"A financial crisis is a great time for professional investors and a horrible time for average ones." - Robert Kiyosaki, American, author
- Credit - More spillover from High Yield into Investment Grade
- Credit and Oil hedges - a paradox
- Credit and the Oil and Gas sector - it's scary out there
- Final chart - Credit on the brink of a blowout – watch global recession risk
- Credit - More spillover from High Yield into Investment Grade
"An outflow week for most asset classes
The year has not started on a positive note. Fund flows continue to point to the downside in fixed income, and equity fund flow shows signs of weakness too. Equity funds were hit by outflows last week; the first in 15 weeks.Starting with credit, outflows were recorded across the rating spectrum. High grade flows turned negative again, after a brief week of inflows at the start of the year. High yield was on the same trajectory and outflows mounted to more than $1.5bn. This was the sixth week of outflows, and the highest one in three weeks.
Elsewhere in the fixed income world, government bond funds had a second week of small inflows, amid broader risk aversion.Money market fund flow was also on the positive side and saw a third week of inflows, as investors looked for “safety”.Equity funds were not shielded from the sell-off storm. For the first time in 15 weeks, the asset class recorded an outflow, however marginal, which is also the largest in 20 weeks.Global EM debt fund flows also tipped back to negative, after recording two brief weeks of inflows." - source Bank of America Merrill Lynch
"Sobering chart: High yield OAS breaks out like its late 2007/early 2008
The Barclays US Corporate High Yield Average OAS is widening out of a 3-year bottom. The last time this high yield spread widened out of a similar bottom was late 2007/early 2008 when the spread completed a 4-year bottom and continued to widen out. This was just prior to the depths of the 2008 financial crisis. We view this as a US equity market risk. A move back below the 5.50-5.30 area is needed to call this high yield OAS breakout into question." - source Bank of America Merrill Lynch.We have warned you well in advance of the contagion risk in numerous conversations and told you that at some point credit spreads would continue to come "Under pressure", which could lead, we think to additional contagion from High Yield to Investment Grade.
Of course there have been plenty of reason at the start of the year with most risky assets coming simultaneously "Under pressure" as indicated by Société Générale in their Credit Strategy Weekly note from the 15th of January entitled "Not the best start for sure":
"2016 could have started better:
The start to the year could have been better. Concerns over China, oil prices performing poorly, worries about EM and more idiosyncratic risk worries have hammered the markets and credit has not been immune. Spreads in IG are already some 15bp wider than at the turn of the year and the total return in IG is already down to -0.29%. But the results are even worse elsewhere. Equities in particular are down 8%, EM is starting to drop hard, commodities are depressed and since sovereigns don’t pay much we believe that this environment will help credit in general. Yes, the start to the year could have been better, and with the current volatility, spreads will continue to slide, but when you see InBev in the market with a $45bn 7-tranche transaction with orders of about 110bn, well it just shows that the appeal for credit remains very strong.
What could go right?
The cycle of China worries, weak oil, falling stock markets and rising credit spreads was very much in evidence this week. Credit had been a relative outperformer since the middle of December, and the big size of the InBev book gave hopes to some that it would stay that way. But US high yield markets are leading global credit markets at present, and fears of defaults in the US market (due to cheap oil, but also to weak growth) are driving up US high yield spreads.
Oil goes up
The decline in oil has been driven by the supply side, but what if oil were to rally due to changes on the demand side? Investors do expect US shale supply to drop as companies default, though we ourselves think that this year’s US defaults are likely to be lower than the market expects, since companies probably have enough liquidity to limp through this year. A bigger supply shock could take place due to political risk in the Gulf. Recent tension between-Saudi Arabia and Iran has not had an impact on oil prices, but if it were to get worse, then oil prices could bounce off $30/brl.
How to position for it
The big winner from such a scenario would be US high yield markets, and particularly the energy sector. The big loser would be Saudi Arabia. Selling US high yield protection at 525bp and buying 5yr Saudi protection at 200bp would make sense under this scenario.
Monetary policy gets easier worldwide
Our US economists expect rates to rise three times this year, with the next hike expected to come in March. Of course, if the turmoil in emerging markets begins to provoke concerns about deflation in the US, this could stay the Fed’s hand. A reversal in monetary policy in the US would impact USD credit, but it might have an even bigger impact on rates in Europe and elsewhere, since market participants might begin to wonder how other central banks would keep their currencies soft if US interest rates are no longer likely to rise. The zone with the biggest pressure on clients to meet their interest rate targets is still Europe, so European credit could be the biggest beneficiary. By contrast, concerns about the lower limit problem in Europe would come back in a big way, and the European credit curve relative to ratings would flatten.
