Macro and Credit - Through the Looking-Glass

"Always speak the truth, think before you speak, and write it down afterwards." - Lewis Carroll

While parsing through the FOMC's latest "hawkish" statement, which somewhat reversed "The return of the Gibson paradox" as per our 2013 rambling, making our gold miners exposure on the receiving end of a proverbial "sucker punch", we reflected on the semantics (the study of meaning) and pragmatics (the ways in which context contributes to meaning) of the Fed's latest musing in similar fashion the character Humpty Dumpty discussed with Alice in Lewis Carroll's Through the Looking-Glass (1872), hence our chosen title analogy:

    "I don't know what you mean by 'glory,' " Alice said.    Humpty Dumpty smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "    "But 'glory' doesn't mean 'a nice knock-down argument'," Alice objected.    "When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."    "The question is," said Alice, "whether you can make words mean so many different things."    "The question is," said Humpty Dumpty, "which is to be master—that's all." - source, Lewis Carroll's Through the Looking-Glass (1872)

One could have had a similar discussion with Fed chair Janet Yellen on the very subject of the supposed upcoming rate hike in June or July we think:

"I don't know what you mean by 'incoming data consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective' " Alice said.
Janet Yellen smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "
"But 'incoming data consistent with economic growth picking up' doesn't mean 'a nice knock-down argument'," Alice objected.
"When I use a word," Janet Yellen said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."

Indeed, the question is whether the Fed can make its words mean so many different things. What we also find of interest with our analogy is that Humpty Dumpty has been used to demonstrate the second law of thermodynamics. This law describes a process known as "entropy", a measure of the number of specific ways in which a system may be arranged (the Global Financial system as a whole), often taken to be a measure of "disorder". The higher the "entropy", the higher the disorder (hence our take on rising "positive correlation" and "disorder" with more and more large standard deviation moves in recent musings). After Humpty Dumpty's tragic fall and subsequent shattering, the inability to put him together again is representative of this principle, as it would be highly unlikely (though not impossible) to return him to his earlier state of lower entropy, as the entropy of an isolated system never decreases in similar fashion it has been incredibly difficult to return the Global Financial system to some state of "normalcy/lower entropy" but we ramble again...

In this week's conversation, we will start by looking at why the ECB is failing regardless of its QE, ZIRP and now NIRP and other tricks in spurring credit growth in Europe through the lens of European banks lack of "profitability". We will as well look at lending growth and the credit cycle.

Synopsis:

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth
• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind
• Final chart: US bond market - The warning sign from the long end

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth

While many pundits are highlighting "Price to book valuations" for global banking stocks. and are asking themesleves if banks cheap enough to take a risk here, we reminded ourselves our conversation from February 2015 entitled "The Pigou effect" where we clearly indicated our discomfort with European banking stocks:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe." - source Macronomics, February 2015

We also quoted at the time Berenberg's take on the "Japanification" of Europe "Through the Looking-Glass" of its banking sector:

"In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans." - source Berenberg as per Macronomics note from February 2015

Given our recent April conversation "Shrugging Atlas", musing around "Atlante", the Italian structure set up to tackle the sizable issue of Nonperforming loans (NPLs) plaguing the Italian banking sector, the performance of Italian banking stocks in particular and European banking stocks in general does validate our preference for financial "credit" than for financial "stocks" in Europe:

"No matter how low interest rates on corporate loans have fallen and has been much vaunted by the ECB and many pundits as a "great success", lack of "Aggregate Demand" (AD) and loans flowing to SMEs thanks to insufficient demand, this will not, rest assured, resolve the on-going woes, which have been much increased by the recent implementation of Negative Interest Rate Policy (NIRP), of the Italian banking sector. Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, hence our chosen title. Also as per our analogy, we wonder if, at some point, in similar fashion to Ayn Rand's book, investors will not go on "strike" when it comes to helping out the Italian banking sector as a whole." - source Macronomics, April 2016

Through the looking glass of the European banking sector, one can ascertain the futility of the ECB's policy in terms of QE, ZIRP and now NIRP in not only stabilize the "equity value" of Italian banks, but as well in resuming "credit growth". In continuation to us "Shrugging Atlas", we read with interest Bank of America Merrill Lynch's Money in the Bank note from the 20th of May entitled "Europe’s riskiest bank bonds":

"From bel canto to bank analysis 

It would be fair, we think, to typify the first trimester of this year for the Italian banks as a torrid one. It’s been tough for all global financials but Italian banks have particularly suffered. YTD Unicredit’s stock has fallen -43%, Monte dei Paschi -53%, Banco Popolare -65% and Intesa -25%. There are a number of reasons for this underperformance but at the base we see the systemic asset quality, credibility and capital problems in Italy as the drivers of investor concerns.

