often not correlated with treasuries (and in many cases is inversely correlated) this bond has too much rate risk to ignore.  Spread compression might not keep up with yields backing up in a “risk on” mode.

If rate risk is a potential issue with the first bond, then watch out for the next two biggest holdings, CIT 5.5% of 2019 and HCA 6.5% of 2020.  Those coupons don’t even sound like high yield, and the yields those bonds are trading at are even lower. Those are both trading around 4.3% and have far less obvious catalysts for spread improvement and are going to struggle to go higher in price if yields back up.

The 4^th largest holding is at the other end of the no upside spectrum.  11.25% INTEL bonds due in 2017.  This sounds great until you realize that INTEL is the ticker and the company is Intelsat and not the chip manufacturer.  But even still at least this looks like a high yield bond, so there must be upside?  Not so much.  The bonds are at 106.25 now with a yield to maturity of 9.4%.  Not bad, but also, not relevant.  They have a yield to call of 7.3%.  These bonds are callable in February at 105.625.  Could these bonds trade to 108?  On cursory glance, sure, why not?  They can’t.  In spite of the of “juicy” coupon and the misleading final maturity, a price of 108 would produce a yield to call of -0.86%.  While Germany might be able to trade at a negative yield, this bond won’t.  So there is less than 2 points of upside in this bond.  You would be betting against their ability to refinance this debt, which in this environment is a silly bet.  And if they can’t refinance this debt because they are having trouble, or the market is weak, then the price won’t be 106.25.

The next largest holding, the FDC 12.625% bonds are better because the call risk is a bit further removed.

So that is the top 5 holdings and demonstrate why expecting a generic pool of HY bonds to perform well, even in a “risk on” environment is a dubious strategy.  Individual credit selection will be important as will specific bond selection.  I am not afraid of high yield, and will be in again, but the ETF’s aren’t going to gap that much higher given the portfolio they have.

If you can do it, going long HY19, the CDS index is a much better “risk on” trade.  It is 100 equally weighted names with a fixed maturity, so it will outpace HYG in a “risk on” mode as it isn’t impacted by rates moving higher, and has a decent fixed duration relative to the bonds with bad convexity.  If I lose you with some of those words, I apologize, but it isn’t just jargon, it is what drives returns in fixed income.

Bank loans lumber along.  I like them here.  Good mix of downside protection and decent carry.  Almost no upside but that isn’t the purpose of owning them. CLO’s continue to get priced and done, meaning there is a deep bid to the underlying loan market.

Muni’s and a lack of liquidity.

Munis did well again, and it is hard to dislike them, but I am almost at that point.  Too much rate risk and far too much comfort with the credit risk.  Markets are thin and an already strong seasonal time for tax purposes, made them even more attractive with fiscal cliff discussions looming, but where you can get good liquidity, it is time to lighten up with the goal of buying back.  I am sadly aware of how limited that strategy is in the muni space since too few bonds have the liquidity necessary to be in and out profitably.  The etf’s aren’t a bad way to play that, but I won’t call a short there yet, because I figure I have to be really right on a call that most RIA’s will say is insane.  So for now, lighten up what you can, with intention of buying back cheaper, not getting out of permanently.

EM

EM did well again.  Not surprising in a general risk on environment, but was also helped by a ruling in favor of Argentina in their long legal battle with holdouts.

Spain – No Mas

I got out too early.  I didn’t see the Greek deal as being that positive.  While the election in Catalonia didn’t concern me too much, I thought it might impede further strength in the market.  I was wrong.  I thought I was smart and lucky as on Tuesday you could sell the 3.75% November 2015 bonds at 100.6, so up on the week and ignoring what I thought was marginal, if not bad news.  The bonds continue to climb, peaking at 101.5 (to yield 3.5%).  By the end of the week they were back to 100.80, making me feel a little better.  I still don’t like these bonds right now because too many people are acting as though things in Europe are done, and all that has happened is they have announced plans to be done, which is very different and leaves too much room for error.  What I really missed is how desperate people are to believe.  The 10 year bonds went from 101.75 last Friday to close at almost 104 this week.  That is far too much in my opinion and will not be looking to be bullish here.

