“As The Beast Sleeps, The Tendency Is Toward Complacency”

To be sure, we’ve spilled gallons upon gallons of digital ink in these virtual pages shouting about how complacent credit (both IG and HY) is. You can read some of the more recent posts here:

And while those are good, these two older pieces are perhaps more entertaining:

Basically, spreads haven’t responded to anything at all this year. In fact, as Deutsche Bank noted in the last post linked above, “the overall € IG non-financials index has only seen a stunningly low 6bps range so far in 2017, the ‘IG All’ corporate index includes financials and across the different rating bands is generally only marginally behind 2006 and/or 2007 as the least volatile year ever, [and] all Sterling and Dollar IG non-financial indices are also in the lowest three volatile years since the iBoxx indices started in 2000.”

That analysis is around 6 weeks old, but you get the point. The apparent lack of interest from credit is astonishing, especially in light of the political turmoil we’ve seen both in the US and Europe YTD. As BofAML’s Barnaby Martin noted earlier this month, “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.

So that’s the context for a new piece out Friday from Deutsche Bank’s Oleg Melentyev.

Now I’m not sure whether Melentyev set out to write what amounts to a warning letter for credit traders who may be asleep at the proverbial wheel or whether it just turned out that way, but if you scroll down to page 10 in his note, he’s got a section wherein he basically indicts, tries, and convicts IG for the heinous crime of complacency.

You can read the IG section below (do note the bit about investors turning to bespoke tranches, because that is a sure fucking sign that no one thinks anything is going to go wrong anytime soon).

Via Deutsche Bank

Corporate credit can be thought of as a double-headed beast, one part risk-free debt security and the other part a short put position on a company’s assets. With US rates stable and risky volatility at lows, valuations on high grade corporate are inevitably pushed higher. As the beast sleeps, the tendency is toward complacency. One struggles to search for signs of alarm when the regressions tell you that IG cash spreads are 8-10 cheap to implied volatilities in equities, currencies and interest rates, and yields on the US IG index still offer more than 125 bps over 10-year JGBs even after a 1-year FX hedge. Yet there are indications that the marketplace is growing comfortable, perhaps too comfortable, with the calm.

A brief catalog of complacency begins, as it were, with bond dealers. Having slimmed down inventories of IG paper by two-thirds between 2014 and 2016, dealers have rebuilt positions to two-year highs. The move can be seen as partially a response to compressing bid-offer spreads in IG, and partially, we think, of the lower expected capital cost of warehousing risk as low vol reduces the value at risk. The higher inventory levels perhaps presuppose a lasting environment of strong liquidity. Dealer positions in IG paper are up 86% from average 2016 levels as of May 17; in duration terms, net dealer positions in 10-year bond equivalents is up 113% to $8 bn from $3.7 bn, on average, in 2016. The trailing 12m rate of inflows into IG corporate bond funds, those focused on intermediate and long maturities, has remained at 10 percent for 10 consecutive months.

The IG CDX product appears as a still pond, or at least as close to one as it has been in the past 11 years, sparking small but renewed interest in exotic derivatives with levered returns. Realized volatility, measured in daily percentage changes in spread, has dropped to 25% per year from as high as 65% per year in mid-2016. Vol is lower than at the cycle peak in 2014.


The last comparable period for such stability in spreads was in June of 2011, and prior to that, early 2007. The drowsy market is not stirred by the historical echoes; by October 2011, spreads in IG cash were 95 bps wider. The lull in delivered credit derivative vol has appeared to spark investor interest in bespoke tranches on CDX, which offer, in an environment of zero IG defaults, levered returns on custom baskets of CDS. The 3m run rate of new credit derivative trades on bespoke baskets registered on the DTCC swap data repository (excluding TRS) has reached $4.2 bn, or 2.5x the average 3m rate in 2016.

The widest IG names thrive in the face of unimpressive credit fundamentals. Non- financial 5-year BBBs are 10 tighter vs single-As this year, and 2 tighter over the past month. At 49 bps, the spread pick-up for moving lower by three notches is lower than 97 percent of weeks since 2009. With single-A spread per turn of gross leverage at the lows, investors eye BBBs as the only remaining high-grade segment with scope to further compress. In 2005 and 2006, investors accepted just 30 bps of spread for BBBs over single-As, establishing a precedent that such tight risk premia are, in fact, possible, if only for a time. (BBBs traded nearly 300 bps behind single-As in early 2009.) In the backdrop, IG issuer fundamentals weaken. Year-over-year EBITDA growth outside the energy sector in IG falls to less than 1 percent after five consecutive months of growth of higher than 4 percent leverage outside the energy sector grows to its late 2015 peak of 2.4x.

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