Thursday, October 16, 2008

The Empire doesn't seen leverage as any threat...

Yield spreads in various areas of the bond market are at non-sensical levels. I'm not talking about financial corporates or junk bonds, which may look cheap, but do have significant risk. I'm talking about state-backed municipal bonds, government-guaranteed student loans, agency MBS, Fannie Mae and Freddie Mac senior debt, among others. These have little or no credit risk, the chance of investors recouping their principal over time has not materially changed, and yet spreads on all these bond types is at or very near all-time wides.

There are specific reasons why each of these sectors has widened. But the real question is, what is going to drive the trading levels on these sectors toward economic reality? Or maybe a better question is, if its an arbitrage, what's stopping the market from taking advantage of the arbitrage?

The answer is leverage, or a lack of it.

Capital is supposed to flow to the area where it can generate the best returns. In the past, arbitragers would constantly comb the bond market, looking for bonds that could be purchased with yields higher than the arbitrager's cost of borrowing. Hedge funds would pledge the bond to a bank or a broker-dealer along with a certain amount of cash, and in exchange was able to borrow at a relatively low rate. Banks would buy bonds that would out-yield their deposit yields. Dealers would buy bonds and put them into arbitrage accounts.

This system worked well until it was taken one step too far and we got SIVs and CDO-squareds, and we all know how the story ends.

Now of course, leverage is extremely difficult to come by, and this makes it difficult for hedge funds and other fast money to get involved. Say you are looking at 5-year Fannie Mae senior debt. The spread on that paper is currently 1.3% over the 5-year Treasury. We know that Fannie Mae has been put into conservatorship by the Treasury, so that spread should be close to zero. So let's say a hedge fund predicts the spread will drop to 0.3%. That would imply a price return of about 4%. But hedge funds can't charge 2 and 20 to make 4% for clients. That 4% return either has to happen quickly or they need to leverage it.

Its going to be a while before we find a happy median between the excessive leverage of the past and the unavailable leverage of the present. Until that happens, yield spreads are going to remain very wide on a variety of fixed-income sectors. Meanwhile, investors in beaten up sectors are going to have to be patient. I've gotten many e-mails from readers about municipal and agency bonds lately. Generally speaking, there is nothing fundamentally wrong with either sector, but its not easy to say when it might start to improve back.

Perhaps the period of excessive leverage programmed investors to expect any arbitrage to disappear quickly. Today its going to take real money buyers coming in to restore fundamental value. And that just takes time.


PNL4LYFE said...

Well said. In addition to not being there to remove these arbtirage opportunites, hedge funds and other (formerly) leveraged fast money investors are currently contributing to the dislocation as they are forced out of relative value trades they put on when the dislocation began. As Howard Marks of Oaktree said, 'being too far ahead of your time is indistinguishable from being wrong.' From what I'm hearing, there is still more forced deleveraging to come; prime brokerage credit officers are very busy these days...

Andy said...

Great Post and I totally agree. As I wrote recently as well, Leverage and the lack of appreciation of it, was the root cause of the financial crisis. Leverage is a double-edged sword that is a powerful ally during boom times, but can quickly become your worst enemy during the ensuing bust. We learnt this lesson the hard way.

Lockstep said...

Good post.