How TRACE helped kill the dealers

Back in 2002, regulators at the NASD decided 'mom and pop' needed protection from the big bad dealers while they were investing in the corporate bond market.  Under this guise of investor protection, they implemented a program called TRACE (Trade Reporting and Comparison Entry Service).  I use the term 'guise' because individual investors are only a tiny portion of the overall volume of the market.  Most individual investors gain their exposure to the bond market via mutual funds.

This may seem archaic to you equity investors, but until that point, virtually no trades in the corporate bond market were recorded and disseminated broadly.  Yes, up until this point, the dealers and their large institutional clients, had an informational advantage.  Bond trading was long the engine room of dealer profits.  

This opaqueness had it's advantages for the large investors as well.  For instance, if a large holder of XYZ corporate bonds (client 'A') decided they no longer liked the credit, they would choose a dealer to begin 'working' out of them.  The dealer would buy $50mm at a spread of, let's say, 100bps (over similar maturity treasuries).  They would quietly take these bonds on to their balance sheet and begin to try to sell them to other institutional investors.  Suppose client 'B' bought the first $10mm at 90bps (for a profit of 10bps to the dealer).  The dealer would now market them to a new batch of investors (clients C through F).  If the process worked, and it often did, the bonds would be successfully distributed from client 'A' to handful of other investors and the spread (i.e. price) would remain largely intact and the dealers would make money....often a boatload.  

Now, we enter the post TRACE world.  If a block of bonds 'prints' on TRACE, the whole world knows that someone is long a slug of risk and that they bought it at 100bps.  If a dealer calls a client and says "we have a small piece of XYZ to offer", the client is likely to say "no, you have a block of them and I won't pay you any more than 98bps" (remember the dealer bought them at 100bps).  So, the dealers ability to make a profit on the bid/ask is subtantially reduced...especially in light of little to no informational advantage.

In this new post TRACE world, dealers rarely take bonds (i.e. risk) on to their balance sheet.  We've seen a dramatic and wholesale shift from a principal model to an agent-only model. 

In the corporate bond market, you cannot have liquidity without capital.  If the dealers cannot make a consistent profit, they will not allocate capital.  No capital, no liquidity.

TRACE is one of the primary reasons that dealers shifted their capital from the trading of corporate bonds (i.e. 'cash bonds') to the trading of credit default swaps.  CDS trading is still opaque and the informational advantage still lies with the dealer.

 

 

  

    

Daily commentary

The market is opening up a bit weaker this morning.  The broad driver of demand with little supply to fill it remains in tact.  However, spreads are reacting this morning to weaker European equities, wider swap spreads and lack of clarity about government intervention.  Stocks and spreads have both rallied like a banshee for the last few days so this could be a 'breather'.  

With regard to the demand mentioned above, JPMorgan notes that natural demand (from maturing bonds and coupons being paid) is ~$75B a month.  As I've mentioned recently, our market is currently seeing heavy crossover demand from equity managers.    In addition, AMG is showing heavy flows into bond mutual funds.  In fact, high yield has seen 5 consecutive weeks of inflows for the first time since May '08.  With only $41B in supply MTD, you can see why spreads are rallying.  I'm told supply will start to pick up soon.  Watch NIM3 on Bloomberg for recent issuance.

Earnings continue to roll in....ex finance, they seem to be about flat vs Q4 '07 which is not a bad thing at all.

I've noted several times that the slope of credit curves matter.  I'd like to point out that 2 well known issuers in Europe (KPN and Nokia) both brought new issues recently with positively sloped curves which is encouraging.

Ford noted during earnings that it tapped it's revolving line of credit.  Not that long ago, that would have absolutely panicked the credit markets as that's often viewed as a death knell.  However, since autos have been downgraded virtually out of existence, they've lost their ability to shock.

Today's 'gee whiz' Bloomberg function is IMAP which gives you a quick easy graphical overview of the global equity markets daily performance.  It's simple to click through to see sectors or geographic regions.  

Daily commentary

Apologies for the late commentary...I'll attribute it to a 'snow delay'.

Spreads in the credit markets are stronger today largely driven by continued demand and little new issuance to soak that up.  In addition, the good bank/bad bank rhetoric from the White House has encouraged market participants.  The Vix has been lower for 5 of the last 6 days and that certainly soothes credit investors.  

I think the muted reaction to today's Fed is largely due to the perception that monetary policy has just about run out of bullets. 

