Bubble Watch: Credit Derivatives on the Rise

The Fed's zero percent interest rates, now on five years and counting, has not restarted the economy for most people. It HAS let corporations borrow cheaply for buybacks, dividends and M&A, dragging corporate debt -- albeit at low interest rates -- ever higher. 

Now ZIRP is being blamed for a new bubble in the bond space. The bubble is coming complete with the kinds of derivatives that ballooned the mortgage bubble in 2005-2006. CLO's Collateralized Loan Obligations for high-yield debt, call them CDO's, complete with the tranches. 

Peter Tchir on Bloomberg last week: (begins about 2:30)

"What we're seeing is the exact same cycle as 2005-2006, where everything gets a little more exotic, a little more difficult to quantify. But that's what people do in a search for spread.... The realization that global yields are so low has forced people this year to re-embrace these structured elements. People are hiring "those people" again."

It's called "structured credit," taking CLO'S those and levering them up. Making the structures riskier. Credit derivatives. The synthetic CDO's, Bespoke (customized instruments negotiated with banks) 

"People are still very tentative, very cautious. Nobody wants to be the next AIG. But we are seeing that accelerate over recent months."

And all for 0.3 or 0.4 percentage points. Below it Tchir's credit bubble pyramid.

credit  Peter Tchir, Head of Macro Research at Brean Capital LLC, Bloomberg August 22

credit Peter Tchir, Head of Macro Research at Brean Capital LLC, Bloomberg August 22

Consensus has been almost universally wrong on the direction of Treasury bonds. Most of Wall Street is on the short end, betting bond prices will go lower and yields higher. The trouble is, says Tchir, much of the world is below the US long bond rate: Germany: 0.99, Japan 0.54, Switzerland: 0.54, even Spain (!) 2.3. Only Italy of the major bond markets is higher than the U.S.

Elsewhere on Bloomberg, the note :

When it comes to predicting where U.S. borrowing costs are headed, the bond market isn’t taking Wall Street’s advice seriously.

After giving up on calls last month that Treasury yields will rise in 2014, forecasters are sticking to estimates those on the 10-year note will climb next year and reach 3.6 percent as the Federal Reserve increases interest rates. Yet based on the performance of long-term Treasuries, implied yields suggest investors don’t foresee yields that high for a decade or more.

More from Tchir,

Consensus wrong, so wrong over 8 or 9 months

Such a massive short interest in the long bond, so I think there is the universal acceptance that yields should go higher, so people have this short interest, but when there is so much on one side of the trade it's hard to move. Especially since the Fed has been buying a huge percentage of this and insurance companies and pension funds need to buy as well...

We haven't seen the capitulation. That's what really scares me. I watch the ETF's. They continue to see a bigger short interest every time we go tighter, so we haven't seen that capitulation. I think we might see it over the next few days. If Yellen comes across as dovish, if Draghi comes out aggressively. I think what the shorts are really missing is, when you look at European yields, bunds are below 1%....

We are really seeing structured credit blossom again. People are coming back to structured credit, in a desperate search for yield....

That's where you start building in the bubble. Everyone has already moved from investment grade into high yield, into leveraged loans, CLO's. sub-prime auto, anything where there is that bit of yield.