Over the past couple of weeks, in the wake of the turmoil that swept across markets amid the ongoing bond selloff and the blowup of the Seth Golden crowd, there’s been no shortage of commentary about what signals credit is/isn’t sending.
This was thrust into the spotlight last week when IG and HY funds were hit with a veritable avalanche of outflows. Notably LQD saw its largest single-day exodus on record just days after witnessing its largest one-week outflow.
Meanwhile, HY funds hemorrhaged, leading some commentators (including us) to speculate on whether outflows from popular junk ETFs could eventually expose the underlying liquidity mismatch and/or perpetuate a new self-feeding loop that, once activated, could be difficult to short-circuit.
Well clearly, markets have calmed down over the past two weeks, with equities rapidly trimming losses and the VIX snapping back to a 16 handle from above 50 immediately after the rebalance risk was realized in the short vol. ETPs on February 5.
But what’s notable is that while equities have recovered, credit still seems to be showing signs of anxiety. We’ve talked about this at length over the past week and considering how much interest there is in the subject, we wanted to highlight a couple of passages from a note sent to Deutsche Bank clients on Monday.
“As [the] market seems to be calming down, we are seeing partial retracements across different market sectors [and] the exact pattern is a function of both the recent path of repricing, residual positioning and market fundamentals (or whatever the market’s beliefs at the moment are),” the bank’s Aleksandar Kocic writes, adding that “the unwind of the stimulus is the real terra incognita here, responsible for the fractured consensus.”
Kocic uses three reference points to illustrate the evolution of cross-asset vol. (shown in the chart below in units of 3M10Y): January 26, which he describes as “all still calm”, February 8 which he calls “market inhales”, and February 22 (“market exhales”).
(Deutsche Bank)
What stands out there is that credit vol. has not come back in as the market “exhaled” and, as Kocic highlights, “the trend is more pronounced for IG than for HY.”
On a relative value note, Kocic points out that IG is actually still too tight to VIX, whereas HY has caught up:
But the overarching point here would appear to be that some folks are misinterpreting what they’re seeing. If there was a blowup (so to speak) afoot, HY would obviously be first in the firing line.
As noted above, that’s not what appears to be going on. Rather, what appears to be happening is that the negative convexity story in IG has bubbled to the surface in light of recent events – as Kocic puts it, this “is making the IG vol. story more transparent.”
The bottom line from Kocic is as follows:
All of this is suggestive that, while there is no visible stress in the credit market, there is an elevated level of anxiety as higher rates make the tail risk associated with bond trade unwind more visible.
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It’s interesting to me HYG & JNK have held strong despite the strong, unidirectional outflows. Count me among those who believed this recent bout of vol would be enough to shake up those products. The ETFs seemingly did not substantially deviate from NAV, so those APs were still facilitating the outflows of underlying bonds. Somebody is still buying.
One interesting trend that I’ve been noticing are Bank ownership %s. As of last reported holdings, Banks hold 9.0% and 8.8% of HYG and JNKs float, respectively, an increase from 3Q’s 4.4% and 7.0%. This represents the highest % ownership from banks since 2010, when the funds first came to market. The latest holding %s predate the shake up, so it would be interesting to see if they back-stopped some of the selling to ease the burden off the APs.
H,
Great insights. Thanks for continuing to focus on what’s happening in the credit markets. They are critically important.
That seems to be where the uber-smart money is – and distant early warnings can usually be found. So we have bleeding and anxiety, but thus far no blow-up or “visible stress” as Aleksandar Kocic puts it.
Staying tuned…