Thursday 31 July 2014

Credit - Nimrod

"I made Nimrod great; but he built a tower in order that he might rebel against Me" (Ḥul. 89b). 

While looking at Spanish 10 year government bonds "Bonos" breaking the 2.50% level, a level not seen since 1789 and French OAT 10 year at 1.51%, a level as well not seen since 1746 in conjunction with the German bund 10 year making new record low at around  1.119%, it seemed to us a clear validation of the "japanification" process we have long been depicting in our numerous credit conversations namely of a deflationary process taking place particularly in the light of the recent print of the European CPI estimate YoY coming at 0.4% in conjunction with very weak CPI pointing towards outright deflation for both Spain and Italy.

The European bond picture and the "japonification" process - graph source Bloomberg:

While we have already used a reference to central bankers' deception tricks in our conversation "Deus Deceptor" (being an omnipotent "deceptive god" as posited by French philosopher René Descartes), we decided this week to venture towards a religious analogy in our chosen title. We already touched on the "Omnipotence Paradox" back in November 2012 when it comes to central bankers and the market's perception of their "omnipotence" in sustaining asset price levels. In fact, last week we mused around  the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:
"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 worldplan." - source Wikipedia.

In continuation to the past reference of "omnipotence" in regards to central bankers actions, we decided to venture towards the biblical character Nimrod when choosing this week's title as he is generally considered to have been the one who suggested building the Tower of Babel and who directed its construction to challenge the "almighty".

By birth, Nimrod had no right to be a king or ruler (such as central bankers). But he was a mighty strong man, and sly and tricky (such as Mario Draghi, Janet Yellen and her predecessor Ben Bernanke), and a great hunter and trapper of men and animals (in their relentless hunt for yield). His followers grew in number, and soon Nimrod became the mighty king of Babylon, and his empire extended over other great cities, but that's another story and we ramble again.

In this week's conversation we will look at the increasing risk in the much "crowded" credit market, namely investment grade and high yield which could be impacted by the rise in interest rate volatility as well as a rise in default rates. We will also look at the Banco Espirito Santo (BES) story which is a continuation of what we discussed recently in our conversation "The European Polyneuropathy":
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

When one looks at the "new credit Tower of Babel", which construction has no doubt been directed by our "omnipotent" central bankers reaching dizzying height (or spread compression that is), we wonder how long this mighty tower will continue to hold given the recent outflows in the High Yield ETF HYG and the disconnect with stocks as depicted in the below Bloomberg graph warrants caution we think for our "equities friend":
HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Given Investment Grade is a more interest rate volatility sensitive asset, whereas High Yield is a more default sensitive asset what warrants caution for both we think is, the risk of rising interest rates for the former and the risk of rising default rates for the latter. 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. 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.
(For a more in depth analysis on credit returns and valuation, please refer to our friend Rcube's guest post "Long-Term Corporate Credit Returns").

In relation to the outflows seen in the aforementioned High Yield segment of the market as illustrated by the above Bloomberg Graph, the recent note from Bank of America Merrill Lynch entitled "Greed Retreat" from the 24th of July indicates the largest weekly outflows from HY bonds since June 2013:
-source Bank of America Merrill Lynch

When it comes to our "new credit Tower of Babel" analogy, bonds ETFs in Europe have swollen as reported by Bloomberg by Alastair March on the 25th of July in his article entitled "Bond ETFs Swell in Europe as Debt Trading Slows":
"Bond buyers are pouring record amounts of money into exchange-traded funds in Europe that buy debt as central bank largess boosts demand and makes investors less willing to part with their fixed-income assets.
 Investors deposited more than $16 billion into ETFs that purchase debt from high-yielding corporate notes to sovereign bonds, almost quadruple the amount in the same period last year, according to data compiled by Bloomberg. BlackRock Inc., the world’s biggest provider of ETFs, estimates bond-fund inflows will climb to about $20 billion by year-end.
The unprecedented era of near-zero benchmark interest rates that’s fueling demand for debt shows no signs of abating in Europe, with European Central Bank President Mario Draghi pledging to keep borrowing costs at record lows for an extended period. Deposits into bond ETFs across the region are growing twice as fast as flows in the U.S. as Federal Reserve Chair Janet Yellen said rates in the world’s largest economy may rise sooner than it currently envisions if the labor market improves." - source Bloomberg

But, with volatility making a come back in the US Treasury space with US 10 year touching 2.59% following the better than expected US macro data as well as four-week average of jobless claims, considered a less
falling to 297,250, the lowest since April 2006, from 300,750 the prior week, given the spread compression seen in the Investment Grade space, there is no real buffer left to support a sudden rise in interest rate volatility, putting the YTD bond flows in Investment Grade at risk. As Bank of America put it in their flow report "quality" is a crowded trade:
"Quality-crowded: YTD bond flows show IG bonds (31 straight weeks of inflows) most at risk from crowding (Chart 2)
31 straight weeks of inflows to IG bond funds ($4.2bn)" - Source Bank of America Merrill Lynch

In true Japanese fashion, credit in a deflationary environment does indeed tend to outperform as we have previously discussed in our conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"

As per our conversation "Deus Deceptor:
"The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds)."

