Credit - Yield Famine

"Hunger knows no friend but its feeder." - Aristophanes

Looking at the recent price action in the credit space with continuous appetite for investment grade credit, with struggling money markets, with high quality issuers spread making new lows, negative core government bonds for some and unquenchable appetite for yield, we decided to step away from literary analogies, and historical references this time around. Last week we saw high quality corporate Nestle issuing 500 million euro worth of a 7 year bond at Mid-Swap +30 bps, then revising its guidance at Mid-swap +15 bps (that means a 1.50% coupon) because there was such a BIG DEMAND for the new issue (there was 6 billion euros plus worth of orders in the book). When you hear that money markets fund in euros are suspending new subscriptions courtesy of ECB cutting deposit rate to zero, it can only mean one thing: it means the “japonification” of the credit markets with dwindling liquidity as well, hence our title "Yield Famine".

Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. In that context of falling yields and falling volatility, we do agree with the recent comments our good cross asset-friend made in our recent post "European Credit versus volatility looks increasingly appealing":

"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions looks increasingly appealing on current levels.

Following the Greek Elections and the European Summit, implied volatilities levels on equity indexes have corrected dramatically while other risk measures are clearly not validating any “blue-sky” scenario (Spain/Italian sov spreads, bund yield, credit spreads…). On current relative valuations long credit vs long equity volatility positions look particularly interesting.

On the credit side you benefit from the relative backing of huge flows from institutional investors hungry for yield, while still enjoying relatively solid balance sheets from a corporate universe that has consistently been rolling over debt maturities.

On the equity side you are paying reasonable volatility levels, almost in line with the recent subdued realized levels with a large upside should any stress materialize in coming months."

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

In our credit conversation, before our credit overview where we will discuss default risk in low yield environments in a deflationary world and revisiting our calls on upcoming financial bonds haircuts, we would like to highlight once more, the complacency prevailing in the credit space with dwindling liquidity pressuring even more quality issuers yields, causing famine in the process.

Truth is nothing has really changed, when it comes to the outlook in the credit space. While demand for Core European bonds remain very strong, pushing more and more core government spread towards negative yields, peripheral names continue to be shunned with atrocious liquidity given inventory levels for market makers remain at record low level. Therefore activity levels in the secondary space remain more or less subdued in terms of flows. We are witnessing indeed some sort of "japonification" in the credit space (a theme we previously wanted to approach). In a June note UBS indicated the following worrying trend in credit:
"A troubling ongoing development for the credit market is the significant decline in trading liquidity (which has been accentuated by European concerns). A challenging liquidity environment is not conducive to a healthy marketplace and is incorporated into overall risk premiums. Coping
with the logistics of trading realities has led to rational decisions from market participants that have influenced the ongoing decline in liquidity.
Unfortunately, this liquidity dynamic is unlikely to see a meaningfully reversal anytime soon given global uncertainties, constrained risk appetites, and the shifting regulatory backdrop." - source UBS - Macro Keys, 7th of June 2012

- source UBS - Macro Keys, 7th of June 2012

While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability.

Pick your poison:

- source UBS - Macro Keys, 7th of June 2012

Deleveraging for banks means a significant reduction in RWA (Risk Weighted Assets) leading to dwindling liquidity for cash rich investors as dealers play close to home.

Courtesy of "improved" bank regulations, banks have been piling up Treasuries, agency, and MBS securities as indicated by UBS:

"The result for the credit market is a more cautious stance from market makers whose reluctance to
be aggressive in a less liquid marketplace is in turn hindering market liquidity." - source UBS - Macro Keys, 7th of June 2012.

Using a baseball analogy from our Americans friends, investors and dealers alike do not want to try stealing third base in this market environment:

"The credit market appears caught in an adverse cycle where both liquidity providers (dealers) and liquidity users (investors) are reluctant to be aggressive, preferring to stick with close-to-home risk positions of light balance sheets for dealers and near-benchmark exposures for investors." - source UBS - Macro Keys, 7th of June 2012.

The Itraxx CDS indices picture, with indices tightening with rising equities and falling core government bond spreads - source Bloomberg:

In that context the Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) fell significantly towards the 650 bps level, tighter by 14 bps on the day. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index fell significantly in the process, respectively by 10 bps and 15 bps.

While we have been monitoring closely the relationship between Itraxx Financial Senior 5 year index and the SOVx index representing the CDS risk gauge risk for 15 Western European countries (Cyprus replaced Greece in March in the index), the discussions of a Banking Union during the last European summit, has led to the SOVx index trading very marginally tighter (nearly 7 bps apart) than the Itraxx Financial Senior index - source Bloomberg:

The sovereign-bank link as indicated by the above credit indices touched recently a low of 18 bps, the bank-sovereign crisis has yet to be resolved meaningfully.

Given the decision of the German Constitutional court to postpone its ruling by three months on the ESM, it leaves the EFSF as sole agent in the recapitalization process of the ailing Spanish banking system.

The current European bond picture with today's rise of Spanish yields back towards the 7% level while German government yields closing back to lower levels around 1.20% (1.32% last week) with other European core bonds (France, Netherlands) making new lows in this "yield famine" environment - source Bloomberg:

As far as our "Flight to quality" picture is concerned, Germany's 10 year Government bond yields are falling again towards record low levels and the 5 year CDS spread for Germany has fallen recently well below 100 bps in the process for now - graph below, source Bloomberg:

Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain coming again under pressure on the back of Sovereign government yields - source Bloomberg:

As far as credit is concerned, we like to repeat our cautious stance in this unquenchable appetite for yield environment. In that context we do agree with Citi's recent Credit Strategy Cheat Sheet from the 13th of July:
"The net result is that we are near the tights with few obvious positive catalysts, but a long way from the wides. In effect, we believe that the upside / downside ratios for at least some segments of the market are not overly compelling at this stage."

In fact we are reminding ourselves we have seen similar "complacency" before. Back in November 2011, we posited the following in our conversation:
"In a low yield environment, defaults tend to spike. Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation."

"Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - Morgan Stanley - "Understanding Credit in a Low Yield World.

We already touched in depth the European car market deflationary environment in our April conversation "The European Clunker - European car sales, a clear indicator of deflation", where we discussed as well French car manufacturer Peugeot (PSA) European woes. To illustrate the point we mentioned above, risk of defaults can indeed rise suddenly. As our good cross-asset friend pointed out recently, Peugeot is indeed a good case study in the sense that the basis between cash and CDS was around 200 - 220 bps, on the 13th of July, in a single day the credit curve repriced by around 150 bps to 200 bps, with the CDS not moving much - source Bloomberg, anonymous dealer cash run:

The last column on the right indicates the change in spread for Peugeot cash bonds rising suddenly ("COD" = "Change On Day"). This clearly indicates that the CDS market had indeed sent out much earlier a warning signal on Peugeot bond prices, which eventually led to a repricing of the cash market for Peugeot. Peugeot announced on the 12th of July that it would shed 14,000 jobs. Its equity price touched its lowest level today at 5.864 euros. Peugeot is currently burning 200 million euros per month and is rated Ba1 by Moody's.
In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment.

It was therefore not a surprise to see Peugeot's  5 year CDS jumping above 800 bps, which amounts to a cumulative probability of default above 50%. Peugeot's CDS has risen by 27.42% last month and by 244% in 2011 according to Thomson Reuters and Markit. Peugeot SA 5 year CDS touched 838 bps on the 16th of July according to CDS Data provider CMA, a 9.73% change on the day and a 74 bps move.

Moving to our pet subject of upcoming financial bond haircuts and debt to equity swap, for those who follow us, we have been sounding the alarm for a while:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken.

We correctly foresaw this process for weaker peripheral banks.

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

"The CHART OF THE DAY shows that the Markit iTraxx Subordinated Financial Index is underperforming the Markit iTraxx SovX Western Europe Index by the most since 2010, when
Ireland forced lower-ranking bondholders to share the cost of saving its banking system. The gauge of credit-default swaps on 25 banks and insurers now exceeds the sovereign benchmark by 1.67 times, up from a ratio of one to one in March. Bank debt risk is rising at a faster pace than that for governments after Spain said it will require burden sharing measures from holders of junior debt in lenders receiving public funds. The move minimizes the cost to taxpayers and was required as a condition for international aid." - source Bloomberg.

As indicated by John Glover in his Bloomberg article - Senior Bondholder Immunity to Losses Begins to Fade on the 17th of July:
"The shelter available to bondholders in senior bank debt is starting to fracture as the escalating
cost of reinforcing Europe’s financial institutions prompts policy makers to seek to share the burden more widely. Bank bonds that rank ahead of subordinated and junior debt for payment have been almost unscathed by the debt crisis. Bankia SA, Spain’s third-biggest lender, has seen the value of its 4.625 percent undated subordinated bonds plummet to 27 percent of face value, while its 4.25 percent senior securities repayable in May 2013 trade at about 92 cents per euro."

It has long been a shared position with our good credit friend that subordinated bondholders as well as bank shareholders, would be facing the music at some point:
"EU will give Euro 100 billion to Spain in order for the country to recapitalize its banks. Meanwhile, Finland has asked for and got collateral for its loans to Spain. As we all wait for these funds to be delivered to Spain, subordinated debt holders will pay a nice contribution. Translation: the Iberian barber will make a nice haircut "à la Irish". The European funds will be lent by the EFSF as the ESM is still non-existent and may remain until September when the German Constitutional Court will give its assessment."

The new Subordinated Liability Exercises (SLEs), to be introduced with new legislation by the end of August by Spain, will allow banks to enforce mandatory exchanges if "liability management offers fail" on a "voluntary basis" – similar to what happened in Ireland a couple of years ago which led to significant losses for subordinated bondholders (30% of which were retail investors versus 60% in Spain...). Translation: "Tender your bonds or else...".
Subordinated debt - Love me tender? We wonder...

On top of that, according to Bloomberg on the 16th of July:
"The European Central Bank would no longer oppose the forcing of losses on senior bondholders of euro-area banks, said two officials with knowledge of the ECB’s thinking.
A key condition to imposing losses is if the bank in question is being wound down, one of the officials said. The ECB supported imposing losses on senior bondholders of ailing Spanish banks at a meeting of euro-area finance ministers in Brussels on July 9, though the proposal didn’t get much traction, the other official said. Both of them spoke on condition of anonymity as the talks are confidential."
On that very subject of losses on senior bondholders, CreditSights in a recent note entitled "What if the Bail-Out Had Been a Bail-in?" made the following key points:
"Bankia is a current example of a big taxpayer bail-out, which provides a good case study for how things might have turned out if proposed bail-in, mechanisms had already been in force.
Their scenarios are hypothetical, and they do not expect senior bail-in mechanisms to be invoked at this stage in Spain or elsewhere in the EU, although subordinated debt is already under threat.
They walked through a revaluation of Bankia’s balance sheet to reflect the write-downs that led to the recapitalisation request, as well as an exercise in segregating out the bank’s encumbered assets and collateralised liabilities, including substantial covered bond issuance and ECB repos.
In future, resolutions authorities might go through a similar sort of exercise to justify the haircuts that they impose on senior debt in a bail-in.
Their estimate is that haircuts of up to 22% could have been justified if Bankia’s senior unsecured liabilities had been the subject to bail-in, based on its end-2011 balance sheet and a recapitalisation need of 12 billion euro. This is predicated on an asset segregation scenario, whereas a full liquidation scenario would imply a higher loss rate."

An interesting exercise indeed, we think.

On a final note many pundits are discussing the need for an additional round of QE by the Fed, Bloomberg Chart of The Day indicates that Fed easing may do little to lift bank lending:

"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, according to Michael Shaoul, Oscar Gruss & Son Inc.’s chief executive officer wrote two days ago in a report. "“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion.
Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote.
Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.” - source Bloomberg.
As far as the ECB is concerned, we should know very soon the true impact of the cut in the deposit rate:

"The CHART OF THE DAY shows financial institutions may meet reserve requirements at the ECB as early as today, three weeks early, if they increase their current-account deposits at the rate of the past few days. Once they reach that level, they won’t earn any more interest and might seek alternative investment opportunities, Klaus Baader, an economist at Societe Generale in Hong Kong, said. “Banks will have to choose what to do with the excess reserves: accept zero return, buy safe and liquid assets that do yield an acceptable return -- not many of those these days -- or, of course, reduce the amount of reserves,” he said. “The best of all worlds, of course, would be if banks started to lend to each other again, but the chances of that happening are remote.” Banks have shifted money from the deposit facility, where funds no longer earn interest, into reserve accounts, parking about five times as much per day as they need to on average. The ECB remunerates these holdings with interest equivalent to its benchmark rate, currently at 0.75 percent, until requirements are met." - source Bloomberg.

"From the gut comes the strut, and where hunger reigns, strength abstains." - Francois Rabelais

It will be interesting to monitor where this "yield famine" will lead us to.
Stay tuned!