Deja Vu All Over Again

May 29th, 2014 8:32 pm | by John Jansen |

This is a great article on the complacency gripping the credit markets. The FT details the carry trade and the use of leverage that have chosen to employ to garner greater returns. This type of activity eventually brought the global system to a supine position in 2008 and 2009 when the music stopped and many found they did not have a seat.

Via the FT:

Last updated: May 29, 2014 5:29 pm

Bond investors borrow to boost returns

By Michael Mackenzie and Tracy Alloway in New YorkAuthor alerts

“Keep calm and carry on” is a British motivational poster from the second world war that has been co-opted by a generation of design-crazy hipsters and now global investors desperate for higher returns.

This year’s extended run of low yields and meagre risk premiums in the bond market leaves investors with a tough choice; they can either accept a very low return or rely on borrowing money to enhance their income.

Investors are increasingly seeking the latter option as they engage in “carry trades”, which involve borrowing money at cheap rates to invest in higher-yielding assets.

“The Japanification of rates and the death of volatility means investors have no option but to participate in carry trades,” says Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch.

Using leverage to boost investment gains has long played a role across markets and was a compelling force behind the massive disruption that erupted across asset classes during the financial crisis, notably in the form of structured credit vehicles.

Half a decade later, at a time of historically low volatility and strong acceptance of the notion that central bank policy remains highly supportive for markets, the risk is growing that some investors will once again embrace aggressive trades that can quickly sour should the current calm backdrop change.

For some time, policy makers at the Federal Reserve have identified high-yield or junk bonds and leveraged loans as having frothy valuations. But for all the warnings from Fed officials, the risk is that the froth may only be in the early stages and that the grounds for immense one-way carry trades are being laid.

The longer the Fed keeps its key borrowing rate anchored near zero and repeats the message that rate rises are well over the horizon, so the prospect of greater leverage being deployed to pump up returns from low yielding bonds will intensify.

Ashish Shah, head of credit at AllianceBernstein says: “My sense is there is a reasonable amount of complacency in the credit market and investor discipline is dropping. We are not yet at the level we saw in 2006 and 2007, but it does worry us.”

For now, many in the bond market say credit markets are showing signs of overheating but are not yet in bubble territory. Such an assurance could change quickly, however, should leverage start climbing and complex structures that were popular in the years leading up to the crisis begin to return.

“A carry trade in my view of credit is basically anything that the clients go long with, so there’s always some risk involved,” says one banker who sells structured credit products. “It’s clearly the case that investors are looking for anything that gives them additional yield – collateralised loan obligations are the most public side of that.”

US sales of CLOs, which bundle together leveraged loans made to junk-rated companies, are on course to reach record levels this year. Investing in the middle tranches of such CLOs is expected to net investors a 7-9 per cent return this year, more than the 5-6 per cent on offer from investing in junk-rated bonds.

“The credit market is fully or fairly valued at the moment when we look at low default rates, strong company balance sheets and ease of debt financing,” says Edward Marrinan, head of credit strategy at RBS Securities.

He adds that an increase in the use of leverage, which is generally hard to measure, would definitely be a step towards pushing valuations in credit to an unsustainable level that would ultimately prompt a major correction.

Anecdotally, for instance, some investors are beginning to employ leverage to pump up returns on the senior slices of CLOs that currently offer the lowest yields.

“The carry demand is not just purely based on a reach for yield, it’s also based on low volatility,” says Marc Ostwald at Monument Securities. “The people who have been selling volatility have to get more and more aggressive about it. If they get more aggressive that means they have to get more leverage.”

Carry trades in credit will pay off for investors as long as markets remain stable, but there is a risk that they eventually head for the exit at the same time.

Robert McAdie, global head of fixed income strategy at BNP Paribas, says: “The risk is more people are pushed into the same trade and more people are long, while regulation is limiting the ability of banks to be on the other side of the trade, especially in a down market.

“It does create an issue in the market where if risk aversion and volatility start to rise, then a lot of people are going to be heading for the same door – and the door is very small.”

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