From bel canto to bank bond analysis: we measure the empirical riskiness of bonds by looking at the standard deviation of daily excess returns. We are not surprised that the Top 5 riskiest bonds in Europe YTD are all Italian banks, specifically Monte dei Paschi Tier 2, Veneto Banca T2 and Unicredit USD AT1. Excluding DB, Italian bank bonds occupy all 9 places of the Top 10 most volatile bonds. Following the 1Q reporting season and the recent events in the Italian banking sector, perhaps it’s a good time to reassess whether the market’s assessment is really a robust one.

We’re mindful that Italian financials are a significant part of the HY Index. There is €27.5bn of Italian paper in the HY Fins Index which is 45% of the total. It’s one thing to be negatively positioned in these when they are in decline but what if there is a turnaround in the assessment of the fortunes of these banks?" - source Bank of America Merrill Lynch

We do not think there will be a turnaround through the looking glass of their "better earnings" thanks to "lower provisioning levels". On this subject we read with interest Bank of America Merrill Lynch's take from the same note:

In 2014, some banks briefly circulated the idea that they were more conservative in their classification of NPLs than other European peers as the reason for the high quantum – this got quashed when the AQR clearly demonstrated the opposite. There have also variously been tax reasons and legacy lending issues, amongst others. We think the reasons may encompass many of these, but at root the answer is probably simpler: Italian banks did not seem to be very good at underwriting, in our view. We think high levels of NPLs are, in some respects, a management choice. To be fair, up to 2016, no one seemed to care and we could get little traction with investors when we talked of asset risks in Italy. This indifference possibly explains the relatively high level of complacency on the part of the banks on the NPL front. Remember this is a jurisdiction where a bank with a 16% NPA ratio is considered best in class.
In contrast to what we might describe as the pusillanimity of the banks in face of this significant challenge, we think the Italian Government has moved relatively proactively to try and address systemic concerns. It orchestrated a fund to help recapitalize some of the banks and avoid failed IPOs which would likely have caused further systemic issues, we think. Importantly, there have also been a series of measures which have been designed to reform insolvency practice in Italy and address tax issues around provisioning. There has even been an attempt to create a kind of bad bank, or more precisely to kick start a more liquid market for NPLs, through the provision of a Government-guarantee to NPL securitisations. We consider the efficacy of these operations in turn. 

Atlante 

Initially, we assessed the Atlante fund as a positive development for the Italian banks as we saw it as an attempt to break the cycle of bad news around the banks. We were slightly disappointed that the fund raised only €4.25bn compared to the €5-6bn that was originally mooted. Originally designed to ensure the success of the BP Vicenza IPO, and in our view, also help rescue Unicredit from its ill-fated decision to be sole underwriter for said transaction, the IPO of BP Vicenza has now passed, with Atlante having to take up the entirety of the €1.5bn in stock that was offered, because outside investors did not take up any allocation in sufficient quantity. According to Borsa Italiana, 10 insitutions offered to buy 5.1% of the shares which was insufficient free float. Atlante now has €2.75bn in resources left. The IPO of Veneto Banca is upcoming (pre-marketing was to start at the end of this week) and has been widely considered e.g. in the Italian press to have a greater chance of success when compared with Vicenza, not least because the bank is trying to place a smaller amount (€1bn). Market conditions remains hazardous though, we think, as recent comments by CONSOB underline. We have seen some discussion in the Italian press that the fund could be scaled up but we haven’t seen anything concrete on this – Bloomberg reported on Wednesday that the Italian Finance Minister was suggesting in an interview that it could be enlarged. Atlante is in any case a closed fund now but 66% of holders could vote to expand it, so we can’t exclude that the fund will grow, especially if it needs to.

