Wednesday, July 25, 2007

I have a bad feeling about this...

Liquidity in the bond market, outside of Treasuries, was the worst I can remember since 2002. Absolutely nothing in the cash market was trading, particularly on the bid side. Supposedly CDS were well traded. But cash bonds bids were not in context with CDS, particularly for LBO or housing-related names.

The situation got so bad that bid lists of AAA-rated stuff were getting pulled for lack of bids. Dealers have become so skittish that they are unwilling to position anything.

There is an old Wall Street saying: the market can remain irrational longer than you can remain solvent. You see a bond trading at LIBOR +50 that should be LIBOR +25. Irrational! you say. But when there is no liquidity, you can wake up tomorrow and its LIBOR +75. Then next week its LIBOR +200. Irrational still perhaps, but you are out of a job anyway.

Why no serious buying on weakness? What happened to the global liquidity glut? I think that's a question yet to be answered. In the short-run, there is just no sponsorship. Real money accounts have been generally negative on the corporate basis for at least 18 months. If you are bearish on corporates primarily because they are tighter than historical averages, you are still bearish now. According to Lehman (if I can trust their numbers) the 10-year average Baa OAS is 165. Its currently 119.

Something has to give between the stock market and the corporate bond market. Since May 1, the Merrill Lynch High Yield Master index is down 4.7% in price return, while the S&P 500 is up 2.1%. If there is a repricing of risk, both markets should be performing poorly.

One possibility is that dealers are trying to work through their sub prime ABS/CDO positions, and its impairing capital. Broker/dealers are providers of liquidity in the bond market. In essence, they are market makers. Its rare that large trades are immediately crossed, which is a term for when the dealer buys a bond from one customer and sells it to another. Usually there it takes some time to find a buyer. Maybe an hour, maybe a month. Anyway, if dealers are unwilling to step in and bid on bonds, there may well be no bid to be had.

In that scenario, spreads have to widen. Because any time there is a motivated seller, they have to sell at a spread so attractive that someone, an end investor, steps up and buys it.

Another possibility is that this is all about the confluence of the heavy calendar in high-yield combined with slowing CLO creation. If that's all it is, then high-yield should be able to stabilize sometime in the fall or winter, once the supply is normalized. The stabilization might be at higher spreads, but I believe that stability will bring the CLO market back. I've maintained several times that if the CLO market can perform well through the sub-prime mess it will be viewed as a validation of the structure and solidify CLOs as an effective risk management tool for banks.

Alternatively, you could have some CLOs experience stress. This might be because one of the recent LBO firms goes bankrupt. Remember that CLOs in general are thought to have heavy exposure to LBO deals, so a bankruptcy would hit multiple CLOs. Remember that CLOs don't need to worry about spread widening. Just because their XYZ corp loan was made at LIBOR +200 and would now be +300 doesn't matter. CLOs (mostly) are cash-flow instruments only. As long as XYZ keeps paying P&I, everything is fine with the CLO. Remember also that CLO deals assume a certain level of defaults, so having some loans default is OK. In fact, CLOs generally have far less leverage than the ABS CDO deals that are currently stressed.

I'm biased to a more benign outcome to all this. Sub prime MBS was such a small percentage of the global fixed-income market, it seems odd to think that even a severe problem in that sector would create a lasting contagion. I think corporates (both IG and HY) settle in at levels near or slightly wider than current levels after a volatile 2-3 months. Buying opportunities will emerge among IG names that for whatever reason become targets of short-sellers or the media (MBIA, Bear Stearns, and Washington Mutual come to mind). There might also be opportunities among HY names caught up in the supply story, like Chrysler, Alltel, FDC etc., assuming those deals don't fall apart entirely. But if you are going to play that, have your resume in order. Those could be some serious bumpy rides.

12 comments:

The Dude said...

Hi,

I'm new to the bond market and was lucky enough to find your site. It's been wonderful to read, thanks so much for all your time and work you put into it.

Best,
Matt

Janness said...

Hi, will like to know, when say on a 10Y corporate bond offered at 7.50% yield, how is this equivalent to Libor + 1.90? I'm assuming the Libor in question is on 3mL which is around 5.36% right now. Otherwise, am i wrong to say that on a 10Y bond, one usually takes the 10Y Swap rate (which is ard 5.6) instead?

Either that or L+190 is actually 10Y swap +190bps. tks!

TDDG said...

Dude:

Welcome to the blog. Thanks for the kind words. Please keep contributing through the comments as it makes the blog infinitely more fund to write.

Janness:

Its depends on whether its a fixed or floating bond. If its fixed, then its 10-year swaps, which are currently at 5.62%. So 7.50% would be about LIBOR +190. Sounds like you were on the right track.

If its floating (as most bank loans are), then its spread off whatever the floating index is. Usually that's 3-month LIBOR, but sometimes its 1 or 6 month LIBOR.

Anonymous said...

Congratulations on your blog! very interesting.

Quick question: What probability would you assign to a AAA CLO "buyer strike" and its possible effect on the cdo/loan market?
Thanks
Mike

TDDG said...

I think if there is a buyers strike in CDOs generally, it will be the market saying they think the rating agencies are incompetent. Bear Stearns recent wrote a bit where they said this is why spreads are widening now.

I come back to the widespread liquidity in the financial system. Where is this money going to go? If indeed credit spreads stabilize, at whatever level that occurs, money will come in.

Anonymous said...

Hi
most interesting blog I found in the bond world. I will check here regularly to read your great pieces.
Can you do a primer on CLOs?
I think your CDO and CMO intros are great stuff!

Keep it up!

TDDG said...

CLOs are not fundamentally different from ABS CDOs, except that the collateral is commercial loans as opposed to consumer loans.

The main difference is that CLOs collateral tends to have average credit ratings in the B to BB/Ba area. ABS CDOs tend to have investment-grade ratings. What I mean by this is the actual bond portfolio that backs the deal.

As a result of this, there needs to be much larger subordination in a CLO deal. More subordination means that the deal can withstand much higher default rates.

So before the while subprime mess, people viewed this as a trade off. In ABS CDO you have higher quality collateral, but you also had more leverage. In CLOs you have lower quality collateral, but less leverage. Investors picked their poison.

As I wrote here...

http://accruedint.blogspot.com/2007/06/whos-more-foolish-fool-or-fool-who.html

The problem with ABS CDOs is less about high defaults and more about high correlation. Let me know what you think.

Anonymous said...

As an equity guy in a heavily focused fixed income shop I find your site to be very helpful. I will be sure to post questions from time to time to 'keep me in the loop'.

I hear conflicting views that credit deteriation is 100% technical through CDO liquidation because balance sheets have been steadily improving since 2002 and IC ratios are solid. On the other hand I hear that the a huge amount of new issuance went to companies that were not so credit worthy but were able to tap the markets becuase of the appetite from securitization vehicles. With this secondary market all but frozen these lousy credits will certainly drive up the bankrupcy rate and thus a system wide credit widening.

I suppose both views could be right to some extent, but would you mind sharing a thought on this debate.

Thank you.

TDDG said...

Anon:

I want to write a full post on this subject, but I have to gather my own thoughts. I think the two reasonable views are 1) its technical and 2) the credit market is predicting a serious economic slowdown.

I think what we really have is a mini bubble coupled with a technical move, but I'll elaborate soon.

Colin said...

it's great to find some well reasoned commentary from someone who understands this whole opaque business. keep up the good work.

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