Tuesday, 5 April 2016

Credit - Paradise Lost

"When a wise man points at the moon the imbecile examines the finger." - Confucius
Looking at the "tax bomb" falling from the "Panama Papers" and awaiting for the radioactive "fallout", we could not resist but use for our title analogy "Paradise Lost" being an epic poem in blank verse written by 17th century English poet John Milton (1608-1674). The poem deals with the biblical story of the "Fall of Man" and the temptation of Adam and Eve by the fallen angel Satan and their expulsion from the Garden of Eden. What we find of interest is that previously we already referred to the "devilish nature" of central bankers such as Mario Draghi portrayed as "The Generous Gambler" back in 2011, which was no doubt to us, a similar reference to the Devil as the one used in John Milton's masterpiece. We re-iterated our reference to the "fallen angel" which probably inspired this great text from Charles Baudelaire in our September 2014 post entitled "Sympathy for the Devil", a reference this time around to the 1968 Rolling Stones title. What we find of interest, given the very impressive rally in credit, which will no doubt continue at least in Investment Grade thanks to Japanese flows, is Milton's criticism of idolatry which is deeply embedded, not only in his poem but, as well in today's financial markets with investors on-going worship of central bankers. In the opinion of Milton, any object, human or non-human, that receives special attention befitting of God, is considered idolatrous, central bankers are no exception. In similar fashion we already touched on the "Omnipotence Paradox" back in November 2012:
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its world plan." - source Wikipedia.
The idolatry and evilness of central bankers have been a recurring them we have used on numerous occasions, particularly in our June 2014 post "Deus Deceptor":
"In terms of blasphemy and the "evil" intent of the central bankers both Descartes and the Cartesian scholars were wrong for the simple reason that central bankers are not omnipotent. Although, our "Deus Deceptors" of the central banking world, have indeed managed to altering mathematics (probability of default risk for the time being) and the fundamentals of logic, no doubt about that." - source Macronomics, June 2014
We also added a quote at the time when it comes to the idolatry in central bankers:
"The greatest trick central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.
 Looking at deflationary pressure rising with Eurozone PPI falling 4.2% in February, being the largest YoY drop in producer prices since 2009, one might wonder if indeed "Paradise" will not be lost in 2016? In our February 2016 conversation "Common knowledge" we also added:
"The concept of "Common knowledge" is central in game theory. If a deity status is only attained if it is not able to lie (SNB, BOJ, ECB, FED...) then central bankers are not omnipotent except the BIS...

When it comes to "Common knowledge" and growth outlook, it seems we always follow the same trajectory:We start with an overall 3% consensus for US growth and US 10 year yield end of the year targets of between 2.50% to 3%, then after a couple of months, it gets revised down to 1.50% / 2% and US yields get revised accordingly towards the same objective." - Macronomics, February 2016
Given the Atlanta Fed latest GDPNow model forecast for real GDP growth in Q1 2016 is 0.7%, it seems that once more we follow clearly the same usual pattern.

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic.

So in this week's conversation, we would like to focus on "credit" and ask ourselves if indeed given the significant rise in the number of fallen angels (number of at-risk companies) to 22% of firms with Moody’s second-highest junk grade according to Bloomberg, if "Paradise" is "Lost".

  • Credit - Investment Grade? Paradise isn't lost
  • Credit - US High Yield? Paradise is lost
  • Final chart: Paradise Lost? A record number in "fallen angels"

  • Credit - Investment Grade? Paradise isn't lost
In our recent conversations, we stressed that Japanese flows did matter, particularly when it comes to credit flows. Whereas inflows in recent week have been significant, particularly in US High Yield (+$13.3bn over the past 5 weeks), given the rising number of "fallen angels", we would rather continue from an allocation perspective to focus on "quality" than chasing High Yield. When it comes to "Paradise", we do think that, in particularly in US High Yield, "Paradise" is "Lost" particularly when one focuses on the deterioration in "credit metrics". We will look at this specifically in our second bullet point.

As we pointed out in early March in our conversation "The Paradox of value", the US investment grade market was no doubt the only game in town when one looks at the performance of the asset class relative to US High Yield. This was highlighted in Bank of America Merrill Lynch Monthly HG Review from the 1st of April entitled "End of the rollercoaster ride":
"March ’16: End of the rollercoaster ride
If you just returned from your sabbatical you would be forgiven to think that not much happened while you were out, as stocks returned +1.35% in 1Q, HY +3.25% while HG was the best performing major asset class at +3.92%. In fact all the asset classes we track in this report had positive returns in 1Q including Treasuries (+3.35%). Of course these quarterly numbers mask the big volatility during the quarter that saw equities reverse a correction and high grade credit spreads retrace a 27% spread widening. Thus March was a great month for most asset classes with equities up 6.78%, and leading the performance table, followed by HY (+4.42%) and HG (2.71%) while Treasuries returned +0.14%.