Name as many AAA rated issuers as you can?  I bet you started with GE....Moody's put them on watch negative yesterday (S&P already did).  'Watch negative' implies an imminent downgrade.  BRK, JNJ, NYLife, TIAA and Toyota Motor Credit are the others that remain AAA (PFE is AAA at S&P only).

One other interesting spread relationship....Campbell's Soup credit is perceived in the market as safer than US Gov't debt.  

DTCC released its CDS outstanding report....net outstanding has fallen 6% in the last month.  This is largely due to (the few remaining) dealers collapsing offsetting positions.  But yes, that does mean less risk in the system.

The Financial Times today has an interesting article here about the conundrum facing governments.  Where in the capital structure (of a bank) do you drawn the line (of support)?  Equity?  Nah, let them suffer.  Senior debt?  No way, it's a nationalized company now.  The grey area is hybrid/preferred space in between.

The number of people taking the CFA Level I exam in December jumped 25%.  The pass rate dropped dramatically to 35%.  Only 20% of the people that start the process pass all 3 levels.

 

Daily commentary

The credit markets are opening a bit better today despite grim CaseShiller and consumer confidence numbers. The recent weakness in US Treasury bonds has made the yields on corporate bonds more attractive. More than one participant is telling me that 'non-traditional' investors (i.e equity folks) are in the market buying. The usual suspects are well known TMT names with low dollar prices.

While the new issue calendar is quiet today (away from a BAC FDIC backed deal), recent new issues continue to perform well. The recent FedEx deal is almost 100bps tighter from where it was issued.

The credit curve remains inverted and the slope has been largely unchanged over the last week.

I'm encouraged by the narrowing of the negative basis. The negative basis is a measure of the rich/cheap skew of cash bonds versus their own credit default swaps. If the basis is negative, that means cash bonds are cheap (vs CDS). As this basis narrows (i.e. becomes less negative), that tells me that there is more relative strength in cash bonds. Cash bonds remain the preferred instrument of 'real money' investors. CDS has long been where 'fast money' and dealers make their tactical moves. So, relative strength of cash bonds means they are being bought by 'sticky hands'.

The sales and trading desks of BAC and MER are done with their first round of cuts. Yet another example of liquidity leaving the market....1+1 = <1. Remember, corporate bond trading is a true OTC market....if you remove a market maker (i.e. sellside trader), that liquidity they provided is gone. Poof.

The cheapest sectors in the credit markets right now are REITs, financials, insurance and energy.

The richest sectors are TMT, healthcare/pharma, and consumer.

Credit Curves: what steep and flat curves mean

Corporate bonds are issued in a range of maturities.  The usual benchmarks are 10 and 30 years.  Bonds with different maturities, despite both being from the very same issuer (i.e. the same amount of credit risk) often trade at different spreads.  Remember, more/higher spread indicate a weaker credit (as investors expect to be compensated more for their perceived increased risk [of default]).  As a reminder, spread is what you receive in basis points over a comparable maturity risk-free bond.

A 'normal' curve is one where the longer maturity bond has more spread than a shorter maturity bond.  This is stasis...WalMart is more likely to default over the next 30 years than it is over the next 10 years.  

If you look at a broad diversified basket of corporate bonds over time, their curves have historically been 'normal' (i.e. more spread in the longer maturity [aka 'long end'] than the shorter bonds).

When a company's credit is viewed as weakening, you'll see their credit default swap spread widen (aka weaken) and their credit curve (of their corporate bonds) 'steepen'.  

When a company's credit is drastically weaker, their curves actually flatten dramatically and often invert (shorter maturity bonds have a higher spread than longer maturity bonds).  The reason for this is that investors are no longer thinking about whether a company will survive but rather 'if this thing files for bankruptcy, what's my recovery value?'  Remember, most corporate bonds are senior unsecured bonds....so you are near the front of the line in bankruptcy court.  Historically, the recovery rate for corporate bonds is ~$40.  So if you have 2 bonds....one a 10 year maturity and one a 30 year maturity...and both are trading ~$40, your potential annual return (aka yield) is much higher if this matures at $100 in the next 10 years (than it would be if it matured at $100 over 30 years).  

So, for equity investors, another good measure of health in the credit markets to watch are the credit curves of a broad basket of bonds.  One quick and fairly simplistic measure is to watch the steepness of the Dow Jones CDX index between the 5 year and 10 year maturities.  As you would probably expect, they are inverted and have been for some time.  If they 'normalize', you should view that as a good thing.  

