Performance Anxiety

Lord knows credit is one of my favorite punching bags.

The reader will forgive me for quoting myself here:

Beating dead horses has become a hobby of mine.

Although “posthumous equine abuse” isn’t something I’d list under “interests” if I were say, signing up for a dating site, I don’t mind engaging in it if I think doing so might drive home a particularly important point.

That’s one of my personal favorite Heisenberg passages.

Credit is definitely a dead horse I’ve beat continually. But that’s just the thing. It’s not dead. Far from it. In fact, it’s alive and kicking. And in need of beating.

Spreads have compressed massively and we’re not seeing much in the way of decompression unless you want to look at European sovereigns (which incidentally we should be looking at as a measure of political risk).

There are myriad reasons for credit’s resiliency in the face of mounting risk. One of those factors amounts to performance anxiety. Put simply, if there’s anything left in the tank for credit, you don’t want to be the guy who de-risks first. And you damn sure don’t want to be the guy who puts on a decompression trade with a costly carry while your peers enjoy the last few bps in the rally.

Consider that, and consider the following brilliant commentary from Citi.

Via Citi

If there is such a thing as a ‘Holy Grail’ in the credit market anno 2017 then surely the no-cost decompression trade is it — the trade that performs, if spreads widen, but doesn’t cost a bundle of carry if they don’t.

Spreads could evidently still compress further under some (optimistic) scenarios, but most portfolios are long to benchmark already and at current levels the potential downside greatly exceeds the potential upside no matter how you look at it. That leaves a glaring asymmetry.

Instead, we’d argue the principal concern people have with decompression trades here is that they tend to be negative carry. In a benign market, it is easy enough to de-risk by shortening maturities, selling higher beta bonds and/or moving to defensive sectors. But as illustrated in our 2017 outlook, when spreads are low, volatility is low and dispersion is low, a few basis points of carry can matter a lot to a fund’s percentile performance against peers. And against the short-term metrics by which performance tends to be measured many will struggle to forego the incremental carry — until a negative trigger becomes immediately obvious.

And so the game of musical chairs continues, even as the stakes seem to be getting higher and higher.