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Trickle-Down QE

Everyone’s heard of trickle down economics, but how about “trickle down QE”?

The concept is basically the same, you just have to replace the people in the equation with bonds, an abstraction which isn’t difficult for bulge bracket banks to make, as subjugating the human element to dollars and cents has been unspoken corporate policy for decades. Just as tax breaks, etc for businesses and high earners are expected to ultimately benefit middle and low income households in trickle down economics, in trickle down QE, the liquidity injected into the system via central bank purchases of sovereign and IG corporate debt is expected to ultimately benefit high yield spreads.

Of course, this is really just another way of repeating what everyone has been saying for the last half decade: central bank largesse forces investors into risk assets by driving down yields on any asset class that could be even remotely construed as “safe.” Fortunately for those of us who are bored with buying plain vanilla equities and dabbling in HY cash credit to get our yield fix, the unique character and scope of Draghi-style easing presents investors of an adventurous disposition with an opportunity to capitalize on trickle down QE via an exciting foray into synthetic credit.

Without further ado, here’s Citi to explain how a hypothetical credit strategist will visit your fictional office and use the concept of trickle down QE to convince an imaginary you to go long euro HY credit via synthetic exposure to Crossover mezz tranches (you can’t make this stuff up):

The argument which finally convinced us that high yield is an attractive long is the potential of ECB QE to “trickle down” all the way to high yield…

 

Imagine … some random credit strategist showed up in your office with the following pitch: “It’s not whether you like this or not, the ECB is going to force you to take more beta. High yield is a good place to do that”. First reaction? Get defensive, partly because this (well-meaning) strategist is reminding you that what you think doesn’t matter because somebody very important is going to force you to do something.

 

After getting through that, you probably want some more detailed advice: “How do you propose me taking that risk?” Considering the strategists’ concerns about idiosyncratic risk, the advice will go along the following lines:

You should build a diversified enough portfolio of high yield bonds because idiosyncratic risk is high and if you’re not diversified there is a chance your losses can be very big. But if you are diversified, the most likely outcome is that the idiosyncratic risk will only cause a small loss in your portfolio.

You use the complaint du-jour to placate him: “Do you realize how liquidity is like in the bond market these days? You should know better before recommending anybody to build a diversified portfolio of high yield bonds. Diversified means I need to buy many, and that’s not easy you know, especially in ‘size’.”

 

So traditional remedies are clearly somewhat problematic when taking high yield risk given idiosyncratic risks. What can be done to take high yield risk, minimizing exposure to idiosyncratic risks but in a way where execution is not prohibitive?

In case you’ve lost the narrative, that last passage is Citi asking itself a rhetorical question from the perspective of an imaginary client. It only gets better when our fictional protagonist reminds the make-believe credit strategist that the last time someone came around hawking an investment “opportunity” in synthetic tranches, the financial universe nearly collapsed shortly thereafter: 

By now … you’re already in defensive mode again, thinking “Here these guys go again trying to solve a problem with synthetic tranches. Don’t they remember that …?” There is plenty of resistance among many investors to use synthetic tranches on the back of not very satisfactory past experiences – we know that. But it turns out that: (i) Synthetic mezzanine tranches are a very good fit for the problem we’re trying to solve here (see below), and (ii) what caused the problems in the past wasn’t the product itself but its over-use … and that’s not the case now – and it’s not only us believing that: 70% of respondents in our recent Credit Derivatives Survey aren’t concerned about investors taking leveraged risk using derivatives. With that, let us go on with our pitch.

So there you have it. Granted, some investors had a “not very satisfactory” (i.e. the entire financial system blew up on the back of pyramided counterparty risk) experience with synthetic tranches in the past, but “it turns out” that the problem wasn’t really the complexity of the instruments, but rather their “over-use” (so, too much of a good thing?). Of course, there’s no over-use problem now (which certainly has nothing to do with investors’ collective memory of what happened last time) and ultimately, you don’t have to take Citi’s word for it, you can just ask any of the banks and hedge funds they surveyed, nearly three-quarters of which definitely aren’t concerned about you taking leveraged risk with derivatives. 

Getting to the specifics (and briefly stepping back from the sarcasm), it’s the Crossover S22 10-20% that you want, as it gives you enough subordination to dodge a few idiosyncratic default bullets and still pays a running spread above 550 bps. For those who buy the trickle down QE narrative and actually see an opportunity in HY heading into ECB asset purchases, here’s the default exposure on this:

 

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Of course, these types of trades are intended for sophisticated investors and in a post-crisis world characterized by humility on Wall Street, we can be sure that these “opportunities” aren’t advertised to clients for whom they aren’t suitable.

From the introduction to the above-quoted Citi note:

Our target audience for this piece is the non-seasoned tranche investor. Don’t be afraid of reading on if you haven’t been involved in tranches before. We’ve written this piece so that you won’t get lost.

And in case you also haven't seen how all this ends, Citi previewed that as well, in "Citi Warns Of "Dancing", "Music" And "Complicated Things" For The Second Time..."