How to position for it
If monetary policy eases – starting in the US, but spreading elsewhere – then the bonds that would benefit most would be longer-dated BBB credits in Europe. By contrast short-dated high quality credits (of single A or above) would do poorly.
Reallocations from EM cease
One big driver for the recent EM weakness has been portfolio reallocations from EM to DM markets. These may be getting close to ending. Our bigger fear is that two other reallocation trends happen in EM this year. The first is that DM banks lend less to EM customers; the second is that EM companies issue fewer corporate bonds in dollars, and more in local currencies. Both trends would increase pressure on EM currencies in the short term and that could rebound on credit (although EM corporates in USD might be a beneficiary). If this trend develops more slowly than we, or the markets, expect, then we could see EM currencies improve and global credit markets also do better.
How to position for it
Ironically, we think developed credit markets seem more sensitive to emerging market currencies at the moment than emerging market credits. The big beneficiary of successful EM issuance in dollars ought to be EM bonds, however, and the best performers probably would be beleaguered Latam oil credits.
But is this likely to happen?
Of the three scenarios above, the most likely at the moment seems to be the second one. However, since easier monetary policy might also spur growth hopes and drive oil prices higher, the first scenario could come about as a result of the second. We therefore think that investors looking for the upside in corporate bonds should invest in US high yield (which has sold off the most, and represents the best value), and in European IG (which would be most sensitive to another move lower in yields)." - source Société GénéraleWe do agree with the second point, namely additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdosis", we think.
When it comes to credit and what is getting us concerned is the deterioration of market internals as highlighted by DataGrapple's team in their latest blog post:
"Believe it or not, despite a 10bps widening of iTraxx Main (ITXEB24) - from 86bps to 96bps -, buy side institutions have (almost) not bought protection on that index last week. They only cut their long risk positions by the equivalent $0.4bln across the 8 most recent series. That probably goes a long way in explaining the stubbornly negative basis (the difference between the quoted value of the index and its theoretical value) of ITXEB, as investors rushed to buy single entity CDS on the energy sector. The reach for protection on oil related names was even fiercer in the US (the sector is whopping 85bps wider at 455bps in investment grade over the past 5 sessions). So fierce that even a reduction by a third of long risk positions in CDXIG – from $36.8bln to $22.9bln across the 8 most recent series – and a 12bps move wider – from 97bps to 109bps - did not prevent the basis to reach the most negative levels since the Great Financial Crisis. That trend only accelerated today, and the basis of CDXIG25 stood at almost 1% at the European close." - source DataGrappleThe stubbornly deeply negative basis between single names and indices clearly indicates there is potential for more widening for the credit indices going forward and warrants as well close monitoring we think.
The question that comes to our mind of course, given the last violent episode in credit spreads coming under pressure was 2011 is if indeed "this time it's different"? To a certain extent it is. The epicenter of the pressure in 2011 on credit spreads, was coming from the financial sector coming under relentless pressure which run its course when the ECB initiated its LTRO program back in December 2011. This time around, Itraxx Financials CDS 5 year index remain for the moment well below the Itraxx Main Europe Financial 5 year CDS index, indicating that the pressure this time around is building up more into specific buckets of the corporate part, namely the Energy sector. This is as well indicated in Bank of America Merrill Lynch's Relative Value Strategy note from the 20th of January entitled "The anatomy of a sell-off":
"This time has been differentOther than the crisis years, the only other time IG and HY have been at or above current levels is during the 2011-12 period (Chart 1 and Chart 2).
But in our view it would be a mistake to characterize the indices in their current state as being akin to their 2011-12 avatars. We believe the difference is largely due to the systemic nature of the sell-off then and the prevalent view today that credit issues are largely idiosyncratic and isolated to a few names/sectors.
The source of portfolio dispersion in IG in particular has been the commodity sector. As Chart 4 shows, non-commodity IG continues to trade relatively tight. Even with the index at 110, IG index minus the commodity issuers CDS results in a portfolio at 69bp.
