Wednesday, April 25, 2007

Who's the more foolish? The fool, or the fool that follows him?

The corporate bond market continues to gather strength during April. After spreads gapped wider when the stock market melted down on 2/27, most investment grade corporate bonds have recovered their losses.

What happened in the corporate bond market in the days immediately following 2/27 and their subsequent recovery tells us a lot about what is driving corporate bond spreads. First an illustration. This graph shows the spread of three long-term, large issue corporate bonds. Goldman Sachs (rated Aa3/AA-), AT&T (A2/A), and Comcast (Baa2/BBB+). Since none of these three have had particularly good or bad news lately, they are all good examples of where corporates in general are moving. I did a basic normalization of all three by starting their spread at 100 and moving it up or down from there. So any point where any of the blue lines are below 100 (dashed horizontal line), the spread tightened from its initial 2007 level. The red line is the VIX, which I'll get to in a minute. The vertical dashed line is the 2/27 mini-crash.

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First, let's agree on three basic premises.

  • Most traditional money managers are negative on the corporate basis, and have been for some time. Many (if not most) are looking for some catalyst that will push corporate spreads wider.
  • Hedge funds and other speculative investors are the marginal buyer or seller of credit risk on any given day. Many hedge funds use quantitative models in building arbitrage strategies involving the corporate bond market. The VIX (or some similar measure) is a very common input in such models. Hedge funds are also involved in paired trades where one is long or short the stock and the opposite of the bond.
  • There remains a tremendous level of global liquidity.
Bearing these points in mind, think about the reaction on 2/27 and the days thereafter in the corporate bond market. Assuming point 2 is right about arbitragers being the marginal buyer or seller on a given day is correct, the corporate market was most likely driven by hedge fund selling during this period. Anecdotal evidence I heard at the time backs this up: dealer desks told me they couldn't sell protection fast enough, and there was very little in cash bond trading. If traditional money managers (or even retail) had been leading the sell-off, there would have been more trading in cash bonds.

So why would hedge funds be buyer protection aggressively in the face of a 400 point drop in the Dow? It sounds like a silly question, because obviously if the Dow is dropping like that, there is some kind of repricing of risk going on. But consider what happened since 2/27. By March 21, the Dow had recovered more than half of its losses from 2/27. But these three corporate bonds did not start tightening meaningfully until mid-April. Today, the Dow is over 220 points higher than its pre-2/27 high. Our selection of corporate bonds are all still wider than before the 2/27 rout.

So those that would chalk the whole thing up to risk repricing must suppose that the stock market and the bond market have divergent opinions of the same set of economic fundamentals. Maybe, but I don't think Occam would approve. What if it isn't really fundamental? If it were entirely technical, then it isn't hard to imagine that the corporate and equity markets would go in different directions because they're subject to different technicals.

Back to the three premises. If portfolio managers are generally negative on corporate spreads, they are likely to view a sell-off as lasting. Let's face it, most people's reaction to market events is biased by their positions. So they don't buy on the dip, not right away, because they see it continuing. They probably don't sell what positions they do have either. They are already short of their benchmarks and are loathe to deviate too much. On the other hand, equity PMs aren't necessarily as bearish. So maybe they are more aggressive about buying on the dip. Still, this doesn't explain why the rally in mid-April. If PMs aren't doing anything, then corporate spreads would be hanging wider.

Meanwhile, there is still this ocean of liquidity. Cash will be invested someplace. But this massive liquidity doesn't come into the market on any given day. It just sits there, buying up a certain amount of bonds each day. So while the liquidity might explain why corporates didn't get even wider, I don't think it explains the delayed rally. It isn't like the liquidity showed up in mid-April after sunning in Florida during March.

So we're back to speculators driving the market. Why would they change their minds on corporate risk so quickly but at the same time, not change their minds concurrent with the stock market rally?

My bet is that some fast money is following the VIX. Look back at my graph. The VIX spikes higher from 11 to 18 on 2/27, corporates sell off. The VIX stays high until the end of March, averaging 15.5 for the next 20 trading days, corporate spreads stay high. The VIX falls lower at the end of March (its averaged 12.9 in April), and corporate spreads get a little better. But the VIX is still well above its recent low of 9.9, just as corporates spreads remain above their recent tights.

Now, I don't know of any quantitative spread model that doesn't involve the VIX, or some other measure of stock volatility. The theory is that higher VIX levels indicate economic uncertainty, which is bad for corporate bonds. So your model says sell corporates as the VIX is rising, and buy corporates as its falling. But looking at this graph, doesn't it look like these traders got whipsawed? If you add to this that CDS were even more volatile than bonds over this period, its likely that some traders really got whipsawed.

I am not here to bury quantitative models. I use them myself constantly. But I think one needs to be careful when using a measure of the market's emotional state as an input into a quant model. The market is manic-depressive. Guessing that today's mood is an indicator of tomorrow's mood is dangerous. So if any trader did get whipsawed trying to trade the VIX while ignoring the economics around him, it isn't the model that's the fool. Its the fool that followed the model.


Anonymous said...

So why would hedge funds be selling protection aggressively in the face of a 400 point drop in the Dow?

d'you mean buying protection?

Accrued Interest said...

Yeah I fixed it. What would I do without commenters editing my work?