If you have not noticed, there is a lot of risky debt outstanding

Sometimes investors have to be hit over the head with a 2x4 to notice risks. This week saw one of those 2x4 moments. High yield spreads as measured by the BAML OAS spread index for both high yield and BBB-rated bonds exploded wider with increases of 50 bps and 15 bps respectively. This was a 10+ percent increase in spreads based on last week's spread levels in both markets. Investors talked about the difficulty of finding liquidity in these markets. While the market seemed to calm by the end of the week, there was only a limited reversal in spreads. 

The debt market structure suggests there is a lot of risk in credit investing. First, the amount of the lower-rated bonds on the cusp between investment grade and high yield has never been higher. Second, the ability to pay as measured by debt to EBITDA could not be worse.  

These conditions are unlikely to change even if there is further Fed rate cuts. Debt supply has not slowed even when rates were rising. Any decline in earnings will hurt the denominator in the debt/EBITDA ratio. There are buying opportunities and liquidity warnings. While the reach for yield may intensify if absolute rates decline, this week was a warning. Fundamentals are not good, so spreads have little reason to tighten. 

Everything you need to know about ETFs and volatility on a 3X5 card

While there are significant benefits and cost advantages from ETF, their growth has impacted the price process for assets. Research suggests that ETFs have an impact on the volatility of the underlying assets associated with the ETF through a short-term liquidity effect. This research is a few years old so the impact may only be greater today with the continued rise in ETF volume. (See for example "Do ETFs Increase Volatility" Journal of Finance December 2018.) 

This volatility discussion is more important because of the strong growth in ETFs with underlying assets that are less liquid. For example, the strong growth in fixed income ETFs, especially with high yield indices, creates an environment where the underlying bonds within the index will see higher volatility based on the flows associated with the ETF. 

ETFs have attracted shorter-term traders (higher turnover clientele) than the underlying assets, so their activity spills-over to the assets included in the ETF. Liquidity traders, not new price discovery, increase negative autocorrelation in the underlying assets. The increasing endogenous risk from changes in market structure from growing ETF usage may have gone unnoticed by many investors in the current relatively low volatility environment, but a change in the environment that may see more rebalancing and asset allocations will spill-over to volatility and co-movement of individual assets. 

The next financial crisis will be different from the last and the impact of ETF flows may be an important part of the future market dislocations. The new "bank runs" will be in financial assets and not just depository institutions. The impact from large inflows and outflows from ETFs will increasingly dominate the behavior of individual assets. This increased price noise will reduce price discovery and create a less healthy market infrastructure. Investors should prepare for these changes with what I will call ETF shock plans.

Momentum - Not an anomaly but just "normal" behavior

“There are patterns in average stock returns that are considered anomalies because they are not explained by the Capital Asset Pricing Model…The premier anomaly is momentum.” Fama - French "Dissecting Anomalies " Journal of Finance 

Many now agree that momentum is not an anomaly but a core risk premium strategy whereby investors receive excess return for following trends either through time series or cross sectional models. It is not an aberration that will go away through better modeling or through identification.

There are a number of reasons for why momentum will work, from behavioral arguments about slow adjustment, under-reaction and then over-reaction, to being paid as an offset to the risk of crashes from herding. A slow speed of adjustment based on behavioral biases seems to fit data and in spite of our knowledge will not easily go away. Additionally, in an uncertain world, cautious behavior is the norm as investors seek confirming evidence. Many arguments are suggestive, but the rationale for trends is still a work in progress with competing narratives. Momentum occurs because there are frictions in markets that run from behavioral, informational, and structural. Nevertheless, it does not change the fact that trends and momentum are the most consistent risk factors measured through time. Frictions do not stop markets from reaching their destination but slows the process which leads to opportunities for those that follow price dynamics. 

The momentum factor, both cross-sectional and time series, has shown long-run return consistency. Yet, long-run consistency does not mean that money will be made every year or that there will not be periods of significant under performance relative to other risk premiums. Poor momentum performance today will lead to futures positive performance tomorrow as this style loses popularity. A time varying risk factor cannot be confused with an anomaly 

This does not mean that momentum trades cannot be crowded, but the underlying nature of trend and momentum makes crowding difficult. Too many investors engaging in a trend trade will not cause trends to disappear. Rather, too many investors will cause the trend to move faster to some equilibrium with the potential to overshoot and then reverse. Slow traders who follow long-term trends will under-perform but faster traders with shorter investment horizons may outperform. Time-frame switches lead to under-performance for the single time frame static trader. This time-frame dynamic is one of the key challenges for any follower of momentum. Crowds change trends and require time-frame diversification. Research shows that momentum will not always be the same. 

Similarly, the behavior of one market will not be the same as others. Structure, costs, liquidity, and the mix of market participants will change the characteristics of momentum but not eliminate the factor. A given market will have its own time varying momentum returns. These aggregated returns across all asset classes show positive returns. Momentum is not a anomaly but part of a market process where returns associated with price dynamics ebbs and flows.

Credit risk premia and credit spreads - These are not the same

Specialized investing in credit risk premia is large and growing market but there are some simple definitions that will help with any discussion about rich and cheapness of premia. Most credit investors will analyze current spreads versus historical data and make a determination of whether they are being paid for the credit risk being taken. However, there is more going on if you truly want to get to the true credit risk premium. The real question is whether the risk premium received is enough to offset the risk of default and downgrade. These factors change with business and credit cycle. Spreads should reflect these risks, but there can be divergences between market prices and actual risks.

The true compensation for risk should account for the loss from a default and the loss from a downgrade. The downgrade risk can be measured through looking at transition matrices which track the likelihood of a downgrade over a time period versus the cost of a downgrade as measured by the differences in spreads with different ratings. The risk of a downgrade will change across the business cycle. If there is an expected recession, then there will be a highly probability that there will be a downgrade. Similarly, if there is economic improvement, there will be a greater likelihood of an upgrade in ratings.

A similar analysis can be done for the risk of a default. An investor needs to measure the likelihood of a default as well as the recovery value from a bankruptcy. The difference between the market price and recovery price will determine the size of the loss. Default probabilities will also change with the business and credit cycle. Hence, OAS spreads, as the weighted opinion on these credit issues, will change with the business cycle.

These credit issues are discussed in the white paper, "Where Has My Credit Premium Gone? A Perspective on the Current US Corporate Bond Market by Mellon Investment Management".

Many investors believe that the cost of downgrade and bankruptcy will be incorporated in the OAS spread, but a closer look at the data show that OAS spreads and credit risk premia are not perfectly correlated. As credit risks increase, there will be a corresponding increase in spreads as seen during recessions. This should be expected, but the difference between what is priced in the market and what is the likelihood of these risks being realized may not be the same. Any discussion of credit risk premia has to look at all of these factors to make an effective judgment on whether there is value in this risk premia.