In spite of being ostensibly private to avoid the state aid rules in Europe, Atlante seems to us to be serving a specifically public policy role, on our reading of its presentation, ‘by eliminating excessive supply with respect to the demand for shares’ though it is supposed to have the ‘interest of investors as its sole objective’. It seems to be an unusual set-up even by European standards.
Atlante has already served one of its primary purposes, we think, in subscribing to the Vicenza increase and sub-underwriting the IPO thereby reducing the risk to Unicredit ofbeing left with a significant overhang of shares. 70% of the funds resources are designed to be available for the support of capital raises, with the balance, or just under €1.3bn currently, for the purchase of NPLs. On NPLs, the idea is not that Atlante replaces the NPL market, but that it promotes ‘the creation and development of an efficient market of distressed assets in Italy’. In other words, Atlante may facilitate the sales of NPLs e.g. by buying mezzanine or equity tranches of NPL securitisations – especially those that take advantage of the Government guarantee (the so-called GACS) for the senior/investment grade tranche of the structure. The first bad loan securitization, with a GACS guarantee, is already happening in Italy with a €500m 3 year transaction for BP Bari. However, as the chart shows, loan sales in Italy have been relatively few. The expectation is that Atlante, plus GACS (plus the legal reforms, below) might provide the conditions to accelerate the creation of a more active market for bank bad loans.

We keep an open mind on the Atlante structure and its benefits – the market has been skeptical hitherto. We recall Fitch’s warnings that Atlante potentially drags healthy banks down in their rescuing less healthy institutions. But we still believe perceptions can quickly change as e.g. NPL transactions materialize using GACS, whether or not Atlante participates. Currently, in our view market sentiment around the Italian banks is still overwhelmingly bearish, especially after the last reporting season which was, in summary, rather underwhelming, in our view. We think it’s rather soon to assess the potential benefit from Atlante. We will need to see successful transactions concluded, however. Positive conclusions for the upcoming IPOs of other Italian banks would also be helpful, we think." - source Bank of America Merrill Lynch

We do not think it is rather "too soon" to assess the potential benefit from "Atlante", as we reiterated earlier on, either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, and through the "looking glass" of Italian banking woes and credit growth, the ECB is failing we think because with its QE and NIRP, it has not enticed Italian banks to accelerate the clean up of their balance sheets on the contrary as indicated in Bank of America Merrill Lynch's note:

"Perhaps the banks are anticipating the benefits of the patto marciano and so believe there is less need to keep provisions high (we understand that many European banks are also eager to anticipate the -0.40% rate at which they may be able to borrow from the ECB, even though that rate strictly speaking can’t be calculated ex ante). Lower provisions was a driver of many of the beats to consensus expectations in Italy, though, it seems. " - source Bank of America Merrill Lynch

Exactly, why bother? On a side note, and in similar fashion, for some countries and in particular France, why bother launching structural reforms when the ECB enables you to borrow for close to nothing (0.5%) for 10 year?

But moving back to why the ECB is failing is once again its lack of basic understanding of "stocks" versus "flows". We have long argued that for Eurozone members, if credit growth does not return, economic recovery may prove to be difficult in the absence of sizable real exchange rate depreciation. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth. 

When it comes to assessing "banking revenues", it is actually pretty straightforward as presented by Société Générale in their European Banks note from the 20th of May entitled "The revenue crisis":

"Net interest income is nothing more complicated than the revenue spread on the balance sheet. It depends on three pretty straightforward variables: the size of the balance sheet, the yield on assets and the cost of liabilities. It is the first two of these variables that have been under consistent, sustained pressure across the sector. Liabilities have not got cheap enough, quickly enough to compensate.
Across the sector, NII contributes c. 60% of the revenue base, and so is the major part of the dynamic. Non-interest income is more volatile, and spread between a multitude of different business lines. Essentially, fee income is a flow on the franchise value of the bank: the branches, the product range, the staff, etc. The outlook is less clear, and the drivers can change quickly. Strong markets would tend to be the biggest single force." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of budget deficits and NPLs.

