Bubble Gum - What CDS is Telling Us

Are junk bonds mispriced? Money began to flow into the nether regions of the credit markets from income-oriented investors and from speculators who have left the equity market and are choosing to speculate in, what we like to call, equities with a coupon (and some recovery potential). Many investors who have acquired junk bonds try to convince us (and themselves) that they are not really speculating. They espouse the belief that the new reality is one of lower defaults and easier access to credit (at lower rates) than in the past. If you replace “junk-rated corporation” with “subprime mortgage borrower” and the today’s junk bond argument is similar to the Housing Bubble’s subprime argument. The thirst for yield and desire to speculate for total return purposes has created a junk bond market with valuations which cannot be justified by corporate credit health. The expected compression between yields found on junk bonds and U.S. Treasuries has, largely, already taken place. We should note that bonds at the very bottom of the credit ratings scale often trade on a dollar-price basis, rather than on a spreads basis. This means that sophisticated market participants are trading them on a perceived recovery value basis. When bonds trade on a dollar price basis, it is an indication that market participants are not expecting to receive par at maturity. We have just gone through optimal years for junk bonds. Much retail money has flowed into junk. If there is a bubble in the fixed income markets, we believe it lies in the nether regions of the junk market. What about the idea that these bonds could rally further on an improving economy? Fed policy has brought the rally forward. I. E. Much, if not all, of it has already occurred. One way to see if there is a bubble brewing in junk bonds is to compare bid side credit spread on cash bonds versus bid side CDS for the same issuer. Let’s use JC Penney as an example. The bid side spread for the JCP 7.95% due 4/1/17 is about 617 basis points over the 5-year Treasury. The institutionally driven CDS market is setting the cost to buy protection for 5-year JCP at about 765 basis points. If we are to believe that institutional market participants are better equipped to judge risk (and Bond Squad firmly believes this to be true), the cash bond market is under estimating JCP’s risk of default. If an institution wanted five-year exposure in JCP, it would be better off selling protection at 765 basis points in the CDS market, rather than buying JCP 5-year debt. One can simulate (even synthesize) A JCP bond by selling 10mm JCP CDS and buying 10mm 5-year Treasury strips. Notice that we used a size of 10mm notional. That is the typical quoted size in the CDS market. The high grade market may be getting rich as well. Let’s look at Alcoa. The AA 5.55 due 2/1/2017 are being bid around a spread of 195 basis points over the 5-year Treasury. Five-year AA CDS is spread around 295 basis points. Again we have a 100 basis point disconnect. Although the Alcoa bond offers an attractive yield for an investment grade credit, it appears rich versus CDS. Let’s look at CVS: The CVS 5.75% due 6/1/17 are being bid at +.70 to the five year. Five-year CVS CDS is at 45 basis points. It appears that, with CVS, investors are over estimating risk versus the CDS market. That JCP and AA bonds are trading at narrower spreads than their respective CDS tells us that it could be the thirst for yield is inflating the prices of bonds offering relatively high yields. This alludes to an underestimation of risk by investors. Consider CVS. The CDS spread for CVS is less than that for CVS bonds. This tells us that retail investors (or funds which must buy bonds instead of derivatives) are avoiding CVS bonds due to their 1.30%-ish yield. Relatively speaking, CVS credit spreads are overestimating credit risk versus what the CDS market believes. Using CDS spreads as a guide is not fool proof. As we have seen in the past, CDS market participants can also misread a situation. However, they have rarely got it more wrong than the bond market, especially when smaller investors are active in the respective cash bond market. We believe that CDS spreads give us a guide as to where risk should be priced. It is not fool proof, but it offers a good guide. Taking that into consideration, it appears that riskier credit market assets are getting a bit rich, with some in a full-blown bubble. The CDS geeks have formulas which they use to gauge default probabilities. It is possible to ascertain the market’s default probability estimates via CDS spreads. Buy running the CDS spreads for CVS, AA and JCP through the International Swaps and Derivatives Association’s Fair Value Model, we get the following default projections for our three aforementioned companies, five years out. CVS: 4.00% AA: 24.00% JCP: 49.00% Whether or not these estimates correctly estimate default probability is a subject of debate, however, they are used when pricing risk. We would not want to be the one facing angry investors should the nearly 50/50 default probability of JCP come up tails when we were betting heads. Bond Squad never simply goes with gut feelings, nor do we blindly run with the herd. We are always looking more deeply into market valuations to see what might be “cheap” and what might be a trap. Bond Squad Subscription Info: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.