Low Yields, the Same Risks, and Rising Leverage

The recent months have been frustrating for a wide range of investors in the market. The S&P is up a sleepy 2% so far this year, but you wouldn’t know it from the cries of momentum growth stock owners which have seen names such as FireEye, Twitter, and Zullily plunge more than 50%.

In the rates market we’ve seen flattening, but it’s been of the bullish variety. Thirty year yields have fallen 60+ basis points while two year yields are flat. This was supposed to be the season of an economic breakout, where slow and steady employment gains eventually led to wage growth & reduced economic slack.

Things are not all bad as loan growth continues to accelerate, initial jobless claims trend lower, and broader unemployment metrics (such as U6) hit post recession lows. What’s clear is that this is a meager economic recovery that nobody is very proud of. Fortunately or unfortunately however, this economic recovery has given both bulls and bears just enough data to continue holding their beliefs and arguing fervently.

The Frustration in Fixed Income

The root of the problem appears to be the volatility that has been sucked out of the market via the Zero Interest Rate policy and QE. The Merrill Lynch Option Volatility Estimate “MOVE Index”, a metric measuring interest rate volatility, is at a near all time low as shown in the chart below. While many money managers anticipated a weakening Agency MBS market during the ongoing Fed tapering, the opposite happened and they are now trading at historically tight spreads. Large funds such as the PIMCO total return fund positioned for longer term rates to rise as their duration exposure was centered on the 1-5yr part of the curve.

So far it’s been the long end which has strengthened and funds hiding out on the front end of the curve have lagged competition.

Investors and strategists aren’t in love with high yield—nor are they counting on price appreciation—but they seem to reckon they can collect coupons since a turn in the credit cycle doesn’t appear imminent. They reason that with current annual default rates under 2% the actual loss adjusted yields are reasonably attractive.

This isn’t sound logic, but the reality is that there’s few places to get 6%+ yields and going with the crowd is a safe career move in many respects. Given that, buying this type of paper in search of a “normal” return is logical from their perspective today even if it might seem crazy in hindsight. To me, this type of logic appears to be a means of justification an asset class which no longer has an attractive overall risk reward.

Outsized Returns Require Leverage

Hedge funds looking for outsized returns in fixed income have had to turn to other methods. Gone are the days you could broadly throw money at a fixed income sub sector such as last cash flow subprime and receive a double digit loss adjusted yield. Some investors are now finding spots they view as cheap and leveraging them through structure.

An interesting example of this came last month, when I was shown a potential bank subordinated debt CDO. The deal would be set up so that a hedge fund could get leverage on smaller, less liquid pieces of bank subordinated debt which they presumably view as cheap. The underlying collateral was subordinated debt yielding approximately 8%. The structure would have two classes: the hedge fund owned equity tranche which is the bottom 50%, and the senior notes which would be paid Libor + 350bps.

Essentially, this fund would earn 12%+ while being twice leveraged to the bank sub debt collateral. The senior note holders would get an investment grade rated bond with 50% support and a 3.8%+ floating rate yield.

Also of interest was a recent non-government backed Mortgage Backed Securities deal “re-remic” proposed by a well known “too big to fail” bank. They were aiming to resecuritize a 2006 mortgage bond which had 10yr interest only loans about to reset and current LTV’s in the 150% range. The high current LTV’s obviously mean these are homes where mortgage holders are still substantially underwater.

These loans still have a high probability of default, thus it trades materially cheaper than other bonds. Like the example above, the new bond would have a senior bond and a support bond. The investor who was behind creating this security had the TBTF bank create this so they could have leverage on one of the few remaining areas of non-agency MBS that had juice left in it. The support bond was priced at about forty cents on the dollar while the senior bond was trading at par.

Investors can no longer achieve certain return hurdles with the current environment and thus are forced to turn to leverage. The CDO and re-remic are just a few of the examples of this going on today.

What does this all mean?

The issue of course is timing. While many segments of fixed income appear rich and arguably have very poor risk reward characteristics, there’s no hard and fast rule that they have to “normalize” anytime soon. The credit curve has flattened dramatically and each incremental unit of risk taken by investors is being compensated with fewer basis points of yield.

It’s conceivable that carry trade investors can continue clipping coupons without a broad selloff for the foreseeable future. Speculating on the impact of Fed policy on markets is fun, but we should have a healthy dose of humility and realize we are in uncharted territory.

Spread risk is now more pronounced across the markets including in munis where historically wide muni ratios have normalized, and Agency MBS where low volatility & issuance have tightened spreads.

Spreads feel like they’re in a perpetual grind tighter, so investors need to know how much they’re getting paid for incremental risk and ensure it’s commensurate considering the range of outcomes are so broad & unknown.

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