Saturday, 11 May 2013
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.