Furthermore, the ECB's NIRP policy has aggravated the "deflationary" spiral in the deleveraging process by limiting the possibilities for banks to offset their NPLs woes with more revenues as pointed out by Société Générale in their note:

"Revenue wipe-out European banks are suffering. Every bank we cover has reported a year-on-year drop in Q1 16 revenue. A heady mix of zero rates, tough markets, weak CIB and stagnant lending volumes is taking a heavy toll. This matters for the sector. While nearterm earnings have been underpinned by better credit quality, this is not a theme that can continue forever. Sector earnings are stuck in a downgrade cycle, and pressure on the revenue line is at the heart of this." - source Société Générale

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think. Although the ECB has been trumping the convergence in Europe in interest rates charged on new corporate loans, as we stated before, the "fun" is uphill, in the bond market, not downhill, in the "real economy". If there is one chart displaying the failure of the ECB we believe it is the below chart from the same Société Générale note that illustrates the ECB's failure in spurring credit growth:

- source Société Générale

With the ECB's NIRP, there is no revenue, and there is as well no loan growth, so some pundits might be highlighting "Price to book valuations" for global banking stocks, we haven't change our views and we would rather play the "credit" side than the "equity" side from an investment perspective particularly "Through the Looking-Glass" of "consensus" EPS trend as displayed by Société Générale in their note:

"The weak revenue environment helps to explain a major anomaly with the Q1 16 results season: the sector generally ‘beat’ consensus on earnings, but consensus EPS downgrades have continued unabated." - source Société Générale

Indeed thanks to the ECB and its NIRP policy, when it comes to European banks stocks, you can no doubt, expect lower, for longer, that's a given. Whereas, the leveraging in the US has run fast and furious in the US credit markets, courtesy of the Fed, as we pointed in our last conversation we expect the impact of the ECB's much anticipated "credit binge" to materially deteriorate the credit quality of European credit markets which had been in recent years much more defensive of their balance sheets, no doubt even in High Yield than in the US. This leads us to our second point namely that, "Through the Looking-Glass", the Fed appears to us to be in a bind, with its "hawkish" stance, highlighting more and more the law of diminishing returns when it comes to its "credibility".

• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind

As indicated in our conversation "The disappearance of MS München", we have been tracking the price action in the Credit Markets and particularly in the CMBS space. The reason behind us starting to track à la 2007 is that the CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. 

As a reminder from our February conversation, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so in the future.

For instance, the continued weakened price action noticed in some space of the CMBX market as per the below chart from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 20th of May illustrates why we are watching closely that space:

- source Bank of America Merrill Lynch

"Through the Looking-Glass" of "retail" CDS price action and the link between retail and CRE, given we told you about this relationship in February with Sears’s management announcing in February that the company would accelerate the pace of store closings, sell assets and cut costs, this is clearly a "headwind" for CMBX and CRE. This is ncreasingly a sign that all is not well in the much vaunted "economic recovery" picture painted by the Fed and Humpty Dumpty aka Janet Yellen and her 'incoming data consistent with economic growth picking up in the second quarter'. As an illustration of the tailwind facing the Fed, the CDS price action depicted by DataGrapple on the 13th of May is indicative of the risk facing CRE investors:

"The above grapple depicts the weekly change of the risk premia of the constituents of the US Corporate cluster identified by DataGrapple. Retailers are easy to spot. In an otherwise resilient market as shown by the greenish shades of most boxes, all of them are red (and some bright red). Most of them reported first quarter numbers, and all of them managed to disappoint. Today, JCP (J C Penney Company, Inc) posted revenues that trailed analysts’ estimates and joined fellow discount-oriented KSS (Kohl’s Corporation) which missed estimates yesterday. Higher end rivals did not fare any better. M (Macy’s, Inc) reported lacklustre results and lowered EPS guidance for the year by 57cts (to $3.15-$3.40 from $3.80-$3.90), while JWN (Nordstrom, Inc) also added to evidence that the department store industry is mired in a deep slump when it cut its annual earning forecast. Shoppers across the income spectrum appear to pull back on purchases of apparel and other discretionary goods." - source Datagrapple, 13th of May 2016

For those with a "short bias mentality", please note that CMBX.6 has the highest percentage of retail exposure. CMBX.6 has considerably more exposure to B/C quality malls...just saying. 

