I’ve switched from positive to negative on credit spreads on Wednesday of last week. Since then we had a big sell-off in spreads on Thursday on the Jobless claims number. Friday we started out with a mini panic in credit spreads after the payrolls number, and I was feeling pretty good about my call. But the afternoon saw credit spreads rally hard to where most names were flat to slightly tighter. Today we’re rallying hard. Bank/finance is 10-15 tighter across the board.
I’m sticking by my models and remaining short credit. But its worthwhile to note that there is a massive back bid in the corporate bond market. Its flowing from a number of sources. The most obvious is that fact that mutual fund flows are dominated by bond flows. A typical core taxable bond fund is going to be 50-80% corporate bonds (vs. about 20% of the overall investment-grade universe) and thus every dollar that comes into bond funds tends to hit the corporate bond market disproportionately.
Another key point is the general disdain for Treasury yields from traditional money managers. I can’t tell you how many bond salesmen tell me that their accounts have excess cash to put to work. Almost universally small to mid-sized advisors have been negative on interest rates since the 10-year first fell below 4%.
You can imagine the mindset. The 10-year rate started rising in rapidly March from 2.5% eventually all the way to 4%. Since you were negative on interest rates, you probably were holding a lot of cash. You are feeling pretty good about yourself. Then you rally to 3.80%. You keep accumulating cash, figuring it will come back to 4% again. Then it rallies to 3.60%, and hell, if you didn’t like it at 3.80% you can’t like it at 3.60%. Then its 3.40%… then 3.20%… and now the pressure is on. You’ve been holding a ton of cash, earning you nothing and producing no capital appreciation, while the rest of the market (and your benchmark index) is leaving you in the dust. You’ve reached a point of pain where you can no longer wait out the interest rate cycle. You have to get your cash to work.
But now cognitive dissonance comes into play. You had assumed you were a genius back when rates were skyrocketing. When 10’s were at 3.80%, your logic had been that “rates are just too low” and now they are even lower. How can your brain marry your self image as a smart investor with the fact that now you need to buy bonds at extremely low rates?
The answer is you fool yourself into believing that if you buy something other than Treasuries, you will be safe. So you buy 10-year Pepsi bonds at +90. Spreads will keep tightening, you tell yourself. Pepsi is a great company, you tell yourself. +90 is a good spread for a company that used to trade with a +50 spread. Nevermind the simple math of it all. If you buy Pepsi bonds at +90 when the 10-year is 3.20%, that’s an all-in yield of 4.10%.
The only way you can really justify this trade while maintaining the same interest rate view is if you would have bought the Pepsi bonds at a 4.10% yield when 10’s were at 4%. Or a spread of +10. Which obviously you wouldn’t have done, most obviously because you didn’t do it!
The other thought you see a lot from people who miss big rallies is that they wait for any pull back to add. Again, its a cognitive dissonance thing. You can tell yourself you were smart to buy when you did because you correctly waited for a pull back. When in fact, you waited too long to buy period.
The truth is, a lot money managers are suffering from an abundance of cash and are scrambling to buy bonds. As long as that is the case, there will be a significant back bid for corporates.