There were multiple reasons for the big turnaround in the markets after the lows on February 11th, including reassurance by the governor of the PBOC that China wants to see a more stable exchange rate, talks between OPEC and non-OPEC members putting a floor under oil prices and a sharp rebound in US economic data alleviating recession concerns. Then later followed global central bank action (BOJ, ECB, Fed).
HG credit spreads tightened 35bps in March for a big excess return of 253bps. For 1Q credit spreads tightened 3bps with excess returns of 18bps.

Sector wise excess return performance in March was led by Metals & Mining (+584bps), Oil &; Gas (+575bps) and Pipelines (+557bps) on the rebound in oil and commodity prices, while the worst performing sectors included REITs (+103bps), Banks/Brokers (+141bps) and Industrial Products (+146bps). For 1Q the best performing sectors were Metals & Mining (+714bps), Pipelines (+178bps) and Media-Cable (+177bps) and while at the other end of the performance spectrum we find Multi-line Insurance (-311bps), Life Insurance (- 200bps) and REITs (-85bps)." - source Bank of America Merrill Lynch
What we also find of interest is the performances in the 1st quarter of US TIPS from a diversification perspective:

- table source - Bank of America Merrill Lynch

In fact, we recommended (a little bit early) looking at US TIPS back in October 2015 in our conversation "Sympathetic detonation" from a great diversification perspective:
"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015
In March again in our conversation "Unobtainium" we commented that we continue to like US TIPS:
"We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?" - Macronomics, 19th of March 2016
As we move into the second Quarter, not only does Investment Grade appear enticing, but, from an allocation perspective US TIPS still remain particularly attractive. But, moving back to Investment Grade, we do believe that "Paradise" is not "Lost" and if indeed as we pointed out, Mrs Watanabe, Japan's GPIF and its pension friends are looking for yield abroad in a more aggressive fashion then indeed adding duration with less credit risk than High Yield makes sense as pointed out by Bank of America Merrill Lynch in their report:
"Early for excess returns, late for total returns
With the biggest three month reversal of high grade credit spread widening behind us (27% spread widening and complete reversal over a three month period), and a more benign rates outlook, we provide updated return forecasts for the remainder of the year.
Our year-end spread target of 150bps (compared with 170bps currently), and outlook for a much flatter spread curve, imply excess returns of about + 400bps this year – which is mostly ahead of us as YtD excess returns are just +18bps (Figure 8). 
In terms of total returns, due to the big decline in interest rates we are already about two thirds through the roughly +6% we now expect for 2016. For 2016 we identified 30-year corporate bonds as a sector that should generate equity-like returns (see: 2016 US High Grade Outlook) – now following a return of about +7% YtD, we expect another roughly +3% by year-end (Figure 9).
Rest of the year
In Figure 11 below we summarize the returns for the remainder of 2016 implied by our full-year forecast. We look for total and excess returns of 2.13% and 364bps, respectively, for the remainder of 2016.

Hence, we look to realize about a third of the total return during the remaining three quarters of the year as well as almost our entire excess return forecast for the year. Just like for the full year, we look for spread curves to flatten and the back-end to outperform both on the total and excess return basis."  - source Bank of America Merrill Lynch

But then again, you might rightly ask why our obsession with Japanese flows and why looking at taking on long duration exposure?

With Bank of Japan implementing NIRP, we believe that when it comes to Investment Grade "Paradise" is not "Lost" and you should be inclined being overweight duration and quality wise going for Investment Grade corporate credit. This is clearly illustrated by Bank of America Merrill Lynch Liquid Insight note from the 4th of April entitled "The Japanese flow playbook":
Land of the rising global bond buyers
A favorite flow theme recently has been Japanese buying of foreign bonds: Japanese investors have bought around $75bn in foreign bonds over the last six weeks, their strongest stretch in three years.