And when we say the Fed is in a bind because of this relationship between "retail" and CRE we are not the only one meaning it. For instance Bank of America Merrill Lynch make the following interesting points in their Weekly Securitization note:

"While limited issuance might otherwise provide a powerful tailwind for spreads, myriad uncertainties remain on the horizon lead us to adopt a more cautious near term view. 

First, as we mentioned above, is the increasing probability that the Fed may raise rates over the next two months. Although a rate hike in and of itself won’t be overwhelmingly negative, it is likely, if not probable, that any near-term hike will be negatively viewed by many investors and could possibly be interpreted to signify that the Fed will be overly zealous as they seek to normalize interest rates against what they believe is an improving economic environment. Second, to the extent higher rates exacerbate the recent credit tightening, it is reasonable to fear that CRE price growth, which is already showing signs of slowing, could be exacerbated to the downside. While the recent Federal Reserve Senior Loan Officers Survey showed that bank lending standards have tightened since the end of 2015, rising recent conduit debt yields (Chart 52) and stabilizing Moody’s stressed LTV (Chart 53) metrics indicate the same is true within CMBS. Risk retention, which dealers are actively planning for, is likely to tighten lending standards further.

The combination of better underwriting, subdued new issuance activity and shrinking dealer balance sheets (Chart 54), which make it difficult for investors to add bonds in size away from the new issue market, have likely contributed to the cash bond spread rally. 

Recent CMBX spread/price movements, however, tell a different story and may provide insight into the macro-related nervousness investors are feeling.

On the week, CMBX prices, especially for tranches at or near the bottom of the capital structure, fell by as much as three points (Chart 55) and have fallen by as much as five points since the beginning of the month (Chart 56).

Again, to the extent that oil prices remain rangebound or increase and no major economic disruptions occur over the next month, we anticipate that CMBX spreads will trade directionally with broader markets." - source Bank of America Merrill Lynch

And of course, "Through the Looking-Glass" of the price action of CDS in the "retail" sector and CMBX, this is indeed a cause for concern regardless of "Humpty Dumpty" aka Janet Yellen's rethoric.

This brings us further "Through the Looking)Glass" of the relationship between lending growth and the credit cycle thanks to UBS's recent take on the subject from their Global Credit Comment note from the 17th of May 2015 entitled "Bank vs nonbank lending signals: the plot thickens...":

"In corporate (non-household) lending markets we believe the proverbial plot has thickened considerably. The two key lending segments are commercial and industrial (C&I) and commercial real estate loans (CRE). For C&I lending, banks comprise less than 20% of total lending; the bond markets are the new marginal provider of liquidity (Figure 2). 

Our non-bank proxy, incorporating bond and trade finance measures of credit conditions, has been indicating more tightening than bank proxies (i.e., the Fed's SLOOS survey) for several quarters. And our proxy is still suggesting further tightening ahead, primarily given that new issuance in US high yield and leveraged loan markets remains sluggish despite recent outperformance (US HY and institutional LL issuance are down 47% and 33%, respectively, in 2016; CLO issuance is off 68% YTD). That said, the rate of tightening has slowed, as HY issuance and trade-credit standards improved in April (Figure 3). 

In short, the trend in lending conditions is still tighter – but there has been some easing in funding conditions.
Conversely, lending conditions in commercial real estate have deteriorated. Banks comprise about 55% of total lending, so the Fed's SLOS survey is more telling. And, in the last quarter, banks tightened lending conditions in CRE, specifically in multifamily and construction/land development vs nonfarm non-residential (36% and 24% net tightening versus 12%, respectively, Figure 4; CMBS issuance is also down 38% through April). 

Why are banks tightening?

