Thursday May 4

Stock indices were little changed today as investors continue to digest the FOMC statement yesterday. The S&P 500 and the Dow Jones each moved less than 0.1% to finish at 2,389 and 20,951 respectively. The KBW Bank index and the DJ Utility Average each rose 0.2%. Economic data today showed that the trade deficit was not as wide as expected and that jobless claims were lower than expected as well. Factory orders rose just 0.2% compared to consensus of 0.4%. Energy stocks in the S&P 500 fell 2% after oil prices continue to slide on oversupply concerns. Interest rates continued to tick up in the US. The two year Treasury yield rose 1bp to 1.31%. The ten year Treasury yield rose 3bp to 2.35%. Accordingly 2yr vs 10yr bear steepened to 1.04%. The dollar was weaker on the day against peers as it will be driven more by long term interest rates which did not change much expectation wise after yesterday’s statement. USD fell 0.9% against EUR to $1.0986 after investors price in the outcome of the Macron – Le Pen debate last night. The German 10 year bund yield rose 7bp to 0.40% which also reflects decreasing concern about the outcome of that election. USD fell 0.3% against JPY to Y112.34. USD fell 0.5% against GBP to $1.2926 after economic data came in strong in the UK. Oil prices experienced a sharp selloff. WTI fell 4.9% to $45.46. Brent fell 4.8% to $48.38.

Some credit analysts are concerned about high valuations in the high yield market. High yield bonds currently return on average 5.7%. At Michael Milken’s annual conference that topic was discussed and the consensus is that it is a much more favorable time to be an issuer than it is to be an investor. Median leverage in the S&P 500 measured using the debt-to-Ebitda multiple is currently at the highest level going back to 1980. At the same time the spread between high yield bonds and US Treasuries is at a notably low level of around 400bp. That suggests that yields are detaching from fundamentals, however given low yields elsewhere that is not surprising. At the same time issuers have been able to dictate the terms of issuances. Investor protections and other covenants have been getting more relaxed over time and investors are accepting relaxed definitions of operating profits. Durations have been extending as well all of which means more risk for investors. This comes as certain investors are entering the space that typically don’t occupy the high yield sector which could lead to uninformed buyers. Many investors have been drawn in by the 24% return high yield has offered since the market hit a bottom at the start of last year. There is no end in sight however, but the market seems to be on precarious footing based on fundamentals.

Volatility is subdued in markets to the point where the VIX isn’t really serving its purpose according to some investors. Typically the VIX is supposed to represent volatility levels and investors can use it to hedge their equity portfolios against the possibility of declines in the stock market. However volatility is at historic lows despite a considerable degree of uncertainty regarding the global economic turnaround and various political risks. As such investors have looked to other ways to hedge their equity portfolios such as buying calls on cash Treasuries. Typically when stock prices fall rates would rally so it makes sense that investors are looking to go long Treasuries as a hedge. The number of call options on 10 year Treasury futures that correspond to a 1.36% yield on the 10 year has increased 500% in just a few weeks. Income generating strategies such as writing calls and puts are also becoming more popular however those have a way of suppressing volatility and contributing to the problem due to the way those trades are hedged on the other side. ETFs and other types of funds that track that strategy have attracted a lot of assets this year, however the risk is that once the feedback loop reverses many investors will be in for a rude awakening.

Puerto Rico filed for bankruptcy protection and officially becomes the largest municipality to ever enter bankruptcy proceedings. Puerto Rico defaulted on $73bn in debt, which dwarfs the size of the second largest municipal default ever which was Detroit’s $8.9bn. Aside from the defaulted debt Puerto Rico also has unfunded pension liabilities of $45bn. Puerto Rico has been struggling with a shrinking population which reduces the tax base as well as an economy that is slowing down dramatically. The economy was damaged in 2006 when Congress ended incentives and tax credits that helped fortify the manufacturing sector in the island. The unemployment rate in Puerto Rico is more than twice the national average. Mutual funds and hedge funds, such as Franklin Resources, Oppenheimer, Aurelius Capital, and Monarch capital are going to try and road block the bankruptcy proceedings under the basis that Puerto Rico didn’t try to negotiate in good faith and instead just waited for the soonest possible time to default. The bankruptcy proceedings could result in imposed losses for investors. The restructuring process is known as Title III and is separate from the U.S. bankruptcy court system. A plan that was accepted by federal officials would mean haircuts for investors. Those exposed to Puerto Rican debt include Franklin Templeton, Oppenheimer, and several hedge funds. Bond insurers are also on the hook for $12bn of Puerto Rico’s $70bn outstanding debt. Accordingly shares of bond insurers Ambac Financial, MBIA, and Assured Guaranty all underperformed the market yesterday. Ambac which guarantees $10bn in Puerto Rican debt fell 1.9% yesterday bringing YTD losses to 18%.

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Thursday May 4

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