John Dizard: Counter-trend rallies are crucial to staying in credit

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Credit investors have, like their more visible equity counterparts, had a tough six weeks. If this is a bear market, and it could well be the beginning of a multi-year downturn for equities, then the only way to make money, if you have to own paper, is to catch the short, sharp rallies. There is a fair chance we could have one of those at the end of this month and the beginning of July.

The sudden aversion to risk, triggered either by the Bank of Japan or a Fed that has discarded its stammering ambiguity, hit all the big asset classes but the credit world has the most highly leveraged positions.

Rather like a hurricane that leaves some houses undamaged and others flattened, there have been odd anomalies in the damage reports, and these may set investors up for some trading opportunities in the near future. I say “trading” rather than “investing” opportunities because of the good chance, if not the certainty, that we are really in a bear market for risk.

Getting the timing right is obviously the point in seeking out short-term rallies, and there is some reason to think the end of this month is a good time to look for one. To begin with, hedge funds and proprietary traders have been selling assets to accumulate cash to be able to return capital to their investors or committees.

Many hedge fund investors have protected themselves by giving withdrawal notices. But not all of them will actually pull their money out. On some day in the next week and a half, most likely between midnight and 4am, many will realise that the other possible homes for their money do not look all that good either, and they will decide to leave the cash with their managers. Then the managers will come back to work after July 4 and decide to buy credit.

Or they will anticipate those managers and buy just at the end of June.

Another indication of when the credit sell-off will go into reverse is the recent statistical history of equity volatility. Equity volatility drives credit spread pricing, and while the traded VIX index is a pretty poor trading vehicle in many ways, the statistical measurement the volatility index provides is a useful guide to market sentiment. People I know who positioned themselves for periods of high volatility found they had better cash in on that volatility within less than a month of a crisis, because volatility declines far more rapidly than markets recover.

What the trading records will tell you is that once it peaks, equity volatility takes between two weeks and, at the most, two months to give up almost all its increase. If you are a leveraged credit investor, that means you do not have that much time to catch the counter-trend rally that would be measured by a decline in the VIX.

The longer periods of volatility occur when there is a real crisis, such as Hurricane Katrina, or the car downgrades of last spring. May’s shock was more of a general realisation that the central banks were really tightening, and that securities were just too expensive. It was leveraged investors such as hedge funds, rather than real money investors such as insurance companies and banks, that were selling. So the counter-trend rally could come by July, rather than a month or two later.

What sorts of trades make sense in this environment? One strategy that has a good chance of working is a relative value trade using credit default swaps versus the underlying bonds. When markets turn quickly, as they did after May 12, there is not time to cut exposure by selling actual bonds. They are just too illiquid and the dealers are not that anxious to add to their inventory. So you “buy protection” using credit default swaps.

As a consequence of a lot of investment managers doing just that, the “basis”, or spread, between many bonds and their corresponding CDSs, has widened out. But they represent the same risk.

Not all bonds were equally hit by the sell-off of May and June, so not all will participate to the same degree in a counter-trend rally. For example, municipal bonds have not been hit at all by the sell-off. In fact, they are the best performing fixed-income sector. David Goldman at Cantor Fitzgerald points out that: “Not since 1999 has there been such a low ratio of munis to Treasuries. In spite of the rise in rates [measured by the Treasury curve], you have actually made money this year on the principal value of munis. I did not expect them to do this well but I believe they are discounting the danger of tax increases.” For US taxpayers, interest on municipal bonds is free of Federal taxes, and state taxes for residents of the issuing states.

Munis, of which there have been an average of $8bn a week issued recently, are usually the least travelled securities, because they are really made for nationals. Since last September, however, they have attracted a large number of non-US buyers, particularly at the long end, say 20- to 30-year paper.

“Since last autumn, I have been seeing international hedge funds, as well as the French and German banks, buying munis,” says a dedicated New York muni manager. “They are relative value buyers, or what we call crossover buyers. At the time, munis had yields of only 97-100 per cent of those of Treasuries, when they usually trade at a discount. The crossover buyers took the long end of the market where they could get more volatility. Now the bonds are much richer, more like 87 per cent of the Treasury yield.”

That means that munis, having not participated in the sell-off, are unlikely to benefit as much from a counter-trend rally. Not that they will crash. As Mr Goldman says, the new spirit of fiscal conservatism in the US is likely to lead to higher taxes on the resident rich, which would mean more dedication to tax-advantaged paper.

The general point is that there is still money to be made in credit but only by recognising that the environment is fundamentally less safe. Relative value trades that come into the money in counter-trend rallies are the order of the day.

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