What are the recent labour market trends?

The economic and employment outlook is bleak and has worsened in recent months and is not expected to improve in 2013, although a more positive outlook for the labour markets is still expected in 2014. The EU is currently the only major region in the world where unemployment is still rising.

The general picture covers a very diverse situation across Member States. There is a growing divergence between unemployment situations. Some MS have weathered the economic crisis well and are recording very low unemployment rates, as low as 4.4% in Austria or 5.4% in the Netherlands and Germany. This is the result of the generally good economic situation in these countries but also because they are reaping the benefits of previous reforms initiated long before the economic crisis hit. In other Member States unemployment is high or rising. Usually these are the countries that were hit hardest by the sovereign and financial crisis, such as Greece or Spain where the unemployment rate is above 25%. But these are also countries with well-identified problems in their labour markets, such as segmentation, insufficiently effective active labour market policies or ineffective links between school and work. These shortcomings have amplified the effects of the crisis though they were not the cause.

Net job creation (employment growth) has consistently decreased at EU level and across Member States. However jobs are still being created or remain unfilled in a number of sectors. During the 2008-2011 period, the ‘health and social work’ sector created more than 1.8 million new jobs and the net demand in this sector is expected to increase by 8 million up to 2020. In the ICT sector, by 2015, is expected that up to 700 000 unfilled vacancies will be available for ICT practitioners.

Unemployment is rising again and has reached unprecedented levels in the euro area. The overall unemployment rate of the EU-27 is currently at 10.6%, while in the euro area it reaches 11.6 %, the highest level since the birth of the EMU. In May 2012 the number of unemployed in the EU exceeded 25 million people for the first time ever and it has increased by an additional 0.75 million in the quarter since then bringing the increase to almost 9 million since 2008. The trend in unemployment is upward in the majority of the Member States.

Full report here.

China’s retail investors have lost all confidence in the nation’s stock market. In spite of improving economic fundamentals (see discussion), the market continues to plunge. Unlike many other emerging markets, China’s domestic stock market trading is dominated by retail investors. And many feel they have been duped, as the market hits new lows.

JPMorgan: – Of the households with stock market investments, 77% had not made a profit. The stock market has been the worst performing asset class over the last 5 years from various investment instruments available to the retail investor. If a retail investor put Rmb100 into the CSI300 5 years ago and left it, it would only be worth roughly Rmb 47 today…

Shanghai Stock Exchange Composite Index (source: Yahoo Finance)

China’s brokers have spent the last few years hyping the market, with a positive projections each new year. And each year retail investors have been disappointed. Now some are waiting for the government to effectively “bail out” the equity market before they would feel comfortable getting in.

WSJ: – “Local retail investors have lost faith on the stock market over the past three years. How can we expect investors to rush into a market where all expectations for a bottom, say the 3000 and the 2000 level, have proven to be wrong?” said Amy Lin, analyst at Capital Securities.

“The market is likely to stay weak until the government launches significant market-friendly measures, such as more stock buybacks of listed companies and another cut in banks’ reserve requirement ratio,” she said.

Many of China’s retail investors simply left the stock market altogether, preferring property and gold instead.

FT: – The domestic Chinese investors who dominate trading in Shanghai have had plenty of bad news to weigh up over the past couple of years. China’s economy has slowed for seven straight quarters and is on track to record its lowest annual rate of growth for a decade this year. There are concerns, too, that the political paralysis surrounding the country’s once-a-decade leadership transition has delayed needed reforms.

Indeed, many Chinese investors have simply given up on equities and moved to other investments such as property, gold or high-yield wealth management products.

The percentage of dormant brokerage accounts has been rising.

Source: JPMorgan

In a market with a more diversified investor pool, one would see this retail capitulation as a bullish sign. But there are very few active institutional players in China’s domestic market (although the government has been trying to change that by increasing foreign investment quotas.) For now it will take either retail investors coming back or a government action to turn it around. And given the change of the guard in China’s leadership, it may take them some time to organize a decisive action. For institutions who do have access to China’s domestic market however, this may be a good time to start testing the waters.

