www.zerohedge.com
Three week ago we showed the dramatic crushing of
shorts in the investment grade bond ETF, the LQD, where shorts
initially soared higher in the first half of March as credit prices
tumbled, then plummeted to all time lows after the Fed
broke a taboo not even Ben Bernanke dared to touch during the financial
crisis, when on March 23 Jerome Powell announced he would purchase
Investment Grade bonds (followed last week by the even more shocking
news the Fed would buy fallen angle junk bond debt).
What happened was unprecedented: as JPM puts it, "looking at
credit ETFs, the short base collapsed in spectacular fashion from LQD,
the biggest HG ETF after the Fed’s credit backstop programs."
As we wrote, all those traders who naively expected that the Fed would
not nationalize virtually every market and - at least implicitly fought
the Fed - were carted out following the biggest, most "spectacular"
short squeeze in history: that of LQD on March 23. The chart below
shows that between March 23 and April 2, the % of LQD shares loaned out -
a proxy for shorting - had dropped from an all time high to a record
low...
... as the Fed triggered a historic short squeeze, crushing all those
who did not even know they were fighting the Fed when they shorted the
LQD, which had become a systemically important instrument, explaining
why everything in the cap structure above IG debt is no longer subject
to any market forces but merely to the whims of the NY Fed's trading
desk - will it buy LQD, and how much. That's all that maters now.
What happens next, we mused rhetorically, and said that with shorts
no longer allowed to speculate in IG debt or anything less risky as it
is all backstopped by the Fed now, only a few things remain subject to
the whims of markets: junk bonds and stocks.
Little did we know that just two weeks later the Fed would "go there"
and announce it would also bail out the biggest systemic threat to the
US credit market - "fallen angel" junk bonds which collectively could
amount to some $3.5 trillion or nearly three times the size of the
entire junk bond market - announcing it would purchase BB-rated junk
bonds which were rated IG as recently as the date is announced it would
purchase IG debt, March 23.
Yet something unexpected happened: unlike the LQD case study where
the short interest collapsed, here bearish wagers against the largest
junk-bond ETF have continued to build despite the Fed's explicit
backstop of high yield debt, as skepticism grows that the Fed support
will not be enough to protect investors.
As Bloomberg shows citing the latest IHS Markit data, short interest on the $16.3 billion High Yield Corporate Bond exchange-traded fund, the HYG is near 38% of shares outstanding, close to a record of 39% reached in late February for the fund.
Remarkably, this is happening after the Fed announced it would buy junk bonds ETFs such as the HYG!
According to Bloomberg the reason for the surge in shorts is that
"skepticism is returning after last week saw the biggest rally on record
for the ETF, which soared on the back of the Fed’s plan to buy fallen
angels and funds such as the HYG."
Arguably, Bloomberg continues "while the Fed’s support will help keep
credit flowing amid the coronavirus pandemic" which is not necessarily
correct - the Fed will merely set the prices of junk bonds ETFs to
whatever it decides they should be, "it does little to lessen the risk of cash-strapped companies declaring bankruptcy, according to Principal Global Investors."
In other words, while fallen angel companies may be safe, for now,
nothing prevents rating agencies from downgrading BB credits further to
B, CCC or lower. And eventually, these former fallen angels may
and will declare bankruptcy, and not even the Fed is bold enough to
demand Treasury permission to buy bankrupt assets and pretend they are money good.
"Actions to backstop high-yield eases the liquidity strain
segment of high-yield spread widening, but it has less impact on the
‘insolvency risk segment’ of high-yield spread widening,” said Seema Shah, Principal’s chief strategist. "It doesn’t necessarily improve the outlook for bankruptcies."
It certainly doesn't, and unless the Fed intends to become an active
participant in post-reorg valuation fights, the Fed will buy
highly-rated junk bonds only to sell them as they become increasingly
more insolvent.
That said, the shorts suffered major pain here too - the HYG surged
7% after the Fed announcement, capping its best week since the fund was
created in 2007. The fund closely modestly in the green on Tuesday after
dropping 1.4% Monday as even more shorts piled in.
In any case despite the Fed's clear warning to junk bond shorts,
there are millions who are still willing to bet that the Fed will fail
to prop up the high yield bond market, making a mockery of Marko
Kolanovic' warning from last night who said that "investors with focus
on negative upcoming earnings and economic developments are effectively
'fighting the Fed,' which was historically a losing proposition."
Guess some investors still dare to focus on negative economic development despite "fighting the Fed."
* * *
Curiously, not all junk-bond ETFs have seen a spike in short
interest. The $10 billion SPDR Bloomberg Barclays High Yield Bond ETF
and iShares Broad USD High Yield Corporate Bond ETF both soared last
week, but short interest has fallen. Shorting shares could also reflect
moves by investors to hedge other parts of their portfolios, rather than
an outright bet on declines, as Bloomberg reminds us.
The fact that the Fed will only be buying falling angels means that
the program isn’t necessarily a positive for the entire high-yield asset
class, according to Columbia Threadneedle.
"Fed purchases will not extend into the tail of high-yield,
and there is an argument to be made that default rates are not fully
priced-in yet," said Ed Al-Hussainy, a senior strategist.
He is certainly correct... for now. Because with the Fed now all in,
it is only a matter of time before the Fed has to backstop virtually
every asset class, everything from single name C junk bonds to single
stocks and equity ETFs. The only question we have is how will the Fed
outlaw bankruptcies once companies realize that the pre-coronavirus
economy won't be back for years, if ever.
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