Is the credit market cruisin' for a brusin'?

A couple of weeks ago, I wrote a post entitled Stocks cruisin' for a brusin'. Now it appears that the corporate bond market has fault lines of its own that may crack soon. Citi strategist Stephen Antczak (via Business Insider) explained that were enormous flows into corporate credit in search of yield over the years:

The first thing to remember, writes Antczak, is that mutual funds and ETFs together are responsible for a big portion of the marginal flows into corporate credit markets in recent years. Mutual funds now account for $1.7 trillion of the market, up 69 percent from the first quarter of 2009, and ETFs are responsible for $200 billion – up 328 percent in the same time period.

If interest rates were to rise, it would create forced selling by funds as investors redeemed:

The problem is that these investors tend to be backward-looking and sensitive to total returns, particularly negative total returns. And if 10-year Treasury rates were to rise anywhere near what our economists expect (again, 2.5% by year end) total returns in the corporate market may very well be negative. And if returns do in fact turn negative, we would expect investors to scale back mutual fund investments, creating forced sellers.

Illiquid market + stampede = Rout
Corporate bonds are notoriously illiquid, who would take the other side of the trade? David Merkel of Aleph Blog explained corporate bond liquidity this way:

In any vanilla corporate bond deal, when it comes to market for its public offering, there is a period of information dissemination, followed by taking orders, followed by cutoff, followed by allocation, then the grey market, then the bonds are free to trade, then a flurry of trading, after which little trading occurs in the bonds.

Why is it this way? Let me take each point:

1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to seven minutes.
2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed. When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?” After that, you panic.
3. cutoff — it is exceedingly difficult to get an order in after the cutoff. You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
4. allocation — I’ve gone through this mostly in point 2.
5. grey market — you have received your allocation but formal trading has not begun with the manager running the books. Other brokers may approach you with offers to buy. Usually good to avoid this, because if they want to buy, it is probably a good deal.
6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds. If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand. They might allocate more to you in the future.
7. flurry of trading — many brokers will post bids and offers, and buying and selling will be active that day, and there might be some trades the next day, but…
8. after which little trading occurs in the bonds — yeh, after that, few trades occur. Why?

Corporate bonds are not like stocks; they tend to get salted away by institutions wanting income in order to pay off liabilities; they mature or default, but they are not often traded.

Signs of froth in credit
What's more, investors have been raising their own risk levels to chase yield, such as maturity extension (i.e. going out longer along the curve) and buying lower credits. Antczak indicated that bond duration of new issuance is way up, indicating rising price risk as investors extended maturity.

Surly Trader illustrated this example of how issuers are responding to investor demand with low quality credit issues:

Jump into the news from WSJ:

The consumer-lending joint venture of private-equity firm Fortress Investment Group and insurer American International Group is planning a rare securitization of subprime personal loans as early as this week, in the latest test of risk appetite for asset-backed bonds, where soaring demand has pushed yields to record lows.

The $604 million issue from consumer lender Springleaf Financial, the former American General Finance, will bundle together about $662 million of loans secured by assets such as cars, boats, furniture and jewelry into ABS, according to a term sheet.

Are you kidding me? Furniture? Do I get a personal loan and show them a picture of my couch? Do you think when I figure out that I won’t be able to pay back my personal loan that I might take my couch with me? Are they going to hold the items in a massive pawn shop?

It gets better:

The 190,627 loans in the Springleaf deal have an average FICO credit score of 602, in line with many subprime auto ABS. But the average coupon of 25% on Springleaf’s personal loans is above that on even “deep subprime” auto loans, probably because there is no collateral for 10% of the issue, an analyst said.

The “A” rated slice of the debt may yield near 2.5%, or two percentage points over an interest-rate benchmark, according to price talk circulated to investors.

Holy s*#t.

With 190,627 loans, that implies that the average loan size is about $3,000. How exactly do you think you will collect on any of those loans if there is a default? Do you think it might cost more than that to even get one guy to pay it back? Average FICO of 602? If you know a bit about credit scores, you know how trustworthy this group has been in the past. There is just 10% of subordination protecting this bond and for putting your head in the guillotine you get a sexy 2.5% interest rate every year…thats $2.50 for every $100 you put on the roulette table…

If you hurry, there might be a few units left for you...


Trouble ahead for the risk trade?
The Business Insider article I mentioned also cited the linkages between the credit market and the stock market:

The chart below, via BofA Merrill Lynch, shows the size of the rally in credit – and how it has mostly tracked that in other risky assets like the S+P 500 that began in November.

The big spread tightening in the credit space that occurred when a deal was reached on the "fiscal cliff" is what caused so many Wall Street strategists to blow through their year-end targets only a few days into January.

However, that uptick circled in the chart above – a significant sell-off in corporate debt at the end of the month – has people talking.

Should we see a selloff in the increasingly fragile credit market, it could turn into a rout whose contagion could spread into other risky assets like stocks. I have no idea what the trigger might be, but stock bulls should be aware of this risk.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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