Credit - What - We Worry?
For a fourth week in a row, we have seen the Iboxx Euro Corporate index,
being one of the most used benchmark in European Investment Grade
mutual funds, tightened by 5 bps in the cash market every week, as the
"grabayield" game goes on or as Bill Blain, a senior fixed income broker
from Mint Partners recently put it recently to a CNBC.com interview
referred to as an asset "grabathon":
"This is going to become an asset 'grabathon', put your buying boots on".
This week's title is a reference to one of one of our great teenage
years read, namely Mad Magazine Alfred E. Neuman's motto. After all the
"grabayield" nonchalance in the credit space, not caring about the macro
outlook, and with the credit markets being confident and
self-possessed, made us venture this week towards this idiomatic
analogy. We would have used "Dumb and Dumber"
as a title looking at the issues being thrown out with such a pace and
abandon (Unbounded enthusiasm; exuberance, being more likely), but, we
did use this title before. Unlike some "goldfish memory span" investors
out there, we do not suffer from Anterograde amnesia,
which has been created it seems, by the use of "powerful narcotics",
namely massive liquidity injections by our favorite Central Bankers.
On that subject of credit investors suffering from Anterograde amnesia,
we could not have agreed more with our old friend and sparring partner
Anthony Peters' column in IFR (International Financing Review) entitled "Investors queue up for perp walk":
"On Tuesday last week I tweeted (@therealadmp, should you wish to
follow): “Enron announces zero coupon perpetual, convertible into
WorldCom – book expected to be six times oversubscribed!”
My outburst was prompted by the ever-increasing slew of bond issues
that defy logic and that seem to be bought by investors, to quote George
Mallory out of context, because they’re there.
What caught my eye was the €1.75bn Hutchison Whampoa perpetual issue, which attracted a book somewhere in the region of €6bn.
I couldn’t help but wonder whether
investors have a clue what distinguishes subordinated from senior
corporate debt and what they are thinking when they pile into corporate
perpetuals.
I never had too much of a problem with banks issuing perps – from a
regulatory capital perspective it makes sense – but corporates don’t
have reg cap requirements and therefore the entire process of issuing
such structures perplexes me.
In the case of default the subs rank
below the seniors and all that jazz, but is it really necessary and are
investors being rewarded for the subordination or for the strip of call
options that are embedded in the structure and which they are selling to
the issuers?
I’m sure that there are plenty of
syndicate managers who could easily argue the point, but they also
argued, not so long ago and very convincingly, that CDOs were failsafe,
that Libor plus 30bp was cheap for Triple A tranches of subprime
mortgage bonds and that government bonds were risk-free. Caveat emptor,
in other words."
Or caveat creditor, we would add to the wise words of our estimated
friend. So in this week's conversation we will look at default rates
and their predictive ability in forecasting a turn in the credit cycle
as well where we are in the credit cycle, as a follow up to last week's
conversation where we focused on the releveraging taking place in the US
market and the Global Credit Channel Clock. But, first our quick market
overview.
The correlation between the US, High Yield and equities (S&P 500)
since the beginning of the year has been growing in strength. We have
also noticed the strong rebound in Investment Grade as indicated by the
price action in the most liquid US investment grade ETF LQD - source
Bloomberg:
In trading on Friday, shares of the iShares iBoxx $ Investment Grade
Corporate Bond Fund ETF (AMEX: LQD) crossed below their 200 day moving
average of $120.77, changing hands as low as $120.46 per share. Since
January the price action has been more volatile in the Investment Grade
than in the US High Yield ETF space, which has mirrored much more the
price action of equities, namely the S&P 500. HYG and JNK are the
two largest investment grade ETFs accounting for 80% of assets. These
two ETFs have seen 1.1 billion USD of outflows highlighting the demand
towards shorter duration ETFs such as High Yield ETFs SJNK and HYS,
which according to CreditSights have taken in over 1.8 billion USD in
combined AUM in 2013.
Investment Grade is therefore a more volatility sensitive asset, whereas
High Yield is a more default sensitive asset. We will look further into
this in this week's conversation.
Although the Eurostoxx have been much more less prone in breaking
records than the S&P 500 and the Japanese Nikkei index, and has been
struggling to break the 2800 level, the latest rise in the German 10
year Government yields towards the 1.27% yield level makes new issues in
the European Investment Grade space much more sensitive to rising
interest rates due to convexity factors than European High Yield. In the
financial space the Itraxx Financial Senior 5 year CDS index
(indicative of credit risk for financials in Europe) has continued to
perform towards 120 in the last couple of weeks while volatility
remains muted at 17.3 for the V2X index - Top Graph Eurostoxx 50 (SX5E),
Itraxx Financial Senior 5 year CDS index, German Bund (10 year
Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied
volatility. - source Bloomberg:
In similar fashion and as displayed by the relationship between the
Eurostoxx volatility and the Itraxx Crossover 5 year index (European
High Yield gauge), high beta credit such as financials and European High
Yield have indeed continue to perform with the Itraxx Crossover falling
below the 2008 levels - source Bloomberg:
At the same time, the absolute level of core European government yields
has somewhat reversed with German yields rising towards 1.30% level, and
non-core peripheral bond yields for Italy and Spain have stabilised
following a very impressive rally induced last summer on the back of the
first episode of "whatever it takes" which was led by Mario Draghi and
which was followed in 2013 by "whatever it takes" episode 2 courtesy of
Kuroda and the Bank of Japan leading to another raft of "grabayield" -
source Bloomberg:
The continued meteoric rise in the Japanese Yen, the Nikkei index and
the receding pressure on Itraxx Japan credit spreads courtesy of
Abenomics continue to validate the aeronautical analogy we made in our
conversation the "Coffin Corner" - graph source Bloomberg:
But, we have been following as well with much interest the relationship
between credit spreads and volatility in the Japanese space, a tale of
growing divergence we think - source Bloomberg:
Whereas the 1 one year Implied volatility has remained relatively
stable, the shorter 3 months Implied volatility has been telling a
different story and why the relationship with credit was stable until
2011, it remained fairly muted throughout 2012 but since the beginning
of the year, while the Itraxx Japan index has continued to perform in
similar fashion to equities and the US dollar versus the Japanese yen, 3
months implied volatility has been surging. Something, we think,
warrants monitoring.
Moving on to the subject of defaults rate and US HY, as indicated by UBS
in their recent Global Credit Navigator from the 8th of May, global
defaults rates since 2010 have remained stubbornly low:
"Since the end of 2010, global default rates have remained stubbornly
low, oscillating in a narrow range of 1.5% to 3.5% (Chart below).
The trend has been broadly similar in the US and Europe despite a
bumpy economic recovery post the ’08-’09 Great Recession and the
Eurozone debt crisis. Exceptional liquidity provisions
by central banks (QE from the Fed, LTROs from the ECB) as well as
“amend and pretends” in Europe have arguably kept default rates
artificially low, at least below levels consistent with economic
fundamentals. The thesis that the credit cycle may be
reaching an inflection point is becoming a growing concern to many
market participants and policymakers (please see “Overheating in Credit Markets: Origins, Measurement, and Policy Responses”, J. Stein, February 2013). Over the past 12 to 18 months, HY issuance has set new records and average credit quality has deteriorated. In
particular, annualized rates of PIK bond issuance and of covenant-lite
loan issuance in the fourth quarter of 2012 were comparable to highs
from 2007.
These recent trends do not bode well for prospective credit returns. Default rates in
the 5% area (currently 3%) could cost about half an investor’s annual
carry on his/her HY investment (US HY indices currently yield c6% per
year). From a rating agency perspective, Moody’s baseline forecasts for
default rates in one year’s time suggest some upcoming upward pressure
on European default rates but on balance no material change to the
latest global trends. However, while the agency’s optimistic forecasts
do not imply a significant improvement in current default rates, the
agency’s pessimistic forecasts underscore material downside risk. In
their “black sky” scenario, default rates could reach 7% in the US, 8%
globally and 9% in Europe." - source UBS
And, as we indicated in November 2012 in our conversation "The Omnipotence Paradox",
zero growth should normally led to a rise in default rates, in that
context, a widening in credit spreads should be a leading indicator
given credit investors were anticipatory in nature, in 2008-2009, and
credit spreads started to rise well in advance (9 months) of the
eventual risk of defaults:
"The empirical relationships between lagged economic indicators (e.g.
global PMIs) and defaults suggests zero growth should move default
rates up towards the 5-8% context over the next 12 months."
- source UBS
What credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and
it should be normally be your concern credit wise (in relation to
upcoming defaults) for High Yield, not inflation as per Morgan Stanley's
2011 note:
"While one could argue that default rates could be high during times
of higher yields owing to higher debt service cost, the opposite is
actually true. High inflationary environments allow corporations to
inflate away their nominal debt as their assets (and revenues) grow with
inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - source Morgan Stanley
So, what is driving default rates you might rightly ask?
For us and our good friends at Rcube Global Macro Research,
and also UBS, as per their recent note, the most predictive variable
for default rates remains credit availability. Availability of credit
can be tracked via the ECB lending surveys in Europe as well as the
Senior Loan Officer Survey (SLOSurvey):
"Senior Loan Officer Survey of 60 large domestic US banks and 24 US
branches and agencies of foreign banks. This is updated quarterly such
that results are available in time for FOMC meetings. Questions cover changes
in the standards and terms of the banks' lending and the state of
business and household demand for loans. We have used the net percentage
of banks tightening standards for commercial and industrial loans to
small firms as tightening credit standards should have a direct effect
on the credit market." - source UBS.
Another factor used by UBS is Nonfinancial leverage:
"Average leverage of non-financial corporate sector (Nonfinancial
Corp Debt/Nonfinancial Corp Earnings, source Federal Reserve)." - source UBS
"In terms of predictive value, the SLO survey and Non-financial
leverage are two clear winners and these two factors alone produce an
R^2 of about 0.6 in the best two-factor model." - source UBS
And as UBS rightly indicated:
"The 2008-2009 financial crisis brought the banking sector to an
abrupt halt, resulting in a significant deleveraging of dealer balance
sheets and contraction in bank lending to large and small firms which
found themselves unable to refinance their debt." - source Bloomberg
This is why the US is ahead of the curve when it comes to economic
growth compared to Europe. We have shown this before but for indicative
purposes we will use it again, the US PMI versus Europe and Leveraged
Loans cash prices US versus Europe - source Bloomberg:
"Positive investor sentiment combined with an excess of demand over
supply pushed the average price of S&P/LSTA Index loans up a
quarter-point to a fresh post-credit-crunch high of 98.4 cents on the
dollar in April 2013. In response, the Index gained 60 bps during the
month, bringing loan returns for the first four months of the year to
2.7%." - source Forbes
As displayed in a recent note from our good friends from Rcube Global Macro Research in relation to the US economy:
"While demand seemed to have eased a touch in the survey, actual
commercial and industrial loan growth remains robust and should stay
that way"
"With all major surveys on credit availability having now been released, we can draw several
conclusions on the health of the global credit channel. Following the 2008 subprime meltdown and
the 2011/2012 European sovereign crisis, the global bank credit channel weakened substantially. It
seems that it is normalizing fast now." - source Rcube
Rcube also added in their note a very important point relating to Europe and the difference with the US economy:
"Europe remains the only place where the credit channel is malfunctioning.
But even there the trend is positive. The % of banks tightening loan
supply and terms is becoming smaller. As we said in yesterday’s Monthly
Review, coming ECB actions will be centered on this issue, potentially
improving substantially the credit transmission mechanism." - source Rcube
Where we slightly disagree with our friends is that we wonder if the
damages which have been caused by lack of credit in Europe, courtesy of
the rapid deleveraging imposed on banks by the European Banking
Association (EBA) to reach a Core Tier 1 capital threshold of 9% by June
2012 can be reversed. Looking at the credit crunch which happened in
peripheral countries in Europe leading to a surge in both unemployment
and nonperforming loans plaguing peripheral banks, it still hindering
bank lending, hence the dislocation in rates between core European
countries and peripheral countries:
- Source Datastream / Fathom Consulting.
- Source Datastream / Fathom Consulting.
Therefore a future rebound in private loan demand in Europe is questionable.
In terms of where we are in the credit cycle, as posited by Bank of
America Merrill Lynch in their recent Credit Market Strategist note from
the 10th of May, we agree with their stance namely that the previous
credit cycle might indeed be shorter this time:
"With vanishing systemic uncertainties one of the key questions is -
Where are we in the cycle? Compared with the previous cycle credit
spreads are currently relatively “early cycle” at 2H 2003 levels – high
grade non-financials around August and, following the recent rally, high
yield a little later (December).
However, due largely to extreme monetary
accommodation certain indicators have us at later stages of the cycle.
Thus, while spread-wise we are still at an early stage, the duration of
the cycle may be shorter this time. Indicators displaying “late cycle”
behavior include the very steep spread curves in high grade as well as
the high percentage of CCC rated issuers that are accessing the primary
market in high yield.
In terms of fundamentals, although
leverage has been increasing over the past two years, we are still not
seeing the downgrade pressures that are typical later in the cycle.
Share buybacks are running at 2006 levels while M&A and LBO
announcement volumes are consistent with earlier cycle 2004 levels. One key aspect of later stages in the cycle is unlikely to recur this time – liquidity.
In the new regulatory environment dealers hold less than one percent of
the corporate bond market. While previously dealer inventories grew to
almost 5% of the market through the cycle, this time they are unlikely
to expand meaningfully from current levels. That limits the potential
for spread tightening as investors require more compensation to hold
off-the-run bonds. Given this, the difficulties investors face becoming
completely comfortable with financials post the financial crisis, as
well as likely more binding constraints on leverage this time we think
potential cycle-tight US high grade spreads are 100bps this time,
compared with 79bps in the previous cycle. For reference the current
spread level is 143bps and our year-end 2013 target 130bps." - source Bank of America Merrill Lynch.
As we have argued in so many conversations, while the credit space is
enjoying a "sugar rush" courtesy of our Central Bankers", and to quote
again our friend Anthony Peters from his recent column:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks
no longer have the risk capital to make big markets in all issues,
least of all unconventional ones, and investors would be well served to
ask themselves now where the pockets of liquidity will be when they are
most needed. Don't disregard the old definition of liquidity as being
something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk.
We could not agree more with our good friend, the risk is real. We used
a reference to Bastiat in relation to liquidity and Credit Markets in
our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen".
If you think liquidity is coming back in the credit space, then you are
indeed suffering from "Anterograde amnesia" caused by the liquidity
induced "sugar rush" as indicated by Bank of America Merrill Lynch
recent note:
"This one is not coming back. Dodd-Frank
leads to less liquidity in the corporate bond and CDS markets, as the
ability of dealers to make markets is permanently impaired by the new
restrictions on balance sheets. For example dealers now
hold less than one percent of outstanding corporate bonds – but during
the previous cycle they were able and willing to expand their holdings
to as much as almost 5% in 2007 (Figure below).
In contrast, for the present cycle we do not expect inventories to
expand materially from current low levels. The natural consequence of
this development is – as we have seen – that liquidity becomes more
concentrated in on-the-run maturities and names. Thus investors will
require an increased liquidity premium to hold off-the-run bonds – the
vast majority of the outstanding corporate bond market. We estimate
below (Figure below) that the difference between spreads on off-the-run
and on-the-run 10-year HG corporate bonds is about 15-20bps, up from
1-5bps prior to the financial crisis.
Obviously this cuts both ways as the liquidity of off-the-run bonds
has declined, while on-the-runs may actually have become more liquid.
However, still one of the most straightforward impacts of
Dodd-Frank is wider credit spreads for the corporate bond market as most
bonds are off-the-run. While the precise magnitude of this effect is
difficult to estimate it could easily amount to 10-15bps for the average
bond in high grade, or about 10% of overall spread levels." - source Bank of America Merrill Lynch.
As we posited in the conversation "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk,
because in “liquid” markets traders forego trying to determine an
asset’s underlying worth – - they trust, instead, on their supposed
ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
"So as credit investors, yes we are indeed still dancing as the music
is playing, but, given the liquidity levels closer to 2002 than 2007,
we'd rather be dancing close to the exit door" - Macronomics - Pain & Gain
What - We Worry?
"The circulation of confidence is better than the circulation of money." - James Madison, 4th American President.
Stay tuned!