Heisenberg Report

“Max Long Liquidity,” A “Bonanza,” & The Coolest Thing You’ll Read On Monday

Ok, let’s see…

Best way to frame this is with two… no wait… three quotes.

#1 from the NY Fed:

Liquidity of the cash bond market has been deteriorating relative to the CDS market.

#2 from us:

One explanation for the trend could be that “investment advisors specializing in corporate credit may have increased their long positions (by selling more protection) in CDX indexes in the second half of 2015 in anticipation of future fund outflows; by selling the more liquid CDS rather than buying the less liquid bonds, investment advisors still take on credit risk exposure while maintaining a relatively liquid portfolio.

#3 from 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 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.

Lots of important points in there, but you know, colloquially, you’ve got the substitution effect as investors migrate away from (relatively) illiquid cash bonds to more liquid CDS, the notion that credit spreads are near post-crisis tights but that really doesn’t matter because betting on decompression is expensive, and (implicitly) CDX and iTraxx should actually become more liquid as vol rises because traders will be looking for the most liquid way to position.

Got that? Great.

Now with that in mind, check out what’s undoubtedly an early candidate for “sellside note of the week” from BofAML’s Barnaby Martin.

Via BofAML

We feel that there still potential for the CDS indices to continue grinding tighter over the spring and summer months, especially as stocks continue to be supported by a strengthening earnings cycle. Even though we doubt that at current levels there is a catalyst to see a significant risk addition in credit, shorting credit indices is still an expensive trade to put on. This is on the back of two key reasons: liquidity and carry.


Max long liquidity

The recent market moves have shown us that credit investors are looking for liquidity. Longs in iTraxx Main have significantly increased in the past fortnight (chart 2). Last week’s moves should have seen more sellers of protection, increasing long risk positioning via Main further (DTCC data currently available for up to the 28th of April). Credit accounts are looking for liquidity and scalability via CDS indices as the cash bond market tends to exhibit less liquidity when volatility rises. To the contrary we find that liquidity in CDS indices is actually positively correlated to market volatility (chart 3). When market becomes more volatile, credit accounts resort in trading CDS indices to manage risk and betas, increasing volumes traded via the product.

In chart 3 we present the countercyclical relationship between CDS index trading volumes vs market volatility. In more detail we present the weekly volumes across the CDS index market (beta-adjusted across European indices) vs the 3M implied vol ranges (over six weeks) as a measure of vol-of-vol in the market.

We find that the higher (lower) the vol-of-vol is (irrespective of the direction – both on the upside and the downside) the higher (lower) the volumes traded in the CDS index market. Effectively when volatility rises investors are resorting to trading risk via the CDS index market.

Good carry + low vol = attractive risk/reward

Liquidity and tight bid/offers in the CDS index market has been pivotal for a number of investors to use the CDS product as a risk allocation tool, rather than a hedging tool that has been traditionally used. However, the record low volatility (chart 4) in the CDS market has significantly contributed in improved risk/reward profile as chart 5 shows. Close to record low implied and realised vols across credit indices has been a bonanza for investors that have been using iTraxx Main as the “liquid” long in European credit (chart 2).