The Participant 10/14/15: UB(credit stres)S

by Jason Kelly

Wednesday, October 14, 2015


UB(credit stres)S

UB(credit stres)S

In a Global Credit Strategy note sent to clients last Wednesday, October 7, UBS’s US credit strategist, Stephen Caprio, wrote about his concerns for the staying power of the credit cycle.

Non-bank credit is a larger funding source than bank credit for US corporations. UBS utilizes the bond market and trade finance to assess the health of non-bank lending conditions, “and both signal a tightening of lending standards ahead. Low quality speculative grade net issuance has fallen sharply in a replay of late 2007 as the stimulative effects of past Fed quantitative easing wears off. Non-bank trade finance has also decreased to its weakest level since September 2011. While bank lending standards currently indicate benign conditions, this may change in short order.”

Due to this, UBS expects bank lending standards to tighten through the end of this year. Caprio concludes, “If our analysis is correct, today’s elevated level of US investment-grade and high-yield credit spreads will persist, and default rates may rise materially through 2016.”

The UBS note followed an October 2 note from Deutsche Bank in which that outfit wondered if we’re standing at the precipice of a default cycle. Business Insider reported that “Strategists Oleg Melentyev and Daniel Sorid looked at six leading indicators to judge whether the credit market has over-reacted, and found that two are flashing red — meaning they are ‘at levels consistent with where previous credit cycles have started.'” Their conclusion is that the next wave of defaults is “closer than consensus seems to believe,” and they predict a 5% default rate for the high-yield (junk) bond market next year. Other analysts pointed to the recent rise in high-yield bond spreads as a hint that recession is on the way.

The high-yield bond spread refers to the difference in interest rates paid for junk bonds when compared with investment-grade corporate bonds. A rising spread means the interest rate on HY bonds is going up more quickly than the rate on IG bonds, meaning the issuers of junk need to offer a bigger reward to attract buyers, which usually accompanies economic deterioration. Higher-yielding junk bonds bring a higher risk of default in all times, which is why investors bail out of them when they think business conditions are going south. Nobody wants to hold a bond issued by a shaky company into an economic storm. So, investors sell HY bonds, sending their prices down. As their prices fall, their yields go higher. We’re seeing this now.

It began months ago. Lipper reported at the end of August that more than $8B fled the nearly 200 HY mutual and exchange-traded funds it tracked over the previous three months. Most analysts said the reason for the great escape was the crash of commodities markets. The energy sector accounts for some 15% of HY bond issuance, and the metals and mining sector accounts for almost the same fraction. Together, then, the struggling firms in the oil and raw materials space have made junk bonds anathema.

Morgan Stanley reported last Friday that “HY just posted the weakest four-month stretch (Jun-Sep) since the end of 2008, -7.03% in total return. This selloff has driven very negative sentiment, as nothing brings the bears out of hiding more so than low prices, feeding into panicky price action in markets.”

UBS’s Caprio summed up his take thusly: “In short, non-bank liquidity has been the main driver of the corporate credit cycle post-crisis, and there are now early signs that it is evaporating.”

Which brings us to the main event. UBS is so convinced of the high-yield crack-up on the way, and how it will compound when meeting the currently illiquid bond-trading environment, that it decided to close its 17-year-old Managed High Yield Plus Fund (HYF $1.66). In a special press release yesterday, it announced that its board of directors of the fund has “approved a proposal to liquidate the Fund in 2016, subject to shareholder approval. … After careful deliberation and a thorough review of the available alternatives … the Board has determined that liquidation and dissolution of the Fund is in the best interests of the Fund.” It will happen “as soon as reasonably practical.”



From Note 37 sent to subscribers last Sunday morning, with data as of Friday, October 9:

The IMF lowered its global growth projection again, this time to 2015 growth of 3.1%, down from 3.4% last year and below the July forecast of 3.3% for this year. It expects a recovery in developed economies to accelerate a bit while emerging ones should slow further for the fifth year in a row. It cited low commodity prices, reduced capital flow to emerging markets, and collapsing EM currencies as reasons to doubt the near-term performance of the global economy.

The current central banking lineup finds the Bank of Japan pretending it won’t provide further stimulus when everybody knows it will, the European Central Bank issuing dovish commentary boosting speculation that it will expand its stimulus, and the Bank of England and the Federal Reserve both pointing to weak inflation as a reason to postpone rate increases.

Against this backdrop, global stock markets soared last week. Not a single major bourse failed to join the flight higher. Indonesia rose 9.1%, Singapore and Spain 7.4%, Germany 5.7%, and France 5%. The 4.x% club welcomed Australia, Canada, Italy, Japan, Hong Kong, China, Malaysia, the Philippines, Thailand, and the United Kingdom. Despite the enthusiasm in the United States, the S&P 500’s gain of 3.3% was one of the less inspiring last week.

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The Kelly Letter is emailed to subscribers every Sunday morning. It costs $19.97 per month or $236.97 per year. The annual price includes a copy of “The 3% Signal.” See a two-minute video about the letter’s low-stress way of beating the stock market at:



The following excerpt is from a note by Roberto Friedlander issued yesterday, as reported by CNBC.

“Players are pricing in the highest chance of an outlying black swan event in the next 30 days. The pricing currently is (for) a 15% chance of a two standard deviation move in the next 30 days. … So (it’s a) yellow flag for sure. Stay alert, stay alive!” wrote Roberto Friedlander, head of equity trading at Brean Capital, in a note to clients Tuesday.

Investors fear a “black swan” catastrophic event in the financial markets right now more than ever before. At least according to the CBOE Skew Index, which measures the prices of far out-of-the-money options on the S&P 500. … Put simply, traders are buying options that pay off only if the stock market drops a whole lot.

The measure is up 30% since the end of September, including a 10% spike for seemingly no reason on Monday.

At its Monday closing level of 148.92, the Skew Index is higher now than levels hit in 2006 before the housing bubble popped and 1998 amid the Long-Term Capital Management implosion. It’s above a level hit last year as markets sold off aggressively near the end of the year and as fears of an Ebola breakout spread.

To see this call in The Z-val Zone, please visit:

Recently Judged Forecasts:

7/9/15 Kass: Lower Stock Prices Ahead | Short-Term Bearish | RIGHT

Excerpt: “I expect rising volatility and lower stock prices ahead, and I remain defensive in a market that seems to be finally wavering in price and appears to be on a ledge of sorts.”

This is the second forecast by Doug Kass to have been judged. It was right, the other was wrong.

So far, twelve forecasts have been judged. Five were right, seven were wrong. The aggregate accuracy rate is 42%. Although the sample size in this young study is still too small to be considered significant, we know from other more comprehensive studies that the accuracy of forecasting is about 50%.

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Background: The term “z-val” is a shorthand introduced in the book, The 3% Signal, for “zero-validity forecasters” and “zero-validity environment.” The latter phrase was coined by Nobel Prize winner Daniel Kahneman in his book, “Thinking, Fast and Slow,” where he wrote that “stock pickers and political scientists who make long-term forecasts operate in a zero-validity environment. Their failures reflect the basic unpredictability of the events that they try to forecast.” This is why stock market forecasters are proven to sport an accuracy rate of about 50%, same as a coin toss, yet they continue forecasting.

You can peruse the growing collection of tracked forecasts in The Z-val Zone at:

Seen a forecast I should track? Send me the link in a reply to this note.



The Atlantic’s Walter Kirn is worried about the end of privacy, and wants you to know the situation is already worse than you think you know. From “If You’re Not Paranoid, You’re Crazy” in the November 2015 issue:

“Not long ago, my wife left town on business and I texted her to say good night. ‘Sleep tight and don’t let the bedbugs bite,’ I wrote. I was unsettled the next morning when I found, atop my list of e‑mails, a note from an exterminator offering to purge my house of bedbugs. If someone had told me even a few years ago that such a thing wasn’t pure coincidence, I would have had my doubts about that someone.

“Now, however, I reserve my doubts for the people who still trust. There are so many ghosts in our machines — their locations so hidden, their methods so ingenious, their motives so inscrutable — that not to feel haunted is not to be awake. That’s why paranoia, even in its extreme forms, no longer seems to me so much a disorder as a mode of cognition with an impressive track record of prescience.”

Yours very truly,

Jason Kelly

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