"Thus it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory." - Sun Tzu
Before we delve into more details of this week's credit conversation, which will deal with corporate leverage and vulnerability, we apologize dear readers, but, we would like to open a parenthesis on Europe and the significant evolution of the entire project following this "Cadmean victory".
When it comes to Greece, we reminded ourselves from our August 2012 ramblings from our conversation "The Unbearable Lightness of Credit". This important we think from our analytical point of view, particularly in the "light" of the events that took place in Europe against the "rule of the people" namely democracy.
Our August 2012 title was an analogy to Milan Kundera's masterpiece "The Unbearable Lightness of Being". This 1984 book explores the artistic and intellectual life of Czech society from the Prague Spring of 1968 to the invasion of Czechoslovakia by the Soviet Union and three other Warsaw Pact countries and its aftermath:
"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries". This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956.
"In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.
The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until; the "Sinatra Doctrine" came up with Mikhail Gorbachev.
"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia
"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source WikipediaBack in June 2012, in our conversation "Eastern Promises" we did write the following:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."
Remember, it is still a game of survival of the fittest after all:
Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:
"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.
Remember, there are "implicit guarantees" in the world and explicit guarantees. The German constitution is the most "explicit guarantee". The "willingness to repay" is an "implicit guarantee", this is the most important variable when assessing "credit risk" as aptly described by "Chan Akya" in Asia Times on the 13th of July in his post entitled "Demonizing the deadbeats":
"The first principle of credit is to look at an applying borrower’s willingness to repay. The second principle is to look at their ability to repay. Please read that again – this IS the order in which you gauge the creditworthiness of your borrower; not, as the various automated credit machines and CDO engines will have you believe, by looking at the latter principle i.e. ability as a guide to the first principle i.e. willingness. That simply doesn’t work, and is almost always responsible for more losses in credit than mistakes in assessing the second principle.Too much about banking these days focuses on a borrower’s ability to repay – the value of any collateral they are willing to provide, their income and expense analysis; and use of proceeds from the loan – and too little emphasis is placed on the actual willingness of anyone to repay. That’s because the latter is a subjective analysis, and these days it is quite dangerous to perform subjective analysis of anyone because of the political ramifications." - Chan Akya, Asia Times, 13th of July 2015.
- The credit channel clock is ticking faster, and not only for High Yield
- Appetite for "Credit" as an asset class is waning - a simple question of "supply" and "demand".
- The credit "mousetrap" has been set by central bankers, yet another "convexity" concern
- Final chart: US M&A Cycle and Equity volatility
- The credit channel clock is ticking faster, and not only for High Yield
"That Which is Seen, and That Which is Not Seen" - Frédéric BastiatOn the subject of corporate leverage we read with interest UBS Global Credit Comment from the 15th of July entitled "Corporate leverage: more than meets the eye":
"Corporate leverage: more than meets the eyeOne of the key inputs into our HY default model is the level of US non-financial corporate leverage. This has proven to be a leading indicator of HY defaults 12 months forward, and along with other indicators, is currently forecasting defaults of 2.5% over the next 12 months. We believe this understates the risk, most notably to the energy sector as we have discussed. However, it also likely understates the risk of defaults in the ex-energy sector, due to the presence of large high quality firms with outsized earnings and little debt. We believe this is a cautionary tale for investors who are using aggregate data to assess the health of US corporates.---
We take a sample of net debt to trailing 12m EBITDA from just over 1,000 US domiciled S&P rated firms today from the BICS Level 1 universe. We then construct two versions of this leverage metric; a weighted version that accounts for firm size (divides the sum of total net debt by the sum of total EBITDA) and an un-weighted version (a simple average of firm net debt/EBITDA ratios). The differences in Figure 1 below are striking.
The leverage of the un-weighted index is growing considerably more than that of the weighted index, as high-quality firms (A-rated and above) help skew the latter down. This is another manifestation of “corporate inequality” as we wrote about recently, per differing cash levels across firms. The main takeaway here is that aggregate leverage metrics are likely to understate issuer leverage and issuer-weighted default rates going forward.
When we isolate our series to just HY rated and BBB rated firms (those firms most sensitive to defaults and downgrades respectively), we can clearly see the deterioration in leverage across these segments. Here, there is no bias from the presence of larger firms; the increase in leverage is pervasive throughout (Figures 2 and 3).
Same goes with equities, end of the day, earnings needs to justify already lofty valuations we think.Now, the leverage metrics we present are likely biased to the upside in the current period relative to history due to survivorship bias and the fact that our sample is skewed more toward HY than in the overall credit universe. However, the point remains that leverage metrics are worse than what appears at first glance. Hence the focus on profits as we enter into Q2 earnings season. As we discussed last week, profit growth at US firms has been anemic recently. Historically when profits have been weak, debt growth has accelerated, and spreads/defaults have come under pressure in future months. This is a fairly consistent relationship we find back to the 1950s. Thus, we need to see a pick-up in earnings soon (driven by top-line revenue growth ideally) to slow down this releveraging cycle among lower-quality credits." - source UBS
"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube
"Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)." - Macronomics, January 2014.
"The Tale Since the Tights: We hit the tights of this cycle in June of 2014 at 96bp for US IG. A combination of M&A and share-repurchase fueled re-leveraging along with opportunistic issuance ahead of Fed hikes, Grexit risks and China-related growth concerns have taken us about 50 bp wider over the past year, to levels not seen since the taper tantrum of 2013. We are nearly 30 bp wider over just the past 4 months.
It Feels Like Cyclical Risk: Even though issuance has been concentrated in Financials, Healthcare and TMT (the latter two to support buybacks and M&A), underperformance has been the starkest in cyclical sectors including Basics and Energy (-4.2% and -5.6% excess returns) as well as BBBs (-3.2%). Financials have been a safe haven in a cycle that is beginning to resemble the late 1990s quite vividly:
BBBs Were Really a Trap: BBBs have significantly underperformed over the past year, down 3.2% vs. just 1.9% for As. While the Energy sector (which has an outsized representation in BBBs) is certainly a reason for this underperformance, other late cycle factors such as weakening fundamentals, elevated M&A and buybacks, and increased downgrades also play a role.
Beta and Volatility: BBB beta has been declining in recent weeks and is substantially off of its LTM highs, while the single-A sector beta has been rising more than valuations would suggest. Surprisingly, BBBs are also the least volatile sector among the three and rewards investors well from a spread to vol perspective. However, we continue to be cautious on BBBs, and believe investors are better off getting their beta from sectors (Financials, Basics and Consumer), and the curve (the long-end) rather than credit quality alone." - source Morgan Stanley
- Appetite for "Credit" as an asset class is waning - a simple question of "supply" and "demand".
We expect credit markets to move wider over the second half, as demand falls but the supply of bonds remains high. We recommend investors overweight the US vs Europe and emerging markets, buy single A and single B credits against BBs and BBBs, and reduce maturity from the 5-7yr bucket to the 1-3y bucket in order to reduce credit duration.
Beta: Now it matters for all the wrong reasons
In the March 2015 Fixed Income Portfolio Strategy we argued that credit beta was likely to rise in the second quarter, and support high beta markets (like emerging market corporates and the US) relative to low beta markets like Europe. EM corporates did indeed outperform Europe, but markets diverged, with Europe going wider and EM markets tightening, then stabilizing.
We expect beta to be critical for portfolios in H2 – but instead of being a positive, as we expected in Q2, it now looks likely to be a negative. We expect global credit spreads to go wider in H2 for three reasons.
Capital could now flow out of credit. Low bond yields have been a boon to corporate bonds, since investors who target a certain yield level (like insurance companies or pension funds) have had to move down the credit curve in order to achieve these yields. The rise in bond yields over the end of Q2 has not completely offset this need. Graph 1 shows our shortfall model, which measures the gap between the returns that European insurers need to achieve and the yields being offered by government bonds. We still measure the shortfall at around 120bp.
However, the demand for credit from yield-based investors could be more than offset in coming months by reduced demand from investors who measure performance against an index. These investors’ demand could be reduced because they face capital outflows, with their clients deciding that credit is now a less attractive asset class.
How could this come about? After all, the yield in credit has risen in recent months, due to the rise in underlying government bond yields. But the problem is not the reward – it’s the risk. Graph 2 shows the information ratio of the credit yield, which we define here as the average yield over a quarter, divided by the standard deviation in yields over that same quarter.
The volatility of yields has risen back to levels last seen in Q2 2013, but average yields are lower – so the information ratio, or the appeal of credit as an asset class, has fallen. This means assets could come out of credit, and demand might wane.
Supply remains very high: Yet, though demand for corporate bonds may wane, the supply of those bonds remains high. Three trends are playing a role here. The first is the long term but slow pattern of disintermediation, with corporations replacing bank loans by public bonds. This continues to simmer in the background. The second is the rise in leverage in the US caused by more M&A activity. Graph 3 shows the change in balance sheet leverage amongst US, European, and EM investment grade companies in percentage terms in 2014 (on the horizontal axis) and in Q1 2015 (on the vertical axis). US companies are clearly boosting their leverage.
European companies are however reducing leverage, as Graph 3 shows. However, this is not benefitting the euro-denominated bond markets because of the third trend – the fact that US issuers are increasingly looking to tap the euro-denominated market. In “What US jumbo issues mean for European indices,” our editorial in the June 5 credit weekly, we showed that the tilt towards Europe is taking place for both cyclical and structural reasons, and we expect it to continue until the percentage of US issuers in the euro-denominated indices returns to its 2008 peaks.
Exogenous worries are continuing: From a regional standpoint, exogenous pressures include political risk – and there is a lot of that about. Concerns about Greece are undermining peripheral credits (with a basket of peripheral CDS widening from 20bp above core spreads to 33bp, as Graph 4 shows). Spreads in central and eastern Europe corporate bonds are also coming under some pressure. Greece is not the only political risk, of course, with Russian corporate credits continuing to be affected by news on the Ukraine, and more recently Turkish corporate credits reacting to the latest elections.
The other issue is M&A. Above we have shown how US leverage has risen, but M&A is also increasing the volatility of individual spreads against one another. This has also boosted the volatility of credit portfolios." - source Société Générale
M&A funding has made a significant contribution to supply volumes so far this year (Figure 4), including large deals both this and last weeks.
In Figure 3 below we list announced M&A transactions with potential funding needs in the USD high grade bond market. Please note that we exclude deals that have already been funded.
- source Bank of America Merrill Lynch
"Credit and equities on different paths
Outflows from high-grade credit funds intensified again. More than $1.3bn has left the asset class. This is the fourth outflow over the last five weeks. IG funds have lost $1.5bn on average every week. On the duration front, investors looked for “safety” in the front part of the curve. Short-term fund flows were in positive territory, while flows for both mid-term and the long-term funds were back to negative.
High yield funds followed the same trend, with $1bn of withdrawals from the asset class, making it the fifth week in a row and the eighth since May, where high yield fund flows were negative.
Elsewhere in fixed income space, government bonds were on their sixth week of outflows, however at a mere $77mn, well below the trend we saw recently. Since the bund sell-off, govies accumulated close to $11bn of outflows, over 10 out of 12 weeks of outflows. Money markets funds had a good week, with $24bn of inflows, but cumulative flows still remain down $28bn since the 22nd of April.
Investors might have retreated from FI markets, but not from equities. Equity funds flows in Europe kept moving upward with an additional $1.4bn of inflows; for the eighth week in a row. ETFs were the main source of inflows for the asset class, for another week. Note that over the past five weeks credit funds (high-grade and high yield combined) have seen continuous outflows, totaling $11.5bn, while equity fund flows have been on the positive territory, with more than $8bn of cumulative inflows." - source Bank of America Merrill Lynch
- The credit "QE mousetrap" has been set by central bankers, yet another "convexity" concern
"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates." - Macronomics, July 2012.
"To be clear, the ECB have not announced a formal “Corporate Bond Purchase Programme”. The ECB have instead added some corporate bonds to their list of Eligible Securities under the Public Sector Purchase Programme. The new names are shown in the side table. High-grade credit issuers added are Ferrovie dello Stato Italiane, Terna, Enel, Snam, Alta Velocidad and SNCF. The first four are Italian issuers, Alta is Spanish and SNCF is French.
Why has the ECB done this? From an operational point of view the list of eligible agency securities was always subject to being amended. We don’t believe the ECB was struggling to buy Italian assets, in fact quite the opposite. Our rates team have highlighted that Italian net supply will be slightly positive in July (€1bn), while being very negative for the Eurozone overall (€105bn).
As our economists have pointed out, the ECB may be “tweaking” QE to show that they are ready to respond to any contagion that Greece may bring (note the ECB haven’t changed the overall size of monthly QE purchases). They may also want to signal that they are aware that a sustained rise in periphery yields will have negative implications for peripheral corporate funding costs. Enel 10yr bonds, for instance, have seen their yields rise over 1% since mid-April.
Nonetheless, with only 6 corporate bonds added to the list, the tweaks feel more symbolic to us at this stage rather than a material policy change." - source Bank of America Merrill Lynch
"Most markets are simply providing diminishing sources for generating excess returns.
Central bank QE has directly contributed to this effect by depressing term premia. One can think of excess returns in being long fixed income instruments versus say T-bills as mainly coming from a) term premia, which is compensation for taking duration risk and b) spreads, which is compensation for taking credit risk. In Figure 12, we show how these two measures have evolved historically.
For the former, we use a term structure model that estimates 10y term premia from the Treasury yield curve. For the latter, we use the Barclays Investment Grade Corporate OAS to Treasuries. As can be seen, historically, investors have been paid to take both duration and credit risk. During 1990-2006; the average term premia in US 10y yields was 1% and corporate spreads averaged 1.3%; currently by our measures, term premia is close to 0% in US 10 year bonds, and IG OAS is 1.4%. With no compensation for taking duration risk, investors are naturally being driven to take spread risk.
Therefore, it is not a surprise that there has been a tremendous increase in investor holdings of spread products directly or indirectly. Figure 13 shows that mutual funds’ holdings of corporate and foreign bonds have grown to $2.5trn, and now account for almost 50% of fixed income holdings of mutual funds (compared with 30-40% pre-crisis).
To put this in perspective, corporate bonds account for roughly 24% of the Barclays US Aggregate index, only marginally higher than the average over the past few decades. Similarly, there has been a rapid increase in ETFs dedicated to corporate and foreign bonds.
Figure 14 shows that over the past ten years, such ETFs have gone from being non-existent to almost $225bn; their growth has been remarkable compared with growth of just $60bn in Treasury ETFs.
Therefore, it is not a surprise that there has been a tremendous increase in investor holdings of spread products directly or indirectly. Figure 13 shows that mutual funds’ holdings of corporate and foreign bonds have grown to $2.5trn, and now account for almost 50% of fixed income holdings of mutual funds (compared with 30-40% pre-crisis). To put this in perspective, corporate bonds account for roughly 24% of the Barclays US Aggregate index, only marginally higher than the average over the past few decades. Similarly, there has been a rapid increase in ETFs dedicated to corporate and foreign bonds. Figure 14 shows that over the past ten years, such ETFs have gone from being non-existent to almost $225bn; their growth has been remarkable compared with growth of just $60bn in Treasury ETFs.
There are a number of reasons why term premia are currently quite low. The global inflation backdrop is still markedly disinflationary, the risks to US growth are skewed to the downside, given the already-long business cycle, and sovereign bonds still represent a good hedge to a portfolio of risk assets. Figure 15 shows that the correlation between stock and bond returns has been negative through most of the post-crisis period and remains so.
Another key driver depressing term premia has been large-scale asset purchases by various central banks. To rephrase Fed Chair Bernanke, the Fed purchased Treasury and agency securities in QE with the intention of lowering yields on those securities, thereby forcing investors to rebalance their portfolio towards riskier assets. This, in turn, raised their prices and eased broader financial conditions. So depressing term premia via balance sheet expansion was stimulative by design, but a rapid unwind of risk premia also poses substantial risks. We have already seen this both in the US during the 2013 taper tantrum, and in the European markets in Q2’15 when Bund yields rose almost 100bp in two months.
In addition, concentration in the asset management industry has also increased. A higher concentration of assets increases the chances of a simultaneous unwind of “popular” trades. According to BIS, “total net bond holdings of the 20 largest asset managers alone increased by more than $4 trillion from 2008 to 2012, accounting for about 40% of their total net assets ($23.4 trillion). These managers accounted for more than 60% of the assets under management of the 300 largest firms in 2012, up from 50% in 2002.”As size and concentration are increasing for asset managers, dealers have been shrinking. Figure 16 shows that absolute broker/dealer holdings of fixed income securities have declined to ~2003 levels, and to multi-decade lows when measured relative to the size of the universe.
Hence, when these investors decide to unwind these concentrated trades, sovereign bond markets are unlikely to be immune to the repercussions given declining liquidity. Term premia are at historical lows, and given the backdrop of diminished market liquidity, any reassessment has the potential to create enormous market volatility. As term premia rise, one should expect “herding” to decline; but the ride is likely to be far from smooth." - source Barclays.Therefore, central banks "overmedication" amount for us as "A Cadmean victory" and the end, rest assured, might indeed refer to a victory involving not one's ruin but, in our case many...
- Final charts: US M&A Cycle and Equity volatility
"At the end of Q1, US non‐financial corporations needed to fund externally $761bln. They did so by mostly by issuing 440bln of corporate bonds, taking 110bln of loans and by tapping their internal funds (100bln). US corporations have sold 900bln of bonds so far this year.
Internal funds are also being used to fund M&A. The M&A cycle leads the volatility cycle by about 1.5 years.
We estimate that by year end the financing gap will have reached $1.1trn. Both M&A and buybacks are sharply rising, internal funds are being tapped, and investment ‐ although weak ‐ is also slowly increasing despite the oil crash. If GDP does not take off, US financing needs as % of GDP could soon reach 2007 levels.
The main difference between this cycle and the previous two is that the cost of capital is much cheaper. Interest rates and credit spreads were both higher when the business cycle reversed in 2000 and 2007 because the FED was raising interest rates and credit spreads had started pricing rising balance sheet leverage. By failing to act early, the FED has once again let leverage rise to levels that will pose systemic risks.
As shown in the below chart, banks will soon need to tighten their lending standards.
This will probably happen at the same time when the FED starts raising interest rates. We expect credit spreads to jump, and volatility to spike as a result. When valuations are as high as today, sentiment becomes the main factor driving risky asset classes. Once spreads widen and volatility increases, bullishness will drop; a bear market will follow." - source Rcube Global Asset ManagementIt is going to be interesting to see if effectively the Fed has the "gumption" to raise rates later in 2015...
"Ignorance has always been the weapon of tyrants; enlightenment the salvation of the free." - Bill Richardson, American politician