The most important factor cited was not CRE fundamentals, cap rates, competition nor funding, but 'other' factors – and by a large margin. What is our interpretation? Increased regulation was the underlying cause. We have previously flagged concerns around the pervasive easing of underwriting standards for corporate lending broadly 5 . Since 2007 FDIC-insured banks have increased nonfarm, nonresidential loans (ex-owner occupied) approximately 82% to $730bn; multifamily loans rose by roughly 142% to $344bn6 . In December, the OCC released its Statement on Prudent Risk Management for CRE Lending in response to "significant growth in CRE lending, increased competitive pressures, historically low cap rates and rising property values". This guidance was originally issued back in 2006, requiring banks with higher CRE concentrations to tighten risk and managerial controls.
We estimate approximately 8% and 16% of FDIC-insured banks by count and CRE debt outstanding, respectively, were above at least one of the concentration levels at YE 2015 (i.e., >100% CLD vs total capital, or >300% CRE vs total capital and >50% growth prior 3 years). For comparison, in 2006 about 31% and 40% of banks, respectively, exceeded one of the thresholds. Last month an American Bankers Association survey suggested similar, but modestly higher, figures in terms of bank concentration levels among respondents. Further, 40% indicated they expected a measurable reduction in credit availability to certain CRE sectors, while another 25% suggested a measurable reduction in credit availability across all sectors from the guidance. 

Why is this important? First, regulation can have a significant impact on the supply of credit, with US leveraged loans a recent case in point8. Back in 2006, the CRE guidance for banks also coincided with a significant tightening in CRE lending conditions. Second, changes in lending conditions for C&I and CRE loans have been quite highly correlated in the past (see Figure 4 above ).

One study finds banks that were above CRE guidance concentrations not only slowed CRE loan growth, but also tended to reduce C&I loan growth. Simply put, macroprudential regulation can have a more broad-based and severe effect on commercial bank lending. One could argue that constraints on lending as the credit cycle matures may guard against excess losses; conversely, an exogenous shock to the supply of credit at a time of lacklustre global growth and upcoming risk events could exacerbate
funding pressures.
And the linkages between CRE and C&I lending are multi-faceted. The lenders – in particular regional and community banks – tend to have higher concentrations of commercial and C&I loans, and some smaller business loans are collateralized by commercial property. Second, borrowers can also be concentrated in certain sectors across C&I and CRE. According to the Fed's Shared National Credit Review the largest industries in the leveraged C&I portfolio included Healthcare (14%), Media/Telecom (13%), Finance/Insurance (12%), Materials/Commodities (6%) and  Retail (5%)10. In CRE portfolios, larger concentrations lie in multifamily (28%), office (18%), retail (16%), industrial (12%), hospitality (8%) and healthcare (7%) according to the ABA. Much of the CRE growth has occurred in coastal cities. This implies, while not directly comparable, C&I and CRE depend more heavily on similar industries – media/telecom, finance (non-bank), retail and healthcare.

The conclusion is that the plot is thickening with respect to the signals of corporate lending conditions, and we believe clients should increasingly view them in a holistic framework. While there are signs of moderation in the rate of tightening for C&I loans, we are already seeing rising delinquencies and defaults weigh on corporate profits and growth (stages 3 and 4 of our rudimentary credit cycle model outlined earlier). But for CRE loans we think there is greater cause for concern as potential harbingers of greater credit constriction emerge.

Importantly, we have yet to see much rise in delinquency and default rates – although examiners noted rising concerns over CRE credit risk for 75% of banks and expected credit risk to rise in 50% of all commercial loans at year-end. The ESRB provides a simple but useful framework for the CRE cycle (Figure 5); while the CRE cycle appears less advanced than the C&I cycle, we believe investors should closely watch for evidence of potential negative effects on credit availability in CRE and potential broader spillover to C&I lending.

In particular, investors should closely watch the media/telecom, finance (non-bank), retail and healthcare industries given the linkages across both markets. In terms of investments, our view of recent trends in corporate lending conditions does not support 'reach for yield' or down-in-quality trades. In corporate credit, we continue to prefer longer duration US high grade bonds versus high yield." - source UBS

We agree with UBS's preference for US longer duration US high grade bonds exposure versus High Yield. When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.

This leads us to our final chart, indicating as well that "Humpty Dumpty" aka Janet Yellen should pay attention to what the long end of the US bond market is telling her no matter what she thinks whether or not she can make words mean so many different things in the FOMC...

• Final chart: US bond market - The warning sign from the long end

What "Humpty Dumpty" aka Janet Yellen doesn't seem to realize is that the credibility of the Fed, is "decaying" in similar fashion as the "theta" (time value) of the "put" option of the Fed. Given the recent "hawkish" tone to somewhat "dampen" the "credibility risk", we tend to agree with Bank of America Merrill Lynch's take on the warning sign being sent by the long end of the US yield curve as per their recent US Rates Watch note from the 18th of May entitled " Fed vs. bond market: The warning sign from the long end". The final chart taken from their note plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target:

"Bond market vs. Fed speak: look at the long end, not EDs 

Recent Fed speak and a slew of important speakers lined up to talk before the June meeting (Dudley, Yellen, Fischer) has shifted attention back to the front end of the rates curve. Eurodollar bears that were forced into hibernation since March have woken up, revisiting similar arguments of dots vs. the Fed, rates vs. US data surprises etc. To us, there is one worrying sign in the reaction of the bond market to the better data and hawkish Fed speak unlike 2013: instead of the optimistic signal the yield curve sent during the taper tantrum, long end rates now suggests a re-ignition of the policy mistake trade. Raising June/July probabilities is a small victory that is coming at the cost of dealing with higher probability of inverted yield curves 2-years forward, in our view. 

This is not 2013: reigniting the policy mistake trade 

A critical difference between 2013 and today is the inability of Fed optimism to filter through into higher long end yields. Chart 1 plots OIS forwards in mid and end 2013 (pre and post taper tantrum).

The combination of better data and shift in messaging from the Fed in 2013 was viewed to be a sign of an optimistic longer term growth picture – the resulting rise in yields was a healthy combination of 1) higher terminal rates 2) higher term premiums 3) and thereby a license for the Fed to hike sooner and faster than was originally thought. Recent communication however struggled in this regard: hawkish Fed talk and better US data has only helped 1) strengthen the dollar and weaken inflation expectations 2) lower terminal rates priced in 3) increase hike probabilities for the near meetings without shifting medium term expectations. 

Lack of credibility constrains effectiveness 

The policy mistake angle assigned to the Fed is visible in more areas than the yield curve. Chart 3 plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target. The market continues to believe that the Fed will deliver real rates that are far too high and miss on its long term inflation target by at least 50bp. To us, this inability of the Fed to improve longer term expectations priced in to the market tows the line of igniting a bigger concern: getting dangerously close to the market pricing in inverted yield curves, 2 to 3 years forward." - source Bank of America Merrill Lynch

So go ahead "Humpty Dumpty", hike, because looking through the "Looking-Glass" of retail earnings, their respective CDS price action, the state of CRE versus lending standards continuing to tighten and the state of the "long end" of the US yield curve, we do think that you will not be able to return the US economy to its earlier state of lower entropy...

"If you stop being scared, that's when entropy sets in, and you may as well go home." -  Tamsin Greig, English actress

Stay tuned!

Macro and Credit - Superstition

"The root of all superstition is that men observe when a thing hits, but not when it misses." - Francis Bacon

Looking with interest our anticipated weakness in USD/JPY coming to bear fruit from 107 since our last post to 109.11, and given we decided to start writing our conversation on Friday the 13th of May, which, for some people, is clearly of "significance", particularly for Stevie Wonder given it is birthday and that we share the 13th as the day, not the month or year for our respective birthdays, we could not resist but pay homage to this great singer once again (see our previous related Stevie Wonder 2013 reference "Misstra Know-it-all") by making a reference to his 1972  "Superstition" song in our title analogy. The song was Stevie Wonder's first number-one single since the live version of "Fingertips Pt. 2" topped the Billboard Hot 100 in 1963. The song's lyrics are chiefly concerned with superstitions, mentioning several popular superstitious fables throughout the song, and deal with the negative effects superstitious beliefs can bring:

"When you believe in things that you don't understand,
Then you suffer" - Stevie Wonder, Superstition lyrics

Obviously our "superstitious" beliefs since early 2016 have not been that "negative" from a P&L perspective rest assured given we have been advocating going long the 30 year US Treasuries as well as gold and gold miners for a while since the end of 2015, meaning for us that, when you believe in things you actually do understand such as "The return of the Gibson paradox" as per our 2013 rambling you do not suffer, on the contrary, you thrive:

"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." - Macronomics, October 2013

Whereas some people have been rightly "Superstitious" over time when it comes to "Sell in May and go away", from the latest raft of "flow data" it seems that there is a continuation in the "Great Rotation" from "equities" into "bonds", particularly in "Investment Grade" credit, confirming our recent musings on the subject. 

When it comