BofAML: Markets Are Once Again Mispricing Tail Risk in Credit

Ghosts of super seniors past.

Bond bulls seeking a scare just two days before Halloween need look no further than Bank of America Merrill Lynch, which offers up some financial crisis-era parallels for investors in junk-rated U.S. corporate debt.

Analysts led by Rachna Ramachandran peer deep into the structure of Markit's CDX HY, a derivatives index tied to the creditworthiness of high-yield corporate bonds and which is divided into layers of seniority known as 'tranches.' The tranches at the bottom are more vulnerable to corporate defaults and losses, while those at the top are in theory more insulated. You can see the theoretical structure in this Markit diagram.

Source: Markit

Super senior things hold a special place in credit investors' collective subconscious, given the events of the financial crisis. Back in 2007 and 2008, triple-A rated super senior tranches on synthetic collateralized debt obligations and other structured finance transactions were unexpectedly overwhelmed by defaults on underlying mortgage-related collateral, causing hundreds of billions of dollars worth of losses -- something which was never really supposed to happen -- for banks and other big investors in the securities.

Here's what the super senior of the CDX HY -- theoretically the safest portion of the index -- is doing right now; It's trading very close to levels last seen in early 2007, according to BofAML.

Source: BofAML

The 2007 parallels don't stop there, however. BofAML also compares the vagaries of the current CDX HY index -- known as series H25 -- to the H9 series that was popular in 2007. Back then, names in the H9 were relatively evenly distributed across a wide range of spread buckets (the blue bars in Chart 5 below). But the same cannot be said for the current edition of the HY25 index. Here (the yellow bars in Chart 5), many names are clumped around certain spread categories, suggesting increased nervousness around junk.

Source: BofAML

To the BofAML analysts, the big concentration of names trading at similar spreads in the H25, indicates a higher correlation and a "more systemic premium" as fear creeps into the junk debt asset class as a whole. Yet, the expected losses on the super senior tranche relative to the index are lower for the H25 than they were for the HY9 back in 2007 -- a fact that could easily be interpreted as yet another mispricing of senior risk.

Or as BofAML puts it:

The charts above all simply re-iterate that overall risk-premiums are still relatively low. This is the reason 14 percent of the index today trades over 1,000 basis points and yet the index itself is tight from a historical perspective. We believe this is why even after the lessons of the financial crisis, systemic risk i.e. super-senior is priced even lower than it was on the eve of the crisis.

While the idea of underpriced super senior risk might be enough to spook enough the most bearish of bond investors, BofAML goes one step further by drawing yet another analogy to the time of financial crisis.

The most frequently heard argument regarding this is that systemic risk is low today because banks are well capitalized. This is of course true. But does all systemic risk rest in banks alone? Even as banks bolstered balance sheets and minimized inventory, the corporate bond market doubled in size and risk now largely resides on investor balance sheets. Over the last year alone we have seen two sizable shocks in high-yield credit, both exacerbated by poor liquidity conditions. As Chart 6 and Chart 7 show, names are moving in a correlated fashion around these shocks. To us this suggests that tail risks premiums, in this case 35-100 percent spread, should be on the rise.

Source: BofAML

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