While we have recommended US investors consider JGBs to monetize the cross currency basis (see Getting sheet smart), looking at it from the other angle requires us to consider a few more variables. This is because Japanese investors appear more willing to take FX and duration risk while US investors going the other way are usually purely interested in monetizing the basis. Japanese investors essentially can consider four options: (1) buy bonds currency unhedged; (2) finance it through repo; (3) FX and duration hedge completely through the cross currency basis swap market; or (4) employ a rolling FX forward hedge." - source Bank of America Merrill Lynch
Now if many bond investors are in the "purgatory" or "hell" of "negative yielding" government bonds in both Japan and Europe, they can take solace in the fact that Japanese investors got their back thanks to NIRP. Increasing flows, meaning effectively that Paradise is US Investment Grade Credit particularly in the long end of the curve. 

Some would then ask us about our views on European Investment Grade. 

Given US investment-grade corporate credit yields currently stands at 3.95% (almost their highest point since the 2013 taper tantrum) versus European investment-grade credit currently yielding around 1.4%, we believe European Investment Grade to be less enticing than European High Yield from a relative value perspective (less leverage in European High Yield than in the US). Whereas the ECB is in effect providing a technical "bid" to the asset class, from a convexity risk perspective, we believe European Investment Grade to be clearly less enticing than US Investment Grade credit. This is clearly illustrated by the recent A1/AA rated Sanofi new issue which saw €7bn of demand for a combined €1.8bn deal. The 3 year tranche was priced at midswaps +17bps, offering a paltry yield of 0.05% and a coupon of zero. While some might be desperate, we'd rather pass on this kind of offering. After all, 5 year swap rates are still marginally positive at around 0.015%. Then again with the ECB being the new buyer on the "credit block", the convexity risk doesn't make European Investment Grade of high quality particularly attractive to say the least. When it comes to "japanification" and the attractiveness of Investment Grade corporate credit, we read with interest Société Générale Multi Asset Snapshot from the 4th of April entitled "It's time to overweight corporate credit":
"US corporate credit undervalued and under-owned
The recent bout of market volatility has pushed valuations across the $7 trillion global corporate credit markets up to even more attractive levels. This is clearly reflected in the following market moves:
  • US investment-grade corporate credit yields currently stand at 3.95%, almost their highest since the 2013 taper tantrum; this is still more than double the benchmark 10-year Treasury yield.
  • US high-yield credit yields exceeded 9% for the first time since the 2011 European credit crisis in February, and have since fallen to 7.7%.
  • US high-yield spreads more than doubled to a multi-year high of 775bp on 11 February from 315bp in May 2014, and now stand at around 600bp.
  • US high-yield credit funds have seen net outflows of $64bn since May 2014, equivalent to nearly a fifth of total AUM
The increase in US high-yield credit spreads now reflects a substantial rise in defaults (see chart below). Moody’s forecasts the US speculative default rate to reach 5.4% by the end of 2016 compared with 3.6% in February.

US corporate credit stands to significantly benefit from any improvement in market sentiment throughout the rest of the year. The extent of the weakness we have seen, driven by the persistently low oil prices and exacerbated by the scale of fund redemptions, leaves US corporate credit, especially high yield, with significantly improved risk-reward for 2016." -source Société Générale.
Whereas we agree with Société Générale's take on the relative attractiveness of US Investment Grade corporate credit, while the dovish stance of the Fed has generated significant inflows into US High Yield in conjunction with a significant compression in High Yield spreads, we'd rather stick to our quality and duration call than chasing this rally. This leads us to our second point, namely is "Paradise Lost" in High Yield?

  • Credit - US High Yield? Paradise is lost
Whereas Société Générale in their report has put a positive spin on the appealing levels of US High Yield we must confess that we do not share their enthusiasm and, that the recent record inflows in short order in the asset class could be short lived. We have in numerous conversations pointed out the clear deterioration of elemental credit metrics in the asset class and we'd rather be safe with Investment Grade than sorry with US High Yield. On that matter we would side with Bank of America Merrill Lynch's take from their Fixed Income Digest note from the 1st of April entitled "Don't go with the flows":
"Flow to low quality might not last
The main forces that we believe will drive the bond market are: modest economic growth and a slight rise in inflation. We continue to favor high quality: investment grade corporates, munis, TIPS and fixed-to-floating rate preferreds.
We believe that modest economic growth and slightly higher inflation will be the main driver of bond market returns for the rest of the year. That leads us to continue favor high quality: investment grade corporates, munis, Treasury Inflation Protection Securities (TIPS) and fixed-to-floating preferreds.Those sectors are doing well so far this year, as Table 1 shows.

But non-US bonds and US high yield (HY), which are mostly low quality, are also doing well. Based on the BofA Merrill Lynch Global Bond Indexes, HY corporates have enjoyed a 3.2% YTD return.
Strong performance of low quality might not continue 
We doubt that low quality will continue its strong run. More than half of the better than 9% returns on both non-US developed country sovereign debt and local currency emerging market (EM) debt has come from the weakening in the US dollar. We expect the dollar to strengthen in the second half of the year as the Fed resumes raising rates.We are also turned off by the average yield of 0.39% on developed country sovereign debt. In the EM world, we favor corporate debt, most of which is denominated in dollars.
We believe that US HY will perform well over the longer term, but we have doubts about the staying power of the recent rally. The jump in oil prices from mid-January through March has been key driver of the HY market, but the rally has extended to non-energy names. Michael Contopoulos, high yield strategist, notes earnings for non-commodity companies have been weak, and they might face challenges in generating the cash flow needed to service their debt obligations. Defaults have been rising and we expect them to rise further.
What we like and why
The case for TIPS is simply that even the modest rise in inflation that we expect for the rest of the year exceeds what is priced into the market. We expect consumer price inflation to rise from its present pace of 1.0% to 2.0% at the end of the year. The breakeven inflation rate for TIPS versus nominal Treasuries is 1.65%.
We also suggest investment grade corporates as an alternative to nominal Treasuries. They are high quality and offer better yields than Treasuries. The average yield on the BofA ML index is 3.2%, a spread of about 170 basis points over Treasuries.
Among preferreds, we still see better value in $1000 pars than $25 pars, but the advantage narrowed somewhat in March when $1000 pars outperformed. We also still favor fixed-to-floaters, although the paucity of new issuance in that sector, and our subdued outlook for bond yields, argues for holding fixed-rate preferreds as well.
The appeal of munis remains their tax free income. For investors in the 25% federal tax bracket and higher the yield on AAA rated munis exceeds the after-tax yield on 10-year Treasuries. In-state munis also stack up well against similarly-rated corporate bonds for those in higher federal tax brackets and those who face high state income tax rates." - source Bank of America Merrill Lynch
While we have pointed out on numerous occasions, that while defaults and leverage matter for High Yield, clearly earnings matter even more and looking at the weaker tone in EBITDA, US High Yield defaults rates have only one way to go but higher. On the subject of US High Yield we would tend to conclude that the latest rally might be short lived and that indeed when it comes to the asset class, we think it is "Paradise Lost". We would have to agree once more with Bank of America Merrill Lynch's High Yield research team with their take from their High Yield Strategy note from the 1st of April entitled "Spring is here, but a fall is coming":
"Spring is here, but a fall is coming
We’re afraid not. Contrary to a true ‘risk rally’, it is the higher quality names that have tightened the most. In fact, when looking at the tightest 50% of non-commodity names we see that they have tightened over 25% from February 11 levels compared to widest 50% names tightening just 16.9%. And with the US HY default rate increasing by 105bps during this time period – a pace we have never seen outside of a recessionary period – we expect this reluctant rally to ultimately fade should retail pull out. Even ex- Commodities, the default rate has risen 48bps since January and is threatening to breach the 2%-handle for the 1st time since 2013 (tab 2.01). Given more than half of our HY sectors have negative year-over-year EBITDA (section 6), a closing of the capital markets (more on that below), and ex-Commodity downgrades outpacing upgrades by a factor of 2 to 1, we expect defaults outside of Energy to continue gaining momentum and for spreads to eventually be forced wider by the mounting credit losses. 

Issuance doldrums
With $34.67bn priced, Q1 2016 saw a 3rd consecutive quarter of less than 3% in new supply relative to the amount of all high yield paper outstanding. The only other time span in which we have seen an extended issuance drought of this magnitude was Q3 2008 to Q3 2009, a period not fondly remembered by high yield investors. And although issuance has increased in each of the last four months and volumes were boosted by a $5.2bn offering from Western Digital, the most recent month still saw the 5th lowest March issuance relative to outstanding supply on record, and the smallest amount since 2009. Even more concerning is the lack of triple-C issuance, where for the 3rd consecutive quarter less than 15% of all HY supply was triple-C rated.
We remain concerned that these risky companies will be unable to obtain funding in the context of poor earnings, forcing them to potentially default on future principal and/or interest payments." - source Bank of America Merrill Lynch.
When it comes to US High Yield forecast, Bank of America Merrill Lynch at the end of March 2016 was expecting 850 bps in spread which would equate to a total return at year end of -3.63%. 

In similar fashion to Bank of America Merrill Lynch, UBS in their Global Credit Strategy note from the 31st of March entitled "Does this credit rally still have legs?" concur with them, in the sense that they do not believe either the recent rally in US High Yield can last contrary to the beliefs of Société Générale mentioned above:
"Structurally, the HY rally is not sound
However, the reasons behind the recent credit rally give us room for pause, particularly in high-yield. Rising oil prices have created a technical bid for the market, which is not sustainable without further increases in oil. On the former, one can see clearly in Figure 7 how high-yield flows have moved in lockstep with oil prices since they began falling in mid-2014, while high-grade demand has remained resilient. US high-yield remains largely a bet on oil prices, while high-grade has more staying power due to new inflows from abroad.

In addition, high yield spread tightening has occurred with anemic primary market issuance. Hence, the main theme is rising oil prices + new fund inflows + limited supply = higher prices. However, this is not solving fundamental credit risk and re-financing issues that will creep up on this market over the next several years7. Figures 8 & 9 below detail weekly high-grade and high-yield spreads vs. weekly issuance respectively. The dotted line is the average weekly issuance one would expect based on seasonal factors from our interactive issuance model and total AUM outstanding.

One can see how high-grade spreads have continued to tighten despite above-average weekly supply hitting the markets, which is a positive signal for US IG that robust demand exists for new paper. In contrast, HY issuance has remained tepid; it has been below average in almost every week of 2016. The recent $5.6bn Western Digital deal may change that fact for this week, but one week does not make a trend. Current primary market conditions are not healthy for high-yield.
The bid for yield vs. credit risk
There is a clear divide taking shape in credit. The bid for yield is lifting high-grade, 
while credit risk is thwarting high-yield. How will we know if the bid for yield or credit risk will win this tug of war? In the short-run, it is impossible to abstract away our discussion from oil prices. Oil prices will continue to drive near-term inflows and outflows from the asset class. But away from oil, we will be watching several key data points. The bid for yield theme will gain credence if high-yield issuance picks up in coming months, particularly for those lower quality issuers rated B & CCC. On the flip side, if lending conditions continue to deteriorate from banks (such as the Q1 Fed Senior Loan Officer Survey released in May), and non-banks (such as the monthly CMI Index of Trade Credit, whose March survey should be released March 31st) and corporate earnings continue to fall through 1H ‘16, we fear that credit risk will begin to encroach on B and possibly even BB-rated firms as the year progresses." - source UBS
 This does indicates that when it comes to US High Yield, if lending conditions continue to falter then this will clearly signal "Paradise Lost" for US Yield no matter how some pundits would like to spin it.
What is another concern about the lateness in the credit cycle is the significant rise in the number of "fallen angels" (issuers migrating from Investment Grade to High Yield).
  • Final chart: Paradise Lost? A record number in "fallen angels"
Whereas the latest news around oil prices and the correlation with US High Yield in particular points to caution in the aforementioned rally we would not be chasing, what is another indicator you need to track apart from the Senior Loan Officer Survey and issuance, is the velocity in the rise of "fallen angels". To that effect, we would like to point out to JP Morgan Default Monitor note from the 31st of March relating to High Yield and Leveraged Loan Research for our final chart:
"In March, there were three Global fallen angels affecting $8.2bn, which followed February’s 30 fallen angels totaling $115.8bn, a record month both in terms of number of issuers and amount of volume affected. And there was only one rising star totaling $600mn in March, which followed one rising star for $260mn in February, the year’s first upgrade to investment-grade. Year to date, Global fallen angel volume totals $140.4bn, compared with $143.1bn during all of last year and a record high of $150.2bn in 2009. Excluding International bonds, US fallen angels YTD total 26 companies (20 Energy) and $107.9bn in bonds ($85.2bn Energy, 79% of the total, $15.3bn Metals/Mining, 14%). For reference, there was $45.5bn of US fallen angel volume for all of 2015, which was a high since 2009’s record $141bn. In terms of EM fallen angels, there have been 10 YTD totaling $27.3bn, which compares to last year’s $90.4bn of EM fallen angels." - source JP Morgan
In Milton's poem, the evil army loses against God and the Devil's reign in Hell starts with his band of loyal followers, composed of "fallen angels", which is described to be a "third of heaven", but that's another story...
"Go to Heaven for the climate, Hell for the company." -  Mark Twain
Stay tuned!

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