GoldSilverWorlds had the honour to do a Q&A with Dimitri Speck who is the author of the best-selling book “Geheime Goldpolitik”. He is chief financial engineer of Staedel Hanseatic and runsSeasonalCharts.com, offering a wealth of intraday trend charts. He is also one of the people who increased the pressure to create transparency in the German’s gold holdings.

A lot has been written lately about the gold price manipulation and the real amounts of gold reserves of the central banks. There are several views on the same topic, the most rational one being purely statistical. As it’s easy to get caught by emotions, we have chosen in this article to let the figures and the charts tell the story.

As a seasoned mathematician, Dimitri Speck is focused on what the charts are revealing. He looks both into intraday charts as well as seasonal charts, the former being one specific variant of the latter. Based on years of chart analysis, he could clearly pinpoint the manipulation in the gold market. In his book, he explores the subject of gold holdings of the central banks, in particular the Bundesbank. Interestingly, there is a link between all the different topics we just mentioned, which was the topic of our Q&A.

Transparency in Germany’s gold reserves

Dimitri Speck observes that the Bundesbank (German central bank) has to audit the German gold reserves on a regular basis and publish the results. That’s an obligation by German law. It needs to include in their reports for example if the gold has been leased out or if it’s physically there.

The point is that nobody has paid attention to these audits for a long time. A couple of years ago several authors started to question why the Bundesbank didn’t publish the results of their audits. Dimitri Speck was one of them. The question did escalate to some members of the Parliament. In Germany in particular, there is a Court of Auditors that picked up the topic two years ago (i.e. “RechnungsHof”, a special office which controls the public finances). The pressure increased and resulted in a promise by the Bundesbank to provide an answer “soon”. Their answer finally came in October. That’s the background of the whole “affair” that was created in October on Germany’s gold holdings.

Gold price suppression proven by intraday charts

Based on his statistical research, Dimitri Speck concludes that central banks started to influence systematically the price of gold as of August 1993. His conclusion comes in particular from his intraday statistics, where he observed several anomalies. First, since 1993, the price has been falling systematically during the trading session of COMEX in NY. Another trading anomaly is that during the PM fix the price systematically tends to drop significantly.

The following chart is the result of some 16 years of recording intraday data. The sudden price drops are so sharp and systematic, that it can only point to intervention.

In the internet press, we mostly read that the manipulation is visible in the COT reports. So our question to Dimitri Speck was how those two relate to each other? Now here is it where it gets interesting. It appears that the manipulation in the futures market (visible in the COT reports) comes on top of the revelations on the intraday charts. The point is that the interventionists increased significantly their activities in the futures gold markets in May 2001, what is visible in the COT report. Before that, the price was more suppressed through selling and leasing of gold. As soon as the futures markets got into play, an increasing number of price shocks have appeared with an increasing intensity. Obviously those price changes were mostly drops rather than increases. It becomes clear on the following chart. As of May 2001, the “climate has changed” because of the futures market, which is clearly an anomaly. The decline in the lower part of the chart, that started at that given point in time, shows the net positioning of commercials as a share of total positions. The line is significantly lower, proving that commercials are more on the short side.

So what’s visible on the charts is that, since May 2001, the commercials have reinforced an ongoing trend that started in 1993.

As a sidenote, Dimitri Speck adds that short positions are not the only condition for price suppression. Before 2001, similar price drops did occurr. Shorts are just one of the many influencing factors. For sure they do have an effect, as we saw for instance in the silver market starting 14 months before the peak of May 2^nd 2011. During that period, central banks temporarily scaled down their interventions as clearly shown by the intraday charts. It led to the gigantic bull run.

From a supply & demand point of view, during another insightful interview, Mr Speck points to the classical example at the end of 2008. There was so much demand for gold at that time because of the extreme fear levels. Yet the gold price remained low price despite long delivery waiting times. Central bank interventions clearly prohibited the price of gold to rise above the $ 1,000 mark.

