Unhedged

Good morning. US stocks have been flattish over the past week; is the Santa rally losing momentum? If so, the reason may be that investors are already uniformly bullish, leaving the market with nowhere to go. We discuss this notion below. As for ourselves, we can always find something to be worried about, especially during the holidays. Let us know your mood: robert.armstrong@ft.com and ethan.wu@ft.com.

From a story on Bloomberg yesterday, by Sagarika Jaisinghani and Thyagaraju Adinarayan:

Sentiment is a solid contrary indicator, for the simple reason that when everyone is feeling maximally optimistic, the only possible change in sentiment is for the worse. Similarly, when everyone feels pessimistic, stocks can “climb a wall of worry” as sentiment reverts to normal. And in support of the article, most of the sentiment indicators we follow suggest that — since late October, when the latest rally started — investors have become a touch giddy:

• The AAII’s sentiment survey bull-bear spread, on a four-week rolling average, is at the high end of its historical range (has been in a rising trend for more than a year, but has risen sharply recently).

• Market breadth, as measured by the number of S&P 500 stocks trading above their 300-day average, has broken above its long-term average.

• Small caps have outperformed large caps in the rally. 

• Among the best-performing sectors in the rally are cyclical sectors such as finance and industrials, along with the usual risk-on sectors such as tech.

• High-risk trading vehicles like the Ark Innovation ETF, bitcoin and Robinhood have shot up.

All that said, however, all of this happened in a great burst in the past five weeks or so, as yields have started to fall. This hasn’t gone on long enough to convince us that we are seeing irrational exuberance and all the dangers that come with it. This may be just a rates-driven relief rally.

And anecdotally, we are just not hearing that much positive sentiment expressed. Asked about his clients’ mood this week, one sell-sider told us that “If they own the Magnificent Seven, they feel pretty good. Otherwise, they don’t feel that great.” A strong November has not made up for a bruising couple of years for bonds and non-Mag 7 shares.

Private credit, the new darling of the asset-management world, has grown fast. So fast that the financial mechanics of the industry are changing on the fly. Here is one oddity, from our colleague Eric Platt last month:

A “private credit CLO” is a rather head-spinning term that requires some explanation.

A traditional CLO works by packaging syndicated bank loans into risk tranches, from equity (the riskiest) to triple-A (close to risk-free), and selling the tranches to investors. If companies default, the CLO distributes losses in a waterfall hierarchy: equity gets wiped out first, then junior debt, then senior. The senior investors get safety, the juniors get better yields. In the history of CLOs rated by Moody’s back to 1993, investors in triple-A or double-A tranches have never borne a loss, and in single-A tranches, it has happened just once. The CLO manager takes fees for building and maintaining this complex vehicle.

Private credit CLOs are a different beast. They retain the waterfall structure. But unlike a traditional CLO that uses bank-originated loans bought in secondary markets, PC CLOs use loans originated by a private credit firm, which also manages the CLO. Whereas ordinary CLOs often sell the equity tranche on to risk-taking investors such as hedge funds, PC companies generally retain the equity in their CLOs. Since they originated the underlying loans, they presumably have insight into, and conviction on, the CLO equity.

To oversimplify slightly, a traditional CLO is a management-fee business, and a PC CLO is a financing method for private credit lenders.

This technique, using CLOs to finance private loans, began in another obscure pocket of finance, middle-market lending. This is what might’ve been called “private credit” a decade ago: high-yielding loans to tiny, risky businesses too fiddly for public markets. But as private credit grew into its golden moment, PC CLOs emerged as a distinct category. “[PC CLOs] is the market’s description,” says Jian Hu of Moody’s. “That term was invented this year. We still call these middle-market CLOs.”

“The reason why folks are using these different terms is that the traditional middle market has changed,” says Jerry DeVito, head of structured products at Blue Owl, a big private credit firm. From smallest to largest, “there are traditional middle market CLOs, then above that private credit CLOs, then above that traditional [syndicated loan] CLOs, [with] the differences based mostly on company and [loan] facility size”.

As a financing source for private credit, CLOs replace loans from banks. The advantage of this is in dealing with defaults and credit events. If a credit event is triggered (eg, a broken loan covenant), a bank that has lent to a PC fund has the right to mark the loan to market, and has discretion over the mark. A bad mark lowers the loan-to-value ratio of the entire bank loan. If the LTV falls enough, the bank could demand cash from the private credit investor. Moreover, banks are more likely to pull back in distressed markets — precisely when private lenders have the most opportunities to find good investments, notes Michael Patterson of HPS, a private credit manager that issues CLOs. There is “an element of correlation between markets and bank loans”, he says.

CLOs sidestep this. Losses are automatically allocated through the waterfall structure. Private credit shops take losses on the equity, but no cash is demanded of them. It’s far less messy.

Attentive readers will note that finding ways to not mark things to market is something of a theme in private markets. We’ll discuss that, and other concerns about PC CLOs, tomorrow. (Ethan Wu)

The voters, not the politicians, are the (fiscal) problem.