Daily Commentary

PLEASE NOTE - I will be on vacation until Monday August 3rd so postings will be sporadic at best.

Spreads are meandering a bit wider this morning but with little conviction. The trends of lower volatility, diminished supply, strong demand and cash outperforming CDS continue.

JPMorgan has lowered their year end spread forecast from 275bps to 225bps (that index closed last night at 225). They've long cited strong technical demand but have now gained confidence that a strengthening economy will benefit corporate credit metrics.

Mutual fund flow data showed few surprises this week....flows continue into high grade and high yield bond funds while equity funds showed slight outflows and money market funds continue to shed assets at a heavier pace.

Many have verbalized their fear that foreign purchases of US Treasuries will decline. Here's the treasury data from May.....look at the declining trend in row #3.

That worry does not seem to have impacted any emerging market debt investors....their prevalent index, the EMBI+, hit a new all time high yesterday according to Bloomberg News.

Recently, I noted the wide holdings of CIT amongst CDOs. One rating agency, Fitch, took a bit of a contrarian stance and noted that the impact will be muted....largely as most of the damage has already been done to those tranches at risk.

Here are some more insightful thoughts on Goldman and the use of VaR.

Bloomberg News notes that some banks that are facing AIG with their credit derivatives positions may not force them to pay but rather hold them until maturity. Ironically, this will gum up efforts to clean up AIG's books (despite the benefit of no cash calls).

Does it seem everyone is giddy about credit? Giddy enough to pay a corporate bond salesman a $6mm 1 year contract? Yup, read about it here.

Daily Commentary

Tighter swap spreads, higher equities and virtually insatiable demand are pushing spreads tighter again today. The credit market is viewing the CIT debacle as isolated and having virtually no systematic risk or impact. Aside from CIT bonds being down $10-15 the only other impact that I can see, or suspect, is the pick up in the MOVE treasury volatility index. The 3 month regression of credit spreads (using CDX) vs the S&P has them both at about fair value.

JPMorgan's recent credit investor survey showed 94% of investors were increasing, or holding firm, their allocation to high grade bonds. This confidence is why the negative basis continues to narrow; cash bonds have outperformed their own CDS almost ~185bps since the beginning of the year. The dearth of new supply is obviously accelerating this too.

Despite the current low supply, the corporate new issue market is clearly functioning quite smoothly. I am encouraged to see some signs of life in the securitization market as witnessed by this recent AmGen Finance deal from CSFB; especially as the underlying loans are not government backed or guaranteed.

Many, including me, are talking about Goldman's quarterly VaR figure released recently. This blog makes an interesting point; that VaR figure is pretty small in relation to the number of >$100mm trading days. They note that Goldman has requested exemptions from the SEC and permission to use non-traditional VaR measures.

We all remember the 'double secret probation' from the movie Animal House....it seems like the US regulators are now applying similar punishments to both Citi and BoA.

The former corporate strategist at Bear Stearns, Steven Begleiter, has made the final table at the World Series of Poker to be played on November 7th. He's guaranteed at least $1.26mm with a chance at $8.5mm top prize.

Daily Commentary

Spreads are tighter today following stronger equities and a new YTD low in the Vix. This tightening started yesterday just ahead of Intel's strong earnings and held overnight. Lower quality BBBs have outperformed single As in this overnight move.

The negative basis continues it's narrowing march as cash bonds outperform single name CDS. The basis now stands at -78 (vs. it's all time wide of -250). Last August, this stood at -50. The most negative (i.e. bonds cheap vs CDS) is REITs at -300. Industrials, on the other hand, are about flat.

JPMorgan research notes that, thus far, the improvement in broad fundamental credit metrics continues from Q4 to Q1 and now into Q2.

Regarding Goldman's earnings, many have noted it's risk; Goldman's VaR was ~29% higher than it's nearest rival and it's highest in history.

Given the blowout in spreads of index constituents CIT and ILFC, I was not surprised to see the intrinsic index basis gap around a bit; it reads 17bps rich but that's largely noise due to huge moves in those 2 issuers (i.e. tough to arbitrage). A few folks have noted that CIT was the 2nd most popular holding for CDOs which will lead to further downgrades. Technically they are not 'held' by CDOs but rather 'referenced' as these are synthetic CDOs where the underlying names may, or may not, be actually held in the pool of securities; but their performance is always reflected.

While CALPERS is certainly known as being activist, few would call them naive investors. They are suing the rating agencies for "negligent misrepresentation." Story is here.

This is not likely to come as a surprise, but investors should take note that post bankruptcy recovery rates for bonds are well below historic averages. Year to date, recovery for bonds has averaged ~$19 (vs ~$27 last year and a long term average of ~$37). Looking higher in the capital structure to secured loans, those have averaged ~$45 (vs $58 last year and long term average of $71).

Has anyone ever really been surprised when Goldman 'beats expectations'? Spreads were initially a bit skeptical but have since moved slightly tighter. Speculation of a CIT 'rescue', higher equities and a lower Vix are the levers today.

Goldman spreads were ~5bps tighter but are now back to unchanged. Here's a quick snapshot:

JPM ~100

WFC ~140

GS ~145

BAC ~195

MS ~195

MER ~220

Citi ~385 (today's outperformer tighter by ~10bps)

There are 2 regulatory stories that rolled this morning that are of interest. One, the Justice Department is investigating the credit default swap market. Markit Partners, the dominant provider of index and pricing services, first received and disclosed this inquiry. My pure idle speculation leads me to suspect that they may be concerned about Markit's said dominance and ownership by the broker/dealers (who's oligarchy of the CDS market has also come under scrutiny). The second story pertains to the rating agencies. The SEC has decided that they might need some oversight. This is the same agency that was told repeatedly, in detail, about Madoff's pyramid scheme and did absolutely nothing.

Given the turmoil in the finance sector, it's not surprising to see some of these issuers fall into high yield. This is causing some head scratching for the high yield folks as they are unaccustomed to a large finance presence in their index. The finance weighting in the Barclays index has grown from 8.6% to 12.1% and Citi predicts it may end up at ~22%. The natural inclination would be to ignore them as few finance companies remain standing (in high yield) for long. However, this year's eyepopping returns will create some tracking risk/error.

On the investment grade side of things, there are some similar technicals in finance due to consolidation. Yes, it helps the sector's credit ratios (due to cost savings) but it creates larger index weights which can bump up against issuer maximum concentrations. So, in theory, you could like a finance co and it's attractive spread but cannot add to your existing position.

I'm a bit concerned that credit curves have gone back to inverting over the last month. I'm also a bit wary of the spread between BBB and single A rated credits. When risk demand is healthy, that spread compresses. This year, it has compressed ~130bps. However, the spread between the two is now steady at ~100bps which leads me to believe that the demand for relative risk has subsided a bit.

Despite the earnings releases, there are 2 deals in the market this morning. One is a small high quality deal from USAA and the other is a lower quality deal for Carefusion. The USAA deal was met with great demand and quickly closed highlighting the bias for higher quality in the market.

The US market has seen several auto parts makers file for bankruptcy this year. Perhaps they should adopt this unique French tactic of blowing up their own plant?

Daily Commentary

Spreads are meandering a bit wider this morning. We are unlikely to see any sharp moves ahead of major earnings releases this week. This should also keep new issue supply muted. However, the technical demand will exist before, during and after these earnings.

As I've noted previously, investors continue to show their preferences for shorter maturities and higher quality bonds. Dan Fuss of Loomis Sayles echoed this sentiment over the weekend in Barrons.

CIT's struggles and and a 4th consecutive week of S&P decline are starting to nibble away at credit investors confidence. Combine this with developing seasonal illiquidity and some investors are getting nervous. As Gartman mentions in today's Gartman letter:

…we should also remember, however, that in the course of the past several decades, the most violent market movements have tended to come in late July and early August just precisely because the dealing rooms are emptier. Illiquidity during times of political duress can create its own problems, and we remember the Russian problems of August of a decade ago, and the problems attendant to LTCM that evolved out of that earlier crisis. These were “summer” crises, and there have been others, so just because the doldrums have set in does not mean that they are permanent, and that they cannot develop into something far more unstable. They can; they have and they will… we simply know not when.

Throughout most of Q1 and part of Q2, I mentioned the demand from equity investors for liquid lower priced corporate bonds. That trend is almost completely over as the average bond price is now over $102 (using JPM data).

Bloomberg has an interesting function for those of you that would like to see what equity prices and volatility imply for a theoretical CDS spread (actual CDS spreads are there for comparison). Type WMT Equity [key] OVCR [go] to see the output (for WalMart obviously). Not all equities are available and the CDS pricing is not perfectly accurate intraday. However, you can sort by outliers (far right column).

Vanity Fair has an interesting article written by Michael Lewis about AIGFP's Joseph Cassano.

Daily Commentary

Today is likely to be very quiet as we have little supply, nice weather on the east coast and earnings season starts next week. While the major credit derivatives index is slightly wider today, my Bloomberg is littered with quotes insisting cash bonds spreads are tighter.

New issue supply this week is on pace to be down ~40%. I've long been a believer that lower supply can actually hinder confidence in the market. It is far easier for a big mutual fund to get a large trade (i.e. buy) done in the new issue market than it is in the secondary market. If those funds are confident that they can be 'active' then they are also likely to add on to their existing positions in the secondary market. Yes, esssentially I'm saying that supply can create demand. However, the current technical imbalance in the market (of very heavy 'natural' demand) is likely to overwhelm this theory.

Addressing that 'technical imbalance', inflows into high grade bond funds remain steady at their average weekly pace of ~$4.3B. This is a bit surprising as I would have thought the drop in overall yields may have slowed the pace but it has not. Inflows into high yield and equity funds have diminished. Money market outflows have picked up their pace.

Having helped run a valuation group, I am very aware of frequency and ease at which disagreements can arise over the pricing of a security. Suppose you are Jamie Dimon and the entity arguing against you is both your regulator and lender of last resort. You are not exactly arguing from a position of strength. We'll see how this one turns out.

Speaking of lenders of last resort, the FDIC is allegedly declining to back stop CIT's debt. CIT cash bonds are now trading in the mid $50s down about ~$15 in last few weeks.

I've seen a few European economists noting the turnover in the Baltic Freight index. You can graph this yourself on Bloomberg using BDIY . Bloomberg News noted that Warren Buffett's favorite index (US freight carloads) to watch to gauge the strength of the US economy is also turning over. Take a look at their graph:

Should mortgage bond funds be labelled like ski runs? Some folks at the New York Times think so.

The Atlantic Magazine has a blog post with an interesting view on the new PPIP program. They argue that the big banks actually received their relief on their toxic asset marks due to an accounting rule change last year (FASB's easing of mark-to-market). Therefore, they may not be the ones selling assets into the PPIP program. The smaller banks, who did not benefit from FASB, would then be the primary sellers of these assets. These price marks then must be used by the bigger banks.....and that does not bode well for their balance sheets.

Daily Commentary

It seems that if we get signs that the economy is weaker, then money moves out of equities and into credit pushing spreads tighter. It also seems that if we get strong economic data, then treasury yields rise making credit look attractive and pushing spreads tighter. Today is following yet a third pattern which is "well stocks are higher so we should be better." This is all a bit alarming as credit seems largely impervious to accepting bad news. The technical demand may be just that strong.

That demand is not currently being satiated by the new issue market. Yesterday saw only one ~$800mm deal. There is a smaller deal from Korean Gas in the pipeline (pun intended).

Try explaining this one to your parents....Morgan Stanley has created a new CLO that is rated AAA. You'll note that the bonds underlying the CLO were recently downgraded 6 notches (from AAA to A3). Ah the joys and benefits of 'credit enhancement.'

Despite the efforts to standardize and make transparent the CDS market, it's issues like the Ciba/BASF succession event debate that keep many traditional real money investors from using CDS.

I don't think I was the only person surprised that PIMCO was not included in the choices for investment managers for the PPIP program. Apparently, they pulled out in June due to "uncertainties." The program was targetted to be $1T in size but so far has had $30B in government support for $10B in private investment.

There has a been a shift of investors recently into higher quality and shorter maturity paper (as evidenced by spreads and yields across the different maturity ranges). This may signal a lessening of the risk appetite within credit (which could pause the tightening).

This is a pretty shocking graph/stat from the NYTimes:

Back in December 2000, there were about 1.1 unemployed people for each nonfarm job opening. In May 2009, on the other hand, there were 5.7 unemployed workers for each nonfarm job opening.

You don't need to tell me that this is clearly a jobless recovery.

Looking at the last 3 months (only), we are starting to see some divergence between credit and equities. Credit is 'predicting' a higher S&P of ~905 while equities are predicting wider spreads (of ~160 vs current ~140).