When it comes to US default, the trend is up as indicated by Fitch's recent report on the matter in their note entitled "Another Jump in US HY Default Rate Looms"
"A potential bankruptcy filing from another struggling giant, Caesars Entertainment Operating Co., would propel the trailing 12-month US high yield default rate to 3.4% from its June perch of 2.7%, according to Fitch Ratings. With its $12.9 billion in bonds in Fitch's default index, the gaming company's impact on the default rate is pronounced - similar to Energy Future Holdings' (EFH) April bankruptcy. Caesars also adds to notable trends of busted LBOs and the exclusive camp of serial defaulters.

There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. The failed LBOs affected $21.8 billion in bonds this year and 26% of all bond defaults since 2008. Caesars would bring the latter tally to 29%. In addition, a Caesars filing would follow two prior restructurings via distressed debt exchanges (DDEs). Since 2008, 24% of issuers engaged in DDEs have subsequently filed for bankruptcy.

June defaults included Affinion Group, Allen Systems Group, MIG LLC, and Altegrity Inc., bringing the year-to-date high yield default tally to 20 issuers of $23.7 billion in bonds versus an issuer count of 19 and dollar value of $8.4 billion in first-half 2013. July defaults have so far included Essar Steel Algoma and Windsor Petroleum Transport.

Notwithstanding the likes of EFH and Caesars, the otherwise low default rate environment has some significant near-term support. Banks continue to ease standards on commercial and industrial loans, according to the Federal Reserve's Senior Loan Officer Survey, and they report stronger demand for such loans. The latter trend is an especially important gauge of economic activity and is consistent with the widely held view that GDP will improve in the second half of 2014.

At midmonth, approximately $33 billion in high yield bonds were trading at 90% of par or less - a relatively modest 2.9% of the $1.1 trillion in bonds with price data." - source Fitch Ratings-New York-29 July 201 - "Another Jump in US HY Default Rate Looms"

Given High Yield is a default sensitive asset class, no wonder the rising level of the default rate has triggered some outflows in the High Yield ETFs space as discussed above.

Our new Nimrod of the central banking world has no doubt pushed further down the line the day of reckoning as the "new credit Tower of Babel" continues to rise. For instance the recent CLO weekly report from Bank of America Merrill Lynch from the 18th of July entitled "Credit Outlook Benign Despite Loosening Lending Standards" indicates the following:
Credit Outlook Benign Despite Loosening Lending Standards
"Leveraged loan markets posted total returns of 2.6% and 2.9% in H1 in the US and Europe respectively, as compared to 5.4% for the HY markets. Up to the end of H1, institutional new-issue volumes totaled $242bn and €39bn in the US and in Europe. Repayment rates were subdued in the US in H1 with many deals having already refinancing in 2013, but hit a record high in Europe as many borrowers took advantage of favorable lending conditions to refinance their debt. If we look at the average leverage statistics for deals issued both in the US and Europe as well as the percentage of issuance that are cov-lite and second-lien, we clearly see that lending standards have loosened since the credit crunch. Despite this, the credit outlook for the loan markets remain benign largely due to a maturity wall that has been pushed out following all the refinancings that have taken place over the last two years and continued improvements in the economy." - source Bank of America Merrill Lynch

When it comes to illustrating our "new credit Tower of Babel" analogy we think that the below graphs from Morgan Stanley's Leverage Finance Chartbook from the 28th of July clearly shows our point:

- source Morgan Stanley

Moving on to the subject of Banco Espirito's woes, it is indeed the continuation of our 2011 prognosis, namely that weaker peripheral banks shareholders and bondholders would face further pain and losses down the line as reminded in our recent conversation "The European Polyneuropathy". The continuous widening in the CDS spread of Banco Espirito Santo illustrates the difficulties of the 2nd largest Portuguese lender:
- graph source S&P Capital IQ

The bank posted a €3.6 billion first-half net loss seeing its market capitalization falling to €1.2 billion. BES stock price - graph source Bloomberg:

Of course the junior subordinated bondholders were not spared either as it looks even more likely that a debt-to equity swap (in similar to what already happened to BES a couple of years ago) is in the pipeline - graph source Bloomberg:

Given the Bank of Portugal requires the lender to raise the money after it set aside 4.25 billion euros for bad loans in the first half, cutting its common equity Tier 1 ratio to 5 percent, below the 7 percent regulatory minimum, you can expect subordinated bondholders to face the Dutch SNS treatment, namely being wiped-out during the recapitalization process needed.