Daily commentary

The credit markets are opening up slightly better so far this morning with the Barclays Credit index at +454bps OAS.  Swap spreads are slightly tighter which should buoy the finance names (see earlier post for why this matters).  Bear in mind that if you watch the CDX index, it's currently near it's all time 'rich' (vs intrinsic) valuation...by ~40bps on a base of 206bps.    

Citi brought an enormous $12B FDIC backed deal successfully on Friday.  That's OK news....not great as it would not have come to market and cleared as smoothly without that FDIC backing.  In other "OK news", high yield issuance last week was $1.8B which was the highest amount since last July.  Investment grade issuance this week should be quiet as it typically is during quiet periods of earnings season.  I'll be surprised if the recent demand (for new issues) shifts to secondary bonds. 

When watching issuance volume, be sure to focus on non-FDIC volume as that is a better proxy for credit health/growth (currently $38.9B MTD vs $35.6 MTD of FDIC issuance).   

In credit spreads, WYE was only slightly wider (~3bps) vs PFE which was ~20bps wider to the merger news.

Despite $148B in taxpayer capital, bank lending was actually down 1.3% between Q3 and Q4.  

JPM data shows the current outliers (where credit and equity diverge) as NCX (lower), URI (much higher), PEP (higher) and NYT (higher).  When I say "higher" that means that the CDS spreads are implying higher equity prices.  

3 separate unique markets within credit

I've long espoused a view that there are 3 separate and distinct markets within the credit space.  One can be rallying like there's no tomorrow while the other is moribund.  The next day, the complete opposite can occur.  There does not seem to be any lead or lag effect.  

Secondary cash bonds - this is the 'old fashioned' market.  You can watch the volume on TRACE (mentioned in an earlier post).  Years ago, before the brokers were nationalized, brokers used to use their firm's capital to take positions and make markets.  While they still do this (principal trading), the capital allocated to it is down by 70-80%.  The margins are now razor thin due to the advent of TRACE.  Now the 'market' is made up largely of smaller regional dealers and banks that have little or no capital.  If the dealers can't make money, they won't trade bonds.  Unfortunately, these are the securities that are held by the large money managers....and their liquidity needs have NOT dropped 70-80%.  In fact, they've largely increased.  Thus the 'liquidity crisis'.  

New issue bonds - The IPO market in debt.  Recently the supply has been enormous, especially if you factor in FDIC backed debt.  Here's the conundrum....this supply has been eagerly gobbled up by investors....while secondary spread have languished.  This was the story for most of 2007 and 2008.  If you owned secondary bonds in XYZ corp, and they brought a new issue, the spreads on your secondary bonds would widen 50 basis points.  Also, you have 'liquidity' in new issue bonds...if you want $100 million worth of bonds, you're likely to get it.  Yes, it's unidirectional liquidity.  

CDS - this is where the bulk of the liquidity in the market exists.  It has been shifting into this market for the last 3-4 years.  This is where the brokers provide the most (relative) liquidity to their clients and other brokers.  Why this market?  Well, 2 reasons...one, there is no TRACE so no one can watch exactly where they are buying and selling risk.  Opaque markets provide profits.  Two, there risk capital weightings and balance sheet needs are lower in this market....higher ROE.  

You can follow the gap between the first and third markets I mentioned here in the 'negative basis'.  Currently, cash bonds are ~250 basis points cheap to CDS.  In theory, this is a risk free arbitrage....but only when it collapses and it hasn't been near flat/0 in a long long time.  This is one huge driver of the losses in the credit hedge fund space. 

Remember, don't assume that a healthy new issue market portends demand for your secondary bonds.  Also, just because CDX (the CDS basket index) is rallying doesn't mean that your cash bonds are following suit. 

What metrics you should watch

If you're not active in the credit markets on a daily basis, here are a few things you can observe to judge their health and trend.

CDX - this is a widely quoted basket of 125 names; bear in mind, it's devoid of banks/brokers.  The wider the spread, the weaker the market.  You can find it on Bloomberg under CDXI or in the WSJ.  This is what you should watch for intraday moves.  

Barclays Credit Index OAS - this is a much broader index.  It is quoted daily but is really only hand price twice a month when the Barclays traders mark each bond.  Watch this for longer term trends.  You can find this in WSJ.

TRACE volume - this is the secondary volume in the credit markets (cash bonds only)

Vix - you know this one; higher Vix oft portends a lousy credit market

2 year swap spreads - this is the rate (actually a spread) at which highly rated banks lend to each other.  As this rate spikes, it shows reticence in the market to extend credit.

If you follow these indicators, you will have a good feeling for the health of the market.