Record Bond Issuance
Relative value credit analytics has been the subject of investor attention over the last 12 months, due to the surge of issuance seen in the bond market and the volatility within the credit sector during COVID-19. Both created opportunities for realisation of value, and whilst the markets calmed down from the turbulence 12 months prior, the party is not over.
By the end of September 2020, US corporate bond issuance had already exceeded that of 2017. By the beginning of the fourth quarter, over $1.91trn had been issued in investment grade and non-investment grade debt. By the end of the year, that figure had swelled to $2.36trn.
Dealogic calculates total global investment grade corporate debt issuance to have been the equivalent of $2.94trn, $2.014trn of which was denominated in US dollars and $772bn in euros. This compares to total issuance of $2.455trn in 2019 and $2.501trn in 2017, so 2020 volumes represented an overall 20% increase over the previous year and no less than a 54% increase in dollar denominated debt.
Bigger the Market, the More Opportunities
Issuance of this scale creates opportunities for investors, as there are more bonds out there. Additionally, there is value to be had due to dislocation.
The bond market sold off in March 2020 dramatically. but also indiscriminately. Everything went down – sometimes by more than was perhaps warranted. As one buy-side manager describes, “The baby got thrown out with the bath water.” Since then, the market has come back a long way, but there are still pockets of opportunity to be had.
“If you’d had asked about relative value in March 2020, I would have said there are tons of opportunities to be had. By September, the number of opportunities had come down relative to March, but there were still a lot to be had. As of today, we are down from October, but there are still opportunities one can utilise to put on really good trades,” he explains, speaking in April 2021.
The growth of electronic trading contributed to the credit market’s efficiency, but only a relatively small proportion of credit products are traded online. In February, JP Morgan’s annual e-trading survey reported dealers anticipate that 20% of all credit trading will be conducted electronically by the end of 2021. This compares with 75% for FX and 50% for rates. MarketAxess is the leader in this space, with an estimated 85% of all US investment grade bonds and 84% of high yield bonds traded. (See Table 2).
The performance of the Bloomberg Barclays US Corporate Bond Index over the last year also suggests there is room for growth. It significantly underperformed the equity markets over the past year with a broad market return of 6.3% compared to no less than 50% in the S&P 500. The feeling that the equity markets are bumping against the ceiling has led to increased interest in credit markets from multi-strategy firms that normally focus upon equity markets. Meanwhile, traditional credit buyers scent an opportunity.
What is Relative Value Credit Strategy?
Relative value credit strategy depends on the isolation of a pair of similar credit instruments, one of which is assessed to be comparatively undervalued or overvalued. These might be bonds issued by the same borrower at different points of the yield curve, or they might be bonds issued by different but similar borrowers. Straightforward credit analysis of cash flow and balance sheets of two seemingly similar pharmaceutical firms might produce the revelation that one deserves to be trading at tighter yields than the other. Such a revelation invites a long/short trade.
The strategy extracts value from dislocation in the pricing of credit risk across markets, instruments and maturities.
Equally, liquidity concerns may affect bonds issued by the same borrower but at different maturities. One security, say a five year note, may trade cheap to a two year note, once again inviting a long trade on the five year against a short position on the two year.
However, opportunities exposed by use of relative value strategies present themselves fleetingly, so investors should act swiftly to exploit these openings. To expose all possible dislocations, credit investors should maximise the field of vision, so they can trade a wide a range of asset classes, including cash and synthetic products.
This includes, corporate, government, municipal, emerging, convertible, hybrid and mortgage-backed bonds, indices, ETFs, loans and CLOs in the cash space, single name credit default swaps, collateralised debt obligations, CDX indices, CDX tranches and credit options in the synthetic space.
Crucially, relative value credit trades are market neutral. Investors look for a dislocation between a pair of credits when one appears to be overvalued or undervalued in comparison. By putting on the trade, the counterparty is expressing a view about what will happen to the relationship between these two instruments, not a view about overall market direction.
“If you have an outright view, then there is no point in doing relative value credit strategies. If you think overall credit quality will go down, then it is better to just go short. What relative value credit does is substitutes basis risk for credit risk,” explains one sell-side dealer.
This is where the investor takes the risk: in the basis between the two instruments, not in a deterioration or improvement of credit.
Analysis and Technology
Investors need adroit analysis and powerful digital technology to survey the credit landscape and to isolate profitable dislocations and execute trades before they vanish. Risk managers also need state of the art tools to measure and report on portfolio risk at all times.
Relative value credit analysis depends upon the capacity to quantify credit values at any point in the curve and across instruments, and to compare these values with others, usually at different points in the curve or in other instruments in order to identify trading opportunities.
This comparison is called the basis, and is generally expressed in spreads. There are many different types of spreads, such as spreads over Treasuries or swap spreads, but the ones much usually used in relative value credit analysis are the zero volatility spread, the option adjusted spread and the implied CDS spread.
The zero volatility spread, or the Z spread, is a tool for calculating the consistent spread between the present cash flow value and the US Treasury spot rate yield curve. This is a fairly complex calculation which involves taking the spot rate at any point along the yield curve and adding the Z spread to it to arrive at a sum of the two.
It does not , however, make allowances for any embedded options in the securities being evaluated. A mortgage-backed bond , for example, incorporates an embedded option as it might pay out at an unexpected date due to different prepayment speeds. If interest rates go down, mortgage-holders are incentivised to prepay mortgages earlier and refinance at lower rates. Here, the issuer of bonds is likely to exercise the call option, pay off bondholders and re-issue new debt at lower rates. Thus, cash flows the investor enjoys are unpredictable (See Table 3).
The value of such bonds is calculated through option-adjusted spreads (OAS). OAS takes account of the option and how it affects the likely cash flow of the bond. It discounts the Z spread according to the value of the option and is a highly dynamic pricing model. There is no single OAS pricing model, but many calculations depend on which pricing model is being used.
Investors can compare cash pricing with CDS pricing to discover dislocations. Buying protection in the CDS market is equivalent to going short in the bond, so a long position hedges the CDS position, but at potentially different prices with different cash flows.
Trading cash against single name CDS, or against CDS indices (CDX in the US and iTraxx in Europe) is a traditional method to exploit dislocations. It has become less popular since the financial crisis as the CDS market has shrunk dramatically due to the demise of the synthetic CDO market.
In 2007, just before the world unravelled, notional principal outstanding in the CDS market was over $61trn; a decade later it was just $9.4trn.
During the Eurozone debt crisis, CDS markets faced unwarranted vilification: the EU blamed CDS instruments rather than the frailties of the single currency for the instability in Eurozone government debt and banned naked, or uncovered, sovereign CDS positions.
Thus, Liquidity in sovereign CDS nosedived and has never really recovered. Only Russia, Turkey and South Africa have a liquid CDS market in the EM market, so relative value trades using CDS is not possible.
While the number of risk-taking institutions and their capacity for risk has shrunk, the asset management industry has ballooned. In early 2021, Black Rock had $8.7trn under management – an increase of no less than $2.2trn in just three quarters.
This is clearly where all the money is going. But asset managers tend to be positioned in the same way, so in a sudden and unexpected credit event all need to get out of those positions fast, adding to the possibility of dislocation between assets. Developments over the last decade have made markets less efficient, but the opportunities for relative value credit trading strategies have grown more abundant not less.
Bearing this in mind, and the continuing breadth and depth of issuance in international bond markets, it looks like relative value credit strategy is here to stay. Although markets are less volatile than they were in the teeth of the COVID-19 gale that blew in Spring 2020, there are still plenty of factors that could introduce new volatility.
Inflation is now more likely than at any time in the recent past. The UK consumer price index increased by 2.1% in the 12 months up to the end of May, despite Bank of England assurances that it would not exceed 2% until the end of the year. In the US, PPI data released on June 15 showed that producer prices are rising faster than at any time since 2009. Investors aren’t panicking; but panic might lie just round the corner. This would introduce new volatility to the market, and underline the value of relative value credit strategy.