When it comes to the capital needed for the troubled BES, Bank of America Merrill Lynch in their note from the 28th of July entitled "Muddle, toil and trouble" put the capital needs at €6.5 billion but that was when the market cap was at €2.5 billion. Today it is 50% lower:
"Quantum of capital = substantial compared to market cap
BES’s capital needs are potentially substantial, we believe. First, there is the direct exposure to the Espirito Santo Group (GES) of up to €2bn. We think it would be best to adopt a ‘provide now, recover later’ strategy with this to be credible. Second, there is the Angola unit. This subsidiary is clearly in difficulty. Some relief came today with press reports that Angola would basically nationalise BESA but also repay the €3.2bn credit line BES had granted to its subsidiary ‘over time’ which we didn’t find that convincing. We think there is a world of difference between lending €3bn to a controlled subsidiary versus a Government-entity in Angola and would expect that to be reflected in the marks on the equity and debt exposures – perhaps at least another €1bn here at risk? Third, we are mindful of the large book of restructured loans for BES’s conventional lending and the low provisioning rate here which we think also is a risk ahead of the upcoming AQR. This is before we consider other third party risks, undeclared exposures or more contingent risk from investors who could claim that BES mis-sold them GES paper. We estimate a starting point of €4bn of potential capital needs, without the benefit of any tax effects. These compare with a €2.5bn market value today. In any case, a large recap number is required, in our view, for the market to turn the page on this affair."  - source Bank of America Merrill Lynch

What is of course of interest is that Junior Subordinated debt only represents €1.2 billion. When it comes to confidence, which is the name of the game in this credit story, a lot of investors believe that BES senior debt will be spared this time again as indicated in the Bank of America Merrill Lynch note:
Lots of people are telling us that in BES, senior is ‘the trade’. Many of our investor interlocutors also appear to have done well out of buying BES senior – even if it is based on the simple equation that ‘senior won’t be touched’ in any scenario. This facile assertion may or may not prove to be correct. In any case, the trade has worked – for those who bought at the lows. At current levels, senior is less compelling in any case, we think – there are cheap AT1 securities that offer the yield and the cash price appreciation but potentially with less headline risk, for example.
If the market really believed the ‘senior won’t get touched’ theme, we would not have, we think, the sharply inverted credit curve that prevails for cash senior bonds – if senior isn’t touched, the inverted curve doesn’t make sense. 
Our base case is that there will not be a rush to bail-in senior under most scenarios but that the capital needs of BES are potentially high which could test this proposition. We are not rushing to load up on ‘less risky’ senior as we still lack sufficient data to be confident about outcomes, even the ‘senior won’t get burned’ scenario. We are also concerned about senior in the context of what might be a less than convincing quantum of capital raised by the bank and what the bank will look like in the future. But clearly, the shorter-dated seniors would be the first port of call if we get clarity on the bank’s future." - source Bank of America Merrill Lynch

We think the only reason senior could be spared would be in a "Dexia scenario" with the government taking in effect control of the bank. If the solution has to remain "private", then we do agree with Bank of America Merrill Lynch's take that an inverted credit curve and a spiking senior CDS spread indicates trouble ahead in particular in the light of the capital needed to restore confidence in the ailing Portuguese lender. As a reminder, BES debt distribution as shown in our conversation "The European Polyneuropathy":
Subordinated bonds cushion is not material enough in the light of the capital needed. "Bail-in" for senior bondholders likely? Possible and probable outcome unless the state gets involved. So either the state gets involved or the senior bondholder gets it....we think.

On a final note, and as we stated recently, the much vaunted US "recovery" depends on an acceleration in wage growth. We have yet to see this trend coming to fruition as displayed by Bloomberg's recent Chart of the Day:
"Miserly pay increases for working Americans back Federal Reserve Chair Janet Yellen’s view that
inflation isn’t about to accelerate, making the case for continued central bank stimulus.
The CHART OF THE DAY shows wage growth remains stuck around 2 percent a year, where it’s been since the recession ended five years ago, even as the Fed’s preferred measure of inflation has recently picked up. Slack in the labor market, including people in part-time positions because they can’t find full-time jobs and those who have stopped searching for work because they are discouraged over prospects, probably means it will be difficult for earnings to accelerate.
“Inflation doesn’t happen with lots of slack and when wage growth falls behind,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed’s division of monetary affairs from 2004 until 2008.
Yellen told Congress today that the Fed needed to press on with monetary stimulus because “significant slack remains in labor markets,” while inflation is projected to be between 1.5 percent and 1.75 percent this year. The difference between the underemployment rate, which takes into account discouraged workers and part-timers who want to work a full day, and the unemployment rate was 6 percent in June, compared with a 3.8 percent average from 1994 through 2007.
Critics of central bank policy, such as Harvard University’s Martin Feldstein, have argued the Fed is already behind in fighting a coming surge in price gains. Feldstein, a former chairman of the White House Council of Economic Advisers, said in June “we are facing a problem of rising inflation” and the Fed is “probably going to respond too weakly, too slowly.”
“Martin Feldstein and others have been warning since 2008 that accommodative monetary policy would lead to a repeat of the 1970s,” said Wright. “This prediction has clearly been false.” - source Bloomberg.

"Do you wish to rise? Begin by descending. You plan a tower that will pierce the clouds? Lay first the foundation of humility." - Saint Augustine

Stay tuned!

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