European Junk: “The Good-Looking Ones Are Always Bad News”
Yesterday, a few different readers emailed to ask my opinion about the European Junk Bond versus US Treasury yield chart that Tiho Brkan from The Atlas Investor Blog recently published.
Well, I have to give Tiho credit, his chart certainly stirred up a lot of primal urgings from investors eager to short European junk bonds. Although I am a huge Kodiak Grizzly of a bond bear, I think there are better ways to express this view than shorting European junk. Let me tell you why.
I couldn’t replicate Tiho’s chart exactly as I don’t pay for the Bank of America / Merrill Lynch bond indexes, but I found a Barclays/Bloomberg index that is close enough. So here is my version.
I also couldn’t determine Tiho’s term for the US Treasury yield in his chart, but it sure looks like the 10 year yield, so I am going with that.
So when comparing these two series, let’s start with the obvious. The current on-the-run US 10 year treasury note has a modified duration of a little less than 9 years. This compares to the European Junk bond index that comes in at under 4 years.
The sensitivity to changes in interest rates will therefore be much higher in the US treasury notes. Comparing these two assets with such different term lengths is a little misleading.
But you might say, “I don’t care – look at past yield levels for European junk! I can afford to have less duration because the credit part will skate me onside.”
And yes, if credit spreads blow out, then shorting junk is much better than sovereigns.
What do I mean by that? When an investor buys junk bonds, they are typically rewarded with an extra yield to compensate for the increased risk. The amount of this extra yield is called the option-adjust-spread, and we can chart it.
Currently, European junk bonds only offer 2.67% over the equivalent sovereign yield. Wait! How can that be? The US year yield is 2.22% and the two series have recently converged, so that doesn’t seem to make any sense. But you have to remember that 4 year German bunds are yielding negative 42 basis points, so that means European junk bonds are trading at roughly 2.25% (267 bps more than sovereigns).
As you can see from the OAS chart, these junk bonds have often yielded considerably more than sovereigns. During the Great Financial Crisis they spiked to 20% more, and even during the 2011 European credit crisis, they got as high as 10% over.
So yeah, I understand the attraction to shorting European junk. It’s easy to look dreamily at this chart and imagine spreads doubling to 5% without batting an eye.
But there are a couple of problems with this trade.
There are no easily traded derivatives on European junk bonds. So unless your friendly neighborhood GS salesperson lets you buy CDS protection on this index, it is kind of a non-starter. Yeah, you might find some ETF and leverage it up a bit, but with a 4 year duration, your returns are going to be mediocre, even if you nail the timing perfectly.
Yet even if I worked in a big fixed income shop and could execute this trade seamlessly, I don’t think I would bother with junk, and would instead focus on the sovereigns.
Getting all hot and bothered about the juiciness of European junk is doing nothing more than repeating the US mistake made by all the hedge funds over the past few years. Remember Carl Icahn’s “Danger Ahead” video? It has now been two years since good ‘ole Uncle Carl blessed you with his advice to put on all the same hedges that worked so fabulously in 2008. Go ahead and watch the video again. See how he recommends shorting credit? And no wonder. This trade worked so well in 2008, it is tough to not look at the tight spreads and think they offer a great asymmetrical risk reward profile (to use the buzzwords from all the hedge fund gurus). And I don’t mean to pick on Carl, practically all these mavens have been positioned the same way. Everyone hedges for the last crisis – even legendary hedge fund managers.
For the last two years, these hedges in the US markets have been a disaster, and I suspect they are about to experience the same sort of pain in Europe.
Don’t mistake my lack of bearishness for European junk bonds as a belief they offer good value. Nope. Not a chance. I wouldn’t buy an asset that offers so little upside, but with the potential for so much downside, in a million years.
Yet I do think shorting sovereigns is a much better trade than betting against European junk. What is going to cause European OAS spreads to blow out? Economic weakness. And what will be the result of more economic weakness? Yup – you got it – more quantitative easing. The ECB is already running out of sovereigns to buy, so what will happen the next time? They will venture even further out the risk curve.
I believe European junk bond yields are headed higher, but only on the back of higher sovereign yields. So if the only way junk bonds are going down is if sovereigns go down, why even bother contemplating shorting junk?
Why not just short the actual security that will cause the other security to decline?
I guess I could sum it up by explaining that I am negative on European bonds, but neutral on option-adjusted-credit spreads.
Governments are going to keep spending and printing until we finally get the nominal growth they so desperately desire (note how I specified nominal growth – they will find it more difficult to generate real growth). If you accept this argument, then it makes way more sense to short sovereigns than junk.
I have argued that the European cycle is mirroring the US experience since the Great Financial Crisis, only a few years behind. If that is the case, then there will be plenty of time to short European junk bonds in the coming years.
In the meantime, I am focusing on shorting the government bonds that are the true bubble. It is funny how so many look at junk and salivate over the possibility of shorting a security yielding 2.25%, yet quietly ignore government bonds yielding negative real rates of return with Central Banks intent on creating the very inflation that bond investors fear the most.
I will leave you with these wise words from the Urban Camel:
Remember, those good looking trades that everyone wants to put on are usually trouble. Instead, look for the more reliable, underappreciated one that is often staring right at you.