Seeking Alpha November 25, 2008
The sheer quantum of bad news due in forthcoming months forms a compelling basis to continue seeking substantively misaligned asset classes in the marketplace. As it is becoming evident that government intervention is rapidly destroying traditional valuation premises in the financial sector, the challenge today is to identify opportunities which will not draw the attention of Washington lawmakers and regulators, for bailout purposes, for many months into 2009.
The recommendation to short high-yield bond ETFs (HYG, EFT, EFR andJFR, depending upon risk-appetite) at or around Monday’s levels is founded on the following three premises. Firstly, despite the fact that the 5-year CDX index (HY-11) spread has widened from 925 to 1550 basis points since early October, the bulk of the high-yield spectrum continues to trade on yields which reflect, comparatively, near-investment-grade ratings which, in turn, have already proven to be inadequate and misleading. Secondly, even the 1550bps level does not fully incorporate the real prospect of additional negativity in default risk perceptions (i.e. credit default swap spreads) as more data on the domestic and global economy enters the public domain over the holiday stretch and in the first quarter of next year.
Finally, the liquidation risk on high-yield debt has risen appreciably in recent weeks; in numerous instances, despite nominal quotes on trader screens, there are no buyers at all. Last week’s meltdown in the commercial mortgage-backed securities (CMBS) market represented only a preliminary (and shocking) insight into an oft-ignored corporate sector which probably needs a Fed-managed funding facility more than Wall Street’s elite institutions; a facility it will not get, at least in the foreseeable future.
For that matter, in view of the irrelevance or inapplicability of ratings, investment-grade ETFs (e.g. LQD) are also creating valid short propositions for investors with a 6-month time horizon. Though the 5-year CDX index (IG-11) spread has widened appreciably this month (last at 270 bps), the outlook remains essentially bearish; spread levels in excess of 400-450 bps are firmly within the realm of reality.
For example, the current spread for highly-rated General Electric (GE) 2013 is 405 basis points, despite the company accessing the Fed’s commercial paper facility and the FDIC’s guarantee program. American Express (AXP) 2013, still being rated in the relatively lower investment-grade category, is being quoted around 670 basis points. Look for a near-term widening (in spreads) of 25% for both issuers.
As the Wall Street Journal specifies on its websites, corporate spreads sometimes mirror and sometimes anticipate share price movements, and the somewhat bullish tone in corporate bonds this week is certainly a result of the remarkable advances in the Dow and S&P500.
But, by and large, the debt matrix, in America and abroad, is still unaffected by the new yield-spread pricing realities which are slowly filtering through the lending environment. Thus far, the focus has been on the slide in benchmark rates. But, from this point forward, the downside play on benchmark rates is limited, at least for US$-denominated loans; a Fed Funds rate of 0.40% has already been priced by the debt markets.
On the other hand, several new corporate loans are now being priced in a “non-traditional” manner: i.e. a benchmark rate (usually Libor) plus the cost of funds, plus the spread on default risk insurance, plus upfront fees. When (not if) this revised, and logical, methodology gathers momentum, short positions, entered this week, in both investment-grade (supposedly) and high-yield ETFs will yield significantly above-average returns. A similarly attractive trade would be to short a liquid, emerging market high-yield-bond ETF, if such an ETF is available.