Central banks have a double interest in gold

During our discussion, Dimitri Speck pointed to the double interest of the central banks. On one hand, gold cannot rise too fast as it reveals weakness of the central banks’ “product” (i.e. it’s currency) and their balance decrease in value. That’s why the Washington Agreement came to life, created in 1999  after a too sharp decline of the gold price. On the other hand, as central banks are accumulating gold especially in the last years since 2008, they have a vested interest for a higher value of the asset they are accumulating.

Gold almost always reflects a political price. It has never been in a real free market:

• In the 60’s gold had a fixed price.
• In the 70’s gold was subject to serious price suppression (more or less officially recognized).
• In the 80’s only a minor number of interventions have taken place, as there was no necessity to intervene (have a look at the gold price chart to understand this point).
• Starting from August 1993, it marked the era of hidden and systematic price suppressions.
• It is very likely that we’ll continue to see manipulation for a long period of time (decades?).

Based on extensive research, Dimitri Speck explains three phases when it comes to central bank interventions in the gold market.

In the first phase, the central banks prevented an increase in price above the threshold of 400 dollars. Phase two was marked by private leasing and lower prices were the result of a desire for profits. Phase three was characterized by a controlled price increase. Although interventions are operated secretly, there is sufficient evidence to prove gold price interventions based on statistical analysis and further evidence

On the question which means are used to intervene, Dimitri Speck explained during an interview withLars Schall that it happens in three ways. First, gold is being sold in the market creating artificial supply. Second, gold is being leasing via the bullion dealers like JP Morgan or HSBC amongst others. That practice mainly started in August 1993 and has the same effect as selling. Although these two two practices are being applied less than before, the third manipulation tactic has gained “popularity”. Sudden shocks are created by selling large quantities in order to influence the behavior of investors.

What will the future bring for gold

In case the financial system will not collapse and we continue at the current pace of inflation below 10%, we could see a gold price 10 times higher even with the ongoing interventions. In a similar way the price increase has been controlled from $ 250 to $ 1,900. It’s a matter of not allowing the gold price to rise too fast. Only if the markets gain control over the money system as the result of for instance much higher inflation rates, the gold price could rise in an uncontrolled way (like the rise of the inflation rate in the 70’s for instance, which was the result of distrust in the monetary system). Currently we don’t see such an event on the horizon, at least it’s not visible yet. That doesn’t tell anything about the future: such an event might occur in 2 years or in 20 years, or even never.

It might happen that central banks change their mind and set a higher gold price in order to stabilize the currency system or their balance sheets. That’s indeed a kind of a gold standard. Here again, it is potentially in the cards but it’s not visible on the horizon.

Mind that a gold standard as such will not solve the over-indebtedness we are currently facing. Once in the indebtedness is “solved” however, gold can play a role in limiting the credit bubbles. Excessive spendings by politicians is the core issue. A gold standard is one of the means to keep that behavior under control.

The future is open and the point is that there are many possible outcomes. One thing is for sure however. In an indebted world it will take a lot of time to see get normal debt levels again. Only with a much lower indebtedness we can return to a stable system again.

Speaking about the future, Dimitri Speck does not hold high expectations about the upcoming Basel III  implementation. He asks loudly whether the new regulation will not bring more problems. Although it’s for sure a good idea to limit the credit to the economy, the fact of having yet more regulation could be distracting. As the financial system is too complicated, less but more strict rules could be a better solution, he says.

Video below.

There was some chatter about the performance of fixed income ETF’s yesterday.  They performed poorly at least relative to stocks and some had a late day sell-off fueling some speculation that credit wasn’t doing well.

That speculation was just wrong, but highlighted so,e problems with existing fixed income ETF’s.

They were trading at a premium and that premium tends to disappear when bonds become easy to source.  While HY bonds remained well bid, the investment grade bond market is being flooded with new issues – primarily to enable large one time dividends.  Might be worth probing into these companies a little deeper, but that is for another day.

So premium versus bond availability explains some of the noise, but to a large degree that is secondary.

The biggest problem facing investment grade and even to a large extent high yield, is that all the ETf’s (and most funds) are yield products not spread products.

While spreads tightened yesterday (especially in the fast money, overly shorted CDS market) bond prices in some cases were down because the move in treasuries outpaced the spread tightening.

If you have time this weekend, read any article about the credit markets and it will drone on and on about spreads but then only give yield investments.  Why tell someone they look great in blue, only to offer the pink dresses?

While HY is traditionally not very sensitive to rates (and is often negatively correlated) there is currently a large portion of the market that is.  Many of the big BB bonds out there trade more like investment grade bonds and the rate risk is real.

I would rather own spread product than yield product here and the only reason I’m not obsessing about rates is that the Fed is going to do everything possible to keep them tame until unemployment is below 7%. Potentially a very long time.

I also think equity is more interesting than credit here.  Too many bonds in HY, the ones that aren’t BB and exposed to rate risk, have awful convexity which limits their upside as they can be called anytime.  Expect HY19 a spread product to outperform HYG – I really like that trade here.

Alternatively move into “second order products” or shift money to those who are good at managing them.  Illiquid credit is worth a look. The non ETF, non hedge fund go-go bonds still offer a yield pick up versus their over owned brethren and let’s be honest, those “liquid” bonds are rarely that liquid when you NEED them to be.  Old structured mortgage debt is interesting but harder to find than a right call on CNBC. Middle market lending, project finance and some other areas abandoned by big banks and not picked up by small banks are gaining a lot of alternative attention – tricky area but can offer real value. CLO paper can be good, and at this pace some will be tempted to resurrect the synthetic CDO market. There are some great opportunities there – many for technical reasons that can generate returns In a hurry.

Basically go ugly early because you will anyways.  This chase for yield (and spread) will continue so look for what people will buy next (less liquid) and make sure you own what expresses your view (if you like spread, don’t just buy yield).

The ISI Group combined four US regional Fed indices with Markit Manufacturing PMI to create a comprehensive US manufacturing index (chart below). A pattern of growth starts followed by fairly sharp corrections emerges. Some have speculated that this volatility, at least in part, can be explained by the Eurozone uncertainty flare-ups: Greece (2010), Italy (2011), Spain (2012). The pattern also exists in the economic surprise indices (see post-1 and post-2).

Source: ISI Group

What’s particularly concerning is that subsequent recovery has not been as strong as the previous “cycle”. Businesses are becoming increasingly skeptical about spurts of growth. A similar pattern can also be seen in the ISM Business Confidence measure.

Source: Tradingeconomics.com

Anecdotal evidence suggests that the current “cycle” will not go into its full upswing until there is clarity with respect to the US fiscal situation.  But already some are talking about a strong first quarter of 2013 induced by Hurricane Sandy reconstruction expenditures – and then possibly another dip next summer, repeating the pattern once again. In the long run, this volatility in confidence is highly undesirable because it inhibits capital investment and hiring, forcing corporations to sit on cash (or pay cash out in dividends).

During his civil lawsuit against the People’s Republic of China, Brian Milburn says he never once saw one of the country’s lawyers. He read no court documents from China’s attorneys because they filed none. The voluminous case record at the U.S. District courthouse in Santa Ana contains a single communication from China: a curt letter to the U.S. State Department, urging that the suit be dismissed.

That doesn’t mean Milburn’s adversary had no contact with him.

For three years, a group of hackers from China waged a relentless campaign of cyber harassment against Solid Oak Software Inc., Milburn’s family-owned, eight-person firm inSanta Barbara, California. The attack began less than two weeks after Milburn publicly accused China of appropriating his company’s parental filtering software, CYBERsitter, for a national Internet censoring project. And it ended shortly after he settled a $2.2 billion lawsuit against the Chinese government and a string of computer companies last April.

In between, the hackers assailed Solid Oak’s computer systems, shutting down web and e-mail servers, spying on an employee with her webcam, and gaining access to sensitive files in a battle that caused company revenues to tumble and brought it within a hair’s breadth of collapse. (full story here).