In HY, the distinction between the non-commodity and the admittedly smaller commodity exposure is not as stark
In a similar vein, the low beta portion of the IG portfolio has barely participated in the sell-off. In fact, until the end of last year, it even managed to ‘decouple’ from the widening in the index, deigning to join in only in the last two weeks:
As a proportion of overall portfolio spreads, the contribution of low-beta names is now the lowest in over three years as commodity-related issuers dominate the tail:
The distinction between the spread moves in the tail relative to the rest of the HY portfolio isn’t as stark as in IG, but the spread contribution of the non-tail names is on the lower side compared to the last 5-6 years:
Single-name volatility within the HY portfolio has increased in recent months, with the proportion of names experiencing more than a 50bp widening each week, similar to that observed in 2012. The distressed ratio too has ticked up, from around 14% in October to 18% now." - source Bank of America Merrill LynchConclusion:
While in High Yield there has been pretty much an overall deterioration with some contagion and spreads widening in sympathy with the Energy sector albeit at a slower pace, it remains to be seen how long Investment Grade is going to hold the line. So far, apart from the "sucker punches" à la Renault or Volkswagen and more recently with Rolls Royce, it appears to us that we are more into an early 2007 scenario for the time being (but things could escalate quickly still). As long as outflows remain muted in the Investment Grade bucket, Investment Grade remains resilient for now. Yet, the overall tone of the market suggest to us that financial conditions continue to tighten thanks to the battering of the Energy sector which will no doubt put lenders towards a more cautious stance, which will accentuate therefore the tightening conditions we are clearly seeing in the High Yield space (it started already with our "CCC credit canary" and recent LBOs tentative are struggling to place debt).
Moving on to the significant widening in High Yield Energy following the continuous fall in oil prices, we find it interesting the divergence in hedging policies between High Yield issuers and Investment Grade issuers. We will address this important paradox in our next bullet point.
- Credit and Oil hedges - a paradox
As we correctly pointed out in our December conversation "Charles law", 2016 is already showing its capacity in inflicting serious volatility and damages in a very short time frame:
"2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016." - source Macronomics, December 2015But, when it comes to assessing credit and oil hedges, it seems that High Yield issuers and Investment Grade issuers have had difference risk approach as indicated by Bank of America Merrill Lynch in their Global Energy Weekly note from the 8th of January entitled "Can oil prices find a floor?":
North American producers remain notoriously under-hedged in 2016…
Despite a last minute rush to lock in hedging deals last November and December, we believe that North American crude oil producers remain notoriously under-hedged on their 2016 crude and nat gas price exposures:
Back in June 2015, we argued that North American companies (both high yield and high grade) were under-hedged for 2016 by 640 million barrels relative to 2014 levels (see The billion barrel question). We now estimate that less than 200 million barrels have been hedged since then. In other words, another 440 million barrels of oil would still need to be hedged in 2016 to match 2014 hedging levels:
…and unhedged for 2017 too, suggesting more selling pressure
True, given the sudden collapse in longer-dated oil prices, many companies have little incentive to hedge at the present time as their production breakeven costs are typically higher than today’s forward crude oil prices. In broad terms, high yield energy companies (Chart 5) have higher hedge ratios than their investment grade peers (Chart 6).
Partly as a result of their higher sensitivity to funding cycles, levered high yield energy companies have tended to hedge a larger portion of their production regardless of price. However, the gap has widened meaningfully this year, as high grade companies have largely stopped hedging all together, presumably deciding to “tough it out”.
Most hedging activity has now moved to the options markets…
Interestingly, those high grade companies that have indeed decided to hedge production in recent months have done so using collars, an option structure whereby the producer typically sells a call to finance the purchase of a put, rather than swaps:
A collar will typically provide a lower level of protection in a falling market, so the change in hedging structure may be related to producers holding a more constructive price outlook than the market. In the high yield space, the most common hedging structure is still a swap, but the use of options has increased (Chart 8), with credit-constrained counterparts likely recurring to the outright purchase of put options.
…and more US oil & gas companies are now filing for bankruptcy
With leverage ratios exceeding on average 4.3x, compared to last cycle highs of 3.9x, oil is “no country for old men”:
Many high yield companies are finally starting to get into trouble. Bond yields for CCC+ rated energy companies have spiked to 30%, while the average bond in a non-investment grade E&P company in the US is now yielding 16%. Given the challenges to refinance, it is perhaps no surprise that in the third and fourth quarter of 2015 at least 20 US oil and gas companies filed for bankruptcy, largely exceeding the levels reached in 2H2008 or 1H2009:
Put differently, financial distress is here and it is finally starting to bite." - source Bank of America Merrill LynchCollars provide limited upside and downside protection by putting ceilings and floors on prices. Typically favoring collars only works in periods of moderate volatility and may be preferable to swaps because there is less exposure to loss if prices continue falling. The paradox is that Investment Grade companies have been using a lower level of protection offered by Swaps and have as well been far less agressive than their High Yield peers in "protecting" their production level.
What is as well of a concern is the relative high debt level versus EBITDA, basically the overall level of leverage in the US Oil and Gas sector as per our next bullet point.
- Credit and the Oil and Gas sector - it's scary out there
- source Deutsche BankNo surprise therefore to read earlier today that ratings agency Moody's had put 175 Energy and Mining companies and groups on review for a potential downgrade downgrade.
Of course, the one and only culprit for the fall of oil prices we think has been the impressive rise of the US dollar since 2014 as shown by Deutsche Bank in their report:
- source Deutsche Bank.The trajectory of the US dollar in the coming month and the velocity of the movement will be essential in determining the level of further stress down the line.
Furthermore, as shown by Morgan Stanley in their Leveraged Finance Insights note from the 14th of January entitled "Making Heads of the Tail", credit being "Under pressure", it is essential to quantify the "stress" and of course the "default potential":
"Quantifying the Stress:
First looking at valuations, a lower proportion of HY debt is currently trading sub $70 versus 2000 and 2008, at 17%. However, because of the size of the market, the par value trading at distressed levels today is $176bn, already greater than $120bn in 2000 but less than $313bn in 2008. By sector, 50% of distressed HY debt is Energy today, compared to 47% that was Consumer Cyclical in 2008, and 36% from TMT in 2000.
Quantifying Default Potential:
We finish by translating the distribution of the tail in the market into long-term default potential. Based on this analysis we get to a 5Y cumulative default rate going forward of 24% if we assume the cycle is turning –which is more modest than the 2008 and especially the 1999 5Y default cohorts. While we could argue for a lower 5Y cumulative default rate going forward (assuming the cycle is turning) when comparing the current tail in the market to 2000 and 2007, the volume of defaults will likely be much larger in almost any scenario given the substantially larger size of the market today. In Exhibit 11 we show a rough approximation of US high yield and loan defaults over the course of a default wave, which we put together in our 2016 outlook. For the purpose of this analysis only (i.e., not our actual forecast), we assume the default cycle starts this year, peaks in 2017 (9.3% HY default rate in that year), with elevated defaults for four years. We assume a cumulative default rate of 25%, comparable with 2008, but more mild than the 1999 cohort.
From this analysis, we get to $627bn in US high yield and loan defaults over five years. Note this number is significantly larger than the volume of defaults in the last two cycles because US leveraged finance markets are so large. If this default wave were to be as severe as the late 1990s or worse, default volumes would clearly be larger." - source Morgan Stanley.
Of course because of the Fed's overmedication, the problem have grown "larger" for "longer, which could indeed spell for significant amount of losses over the next 5 years as calculated above by Morgan Stanley. When it comes to the stage of the cycle, we are not yet on "Nightmare in credit street" as we think, the latest moves are reminiscent of 2007, but are nonetheless trending towards 2008 when it comes to assessing the default risks induced by the collapse of the commodity sector thanks to the rise of the mighty US dollar.
What triggered the boom and now the bust you might rightly ask? For us, it is pretty straightforward and ties up to our "reverse osmosis" global macro hypothesis described in our August 2013 conversation "Osmotic pressure":
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - source Macronomics, August 2013Of course there is more to it, and it is linked to the relationship between global interest rate gap and commodity prices. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011 as a reminder:
"Negative interest rate gap
In order to assess the relationship between changes in monetary conditions and developments in commodity markets, a good proxy is the “global interest rate gap”, which is the weighted average of
the interest rate gap in each country with its corresponding GDP used as a weight. The interest rate gap itself denotes the difference between the real interest rate, defined as the nominal short-term interest rate minus headline CPI inflation, and the potential growth rate of an economy. If the interest rate gap is positive, meaning that the real interest rate is higher than the potential growth rate, then the financial condition is tight. Conversely, if the interest rate gap is negative, it means that the financial condition is lax, as the real interest rate is lower than the potential growth rate.
As shown in Chart 7, the global interest rate gap has become more negative, albeit fluctuating, which suggests that global monetary conditions have become accommodative over the observation period.
The interest rate gap in developed countries turned negative through the mid 2000s during the so-called “Great Moderation” period, and has remained in negative territory, reflecting accommodative monetary policies since the Lehman crisis. Also, the interest rate gap in emerging countries has become more negative throughout the observation period. Admittedly, by a nominal measure, monetary policies in emerging economies have been tightened with rate hikes since late 2009, preceded by a series of rate cuts after the Lehman crisis as was seen in developed countries. However, rates in emerging economies have not been hiked sufficiently fast, given the strong inflationary pressure and increase in real output growth. This “behind the curve” situation has caused the negative interest rate gap to widen in emerging economies.
Relationship between global interest rate gap and commodity prices
Global commodity prices are negatively correlated with the global interest rate gap, as seen in Chart 8.
This is because rising commodity prices increase inflation, decreasing the real interest rate as a result. If the rise in commodity prices is driven by the narrowing of the global output gap and the intensity of the price surge is too strong, however, the real interest rate needs to be raised by central banks in order to tame inflationary pressure. Such a principle of central banks would lead to a positive correlation between global commodity prices and interest rate gap, and the increase in real interest rate then would cool physical demand for commodities and dampen the rise in commodity prices. But what Chart 8 shows is that monetary policy stance of central banks have not satisfied that principle on a global basis, and hence easier monetary conditions have boosted commodity prices.
For individual central banks, the fluctuation in global commodity prices may be an exogenous supply shock. Even if a single central bank attempts to counter the fluctuation in commodity markets, it may achieve nothing other than making the domestic economy more unstable. In other words, for each central bank, an independent action to tame global commodity markets may not be an optimal choice. This reluctance of each central bank to counter rising commodity prices, however, could cause them all to be collectively worse off, because it is likely to accelerate the surge in commodity prices and thus to expand the negative global interest rate gap. The failure of this collective action leads to a higher-than-expected increase in demand for commodities. This vicious cycle may develop self-fulfilling expectations of a further appreciation in commodity prices, thereby driving commodity prices above the equilibrium level justified by supply-demand conditions (as proxied by global output gap). The experiences in several countries also suggest that accommodative monetary conditions, as characterized by the negative interest rate gap, enhance the risk-appetite of investors and induce “yield-seeking” investment flows into financial asset markets. Eventually, this process may increase the probability of an economy becoming trapped in a bubble." - source Bank of Japan, 2011 paper.
Quod erat demonstrandum. When it comes to the boom and bust of the commodity bubble and our "reverse osmosis" theory playing out. This also ties up quite well with "the return of the Gibson paradox" we discussed in October 2013:
"What of course has been of interest is the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - source Macronomics.QE2 (November 2010 to June 2011 = peak gold prices) and negative real interest rates from the US triggered massive flows towards Emerging Markets and commodities. The start of the tapering stance of the Fed and the road to normalization and "positive" real interest rates" in the US triggered the "reverse osmosis": Massive capital outflows from Emerging Markets, a massive surge in the US dollar and a collapse in commodity prices.
Overall the Fed is entirely responsible for the commodity boom and bust bubble. The negative interest rate gap of its QE, also put the risk-appetite of investors into overdrive and induced massive “yield-seeking” investment flows into financial asset markets. That simple...
Now the conditions are ripe for an epic credit blow out in Emerging Markets, in particular those who borrowed generously in US dollars as per our final chart and bullet point.
- Final chart - Credit on the brink of a blowout – watch global recession risk
"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell."Given many Emerging Markets have been struggling in stemming capital outflows as of late, we believe some will experience "excessive osmosis" and the country will eventually "burst" (default). Our final chart comes from Bank of America Merrill Lynch's Emerging Convictions note from the 21st of January entitled "Black gold down"
"Credit on the brink
The benchmark EMBI sovereign spread has risen to the top of the 15-year range and is now likely to either retrace or target the blowout levels of the 2001/02 or 2008/09 crises (Chart 7):
In most cases, spikes in the current level did not last long, as they resulted in a global policy response or value buyers emerging. So the crucial question here seems to be the likelihood of a full-fledged crisis scenario.
The key to this question is likely whether the negative side effects of the commodity shock will be severe enough to raise global recession risks. The Chart above shows the EM credit crises of the past 15 years were associated with US manufacturing ISM below 45, the level that is almost always associated with a GDP recession.
Our house economic and oil view implies that the world economy – and thus EM credit – will pull back from the brink. Our DM economists emphasize that the economy outside manufacturing remains robust. Our oil team has argued for a temporary dip to the mid-20s on China, Iran and the warm winter, but continues to expect a recovery above $40 by 2Q as demand grows and US supply contracts. Again, the crucial risk to this oil view would seem to be whether the oil supply shock mutates into a global demand shock.Place your bets accordingly...
If this view is correct, commodity credits look oversold. Nigeria stands out because it is already wider than during the Euro crises and post Lehman. Russia is wider than during the Euro crisis but below the Lehman levels, though it now has a flexible rouble. South Africa is close to its post-Lehman level. Among the commodity importers, Turkey is trading at the same z-spread as during the previous global financial stress periods. CEE remains tight vs historical blowouts due to improved fundamentals." - source Bank of America Merrill Lynch
"But all bubbles have a way of bursting or being deflated in the end." - Barry Gibb, English musician.Stay tuned!