Lay Down, Roll Over and Be Dead


Adverse market conditions.

The final season of a long-running zombie drama treats the undead as little more than scary scenery. Alarming, but hardly a real threat. That could be a big mistake. The Walking Whatnow? No, no. I’m talking about the corporate bond market.

November was arguably the worst month for bonds since 1994. Volatility was up, junk and investment grade sectors sold off, and the yield curve flattened to a bearish extent not seen since 2007. The (once) market-darling investment-grade bond ETF, LQD, is now down 5.3 percent year to date. The TLT long-term Treasury ETF is down 3.2 percent on the month.  

Yes, Jay Powell is reportedly getting the vapors about taking away Donald Trump’s punchbowl, but the market is sure rates will rise on the 19th nonetheless, and the Fed boss has cannily announced that he will give a press briefing after every FOMC meeting going forward – meaning that the committee will have a lot more flexibility about when it changes rates. (Now it does so only at the meetings that feature press conferences.)

Well, so what. Rates are still low, employment and inflation numbers look good. But take a look at the massive increase in business debt in recent years – it is now $32 trillion, over three times the size of the mortgage debt that almost sank the global economy in 2007-08.

As rates rise, and a lot of that debt needs to be refinanced, some of those zombie companies that have survived on the “accommodative” nature of the junk markets in recent years are going to be in trouble. Suddenly, cash flow negative starlets like Tesla and Netflix, which have to borrow to keep the lights on, might lose their luster. And market leaders that have done really, really stupid things, like Apple, which borrowed $150 billion to buy back stock, could rue their fates when it comes time to refinance.

That may be soonish. Most fixed rate corporate debt has a maturity around five years; companies have been on a debt binge for five or more years, hence talk today of the coming fearsome “wall of maturities”. In May, Bloomberg estimated that $4 trillion would have to be refinanced in the next five years. More recently, BNP said S&P 500 companies alone have $1.6 trillion to refinance over the next three years – nearly 4.5 times as much as they had to refinance going into the financial crisis in 2007.

As market watchers shriek in horror as GE, with its $135 billion in debt, makes its shambolic way down the credit curve, other zombies are queuing up at the door. Time for investors to keep their, uh, brains about them.

“Passive” ETF Investors Get Antsy, Drive Vol…

Goldman reports that short sellers are contributing less to vol (and vol of vol, I assume) than are passive funds, especially the big index-hugging ETFs. That’s worrying. From Goldman, via Heisenberg:

Heavily shorted names showing lower than expected volatility. For the first time in 6 years, the volatility of the S&P 500 has been greater than the volatility of the most shorted stocks. This suggests investors that short stocks (i.e. Hedge Funds) are not making big changes to their positions on a daily basis, while investors that trade at the index level are rapidly changing their positioning. We believe it is increasingly important for portfolio managers to know how much of their stocks are owned by passive funds as that appears to be one of the primary sources of the recent volatility. It may be less important than normal to track the institutional investor ownership of stocks as that is not the primary source of recent volatility.

via Heisenberg

Leak-proofing Your Intuition Pump

Massimo has an interesting item out on how metaphors can be misused in science, with some useful ideas on how to use them effectively.  From Footnotes to Plato:

While discussing some sections of a paper I wrote with Maarten Boudry, we have seen a number of reasons why using machine-information metaphors is bad for science education. As I pointed out before, the full paper also devotes quite a bit of space to arguing that those metaphors haven’t been particularly good in actual scientific research. One of the fascinating things to watch after I posted the first part of this commentary was the number of people who vehemently defended the “biological organisms are machines” take, both here on the blog and on my Twitter feed. It’s like here we are, in the second decade of the 21st century, and there are still a lot of Cartesians around, who have apparently never heard of David Hume. Oh well.

Massimo doesn’t throw the baby out with the bathwater – of course. Metaphors, after all, are some of our most useful intuition pumps.

After 18 Years, Watchdogs Set to Leash Credit Swaps

RISK reports that the CFTC and SEC are partnering to oversee single-name credit default swaps, something required under Dodd Frank. This could bring to an end the damage, potential and actual, created by the product in the 18 years since the disastrous Commodity Futures Modernization Act of 2000 left over-the-counter derivatives completely free of regulation.

From RISK:

The top US markets regulators have reached a tentative agreement to jointly regulate single-name credit default swaps (CDS), has learned. The deal will pave the way for the Commodity Futures Trading Commission to propose a clearing rule for single-name CDS, fulfilling a key provision of the Dodd-Frank Act.

CFTC chairman Christopher Giancarlo discussed the agreement in a behind-closed-doors meeting with industry participants on March 13.

Neither regulator covers itself in honor on a regular basis, but the SEC is known to be more conservative in its views. Whether it will re-litigate the “insurable interest” question that CDS critics have leveled at those who take naked short positions (pretty much everyone in the market, that is), is unclear. But as RISK notes, this could be a step toward central clearing, moving credit products toward the same fate as interest rate derivatives, cratering dealer earnings but reducing systemic risk.

Unless, like me, you worry that clearinghouses just concentrate risk. But that’s another story.

Leveraged FANG ETNs admit: you better track us hour by hour, and maybe kiss your principal (and/or the “whole industry”) goodbye.

An “investor” is born (or, given the externalities inherent in this snake pit, perhaps “borne” is the word) every minute.

Well said, BlackRock boss: “For its part, BlackRock has steered clear of leveraged ETFs. CEO Laurence Fink told the audience at a Deutsche Bank-hosted investor conference in 2014 that: ‘We’d never do one. They have a structural problem that could blow up the whole industry one day.'”

Via Grant’s Almost Daily (sorry, no link):


Day traders delight

The revolution was not, in fact, televised.  A simple press release filled the bill instead. This morning, BlackRock released its ETF Pulse Survey, a look at the pace of exchange traded fund adaptation across different demographics.  The survey of individual investors found that only 27% of baby boomers (aged 52 to 70) own ETFs, compared to 42% of millennials (21 to 35) and 37% of “silvers” (aged 71 or older). Martin Small, head of BlackRock’s iShares unit in the U.S., surmised that boomers: “May still be holding onto a stock-picking mentality. They may not realize that ETFs are as easy to trade as stocks and available in virtually every market segment imaginable. As a result, many pre-retirees and investors in their early years of retirement may be overlooking the ETF revolution.”
Much as crypto-currencies run the gamut from relatively established first movers like bitcoin to ICO’s such as “Lehman Brothers Coin” (Almost Daily Grant’s, Jan. 19), so does the exchange-traded fund realm range from the simple (such as the SPDR S&P 500 ETF Trust, or SPY on NYSE Arca, which today crossed the $300 billion in assets under management for the first time), to the exotic.
For a demonstration of the latter, we turn to the BMO Rex Microsectors FANG+ Index 3x Levered ETN (FNGU on NYSE Arca) and its evil twin, the FANG+ Inverse Leveraged ETN (FNGD on same), which debuted yesterday.   Bloomberg Intelligence harkened the vehicle’s debut with the apt headline: “Leveraged FANG ETNs Aim to Bring Volatility to Bored Traders.”  The ETN will charge a 95 basis point expense ratio (10 times the SPY), while the underlying FANG+ Index comprises equal weighted holdings of Facebook, Inc., Apple, Inc.,, Inc., Netflix, Inc., and Alphabet, Inc., (nee Google), as well as Alibaba Group, Baidu, Inc., Nvidia Corporation, Tesla, Inc., and Twitter, Inc,.
Eagle-eyed readers will spot that those leveraged securities are classified as ETNs, or exchange traded notes, rather than the conventional ETFs.  The Wall Street Journal explained the difference on Feb. 5, 2017:
Both ETFs and ETNs track the price of things like baskets of stocks, bonds or commodities, but they do so differently. ETFs own a portion of the assets they track – an S&P 500 ETF, for instance, owns stocks that are included in the index. ETNs don’t own a portfolio of assets. They are simply debt issued by banks that promise a return to the investor linked to the performance they track.
Indeed, the registration statement filed with the SEC states that: “The notes are unsecured [and] . . . do not guarantee any return of principal.”   As for the leverage factor, the document carries the following disclaimer: “The notes are riskier than securities that have intermediate- or long-term investment objectives, and may not be suitable for investors who plan to hold them for a period other than one day or who have a ‘buy and hold’ strategy . . . Investors should actively and continuously monitor their investments in the notes, even intra-day.”
The May 19, 2017 analysis in Grant’s (“Loaded for bear”) took a different tack in describing these products which evidently require a day trader’s attention (and attention span): “Take every known principal of long-term investment success, negate those precepts and multiply the negative by leverage. That would be one aspect of the 4X, 3X or 2X story.”  Why?   Biff Robillard, co-founder of Bannerstone Capital Management LLC, explained the problem:  To make money in leveraged ETF’s, one must correctly predict not only the direction of prices, but of their realized volatility as well.
Not the implied volatility, and not the VIX per se, [but] the actual volatility that the underlying entity driving valuations will experience going forward. You have to have an opinion about that. High volatility reduces, even reverses, returns on leveraged ETFs.
The piece then goes on to demonstrate a hypothetical example:
Say that you own $100 of a thrice-leveraged ETF. On day one, the underlying index moves up by 5% – your fund as gains three times $5; it’s worth $115. Next day, the index falls by 5%; oops, your fund is now worth $97.75. Repeat across 10 days – alternating up 5% and down 5% – and you would finish with $89.23, down by 10.8%. Over the same course of choppy trading days, an unlevered fund would have lost only 1.2%.
So too, does the leverage mandate pose the potential to exacerbate market volatility, should this period of historic serenity be interrupted:
In a conventional margin account, leverage ratios fall as the value of portfolio assets rise. Not so here. An ultra ETF keeps its leverage constant by boosting its indebtedness – drawing on its swap arrangements – as the value of its assets appreciates. To bulk up in a rising market and sell down in a falling one is a technique that recalls the misadventures of portfolio insurance [an aggravating factor in the 1987 stock market crash].
For its part, BlackRock has steered clear of leveraged ETFs. CEO Laurence Fink told the audience at a Deutsche Bank-hosted investor conference in 2014 that: “We’d never do one. They have a structural problem that could blow up the whole industry one day.”  That prompted a rejoinder from Trevor Hewes, spokesman for ProShares, which offers many such products: “Leveraged ETFs are well regulated, transparent products and there is no credible evidence that they have any harmful effect on the markets or our industry.”
For our part, we wonder about the soundness of ETFs as a whole, not just the plainly perilous leveraged variety.  Recall the increasingly distant (in terms of time elapsed and market environment) events of Aug. 24, 2015, a steep sell-off that left the S&P 500 lower by as much as 5.2% intraday and 3.9% by the close.  In that session, even straightforward ETFs were severely dislodged, with the SPY falling by nearly 8% intraday.  The S&P 500 equal-weighted index dropped by as much as 4.6%, while the Guggenheim S&P 500 equal-weight ETF sank by as much as 43%, before finishing in the red by just 4%.

Heisenberg’s Doom Loop Update – Required Reading Edition

Presented without further interruption…

Hopefully you don’t need a refresher on this, because if you do it likely means you haven’t been paying much attention to how shifts in market structure are creating systemic risks that no one understands, but just in case, the idea is that thanks to the low starting point on the VIX, a nominally small spike could force inverse and levered VIX ETPs to panic buy VIX futs into said spike, thus exacerbating the situation and ultimately forcing CTAs, vol. control funds, and risk parity to deleverage into a falling market.

via Market Doom Loop Update: Risk From VIX ETPs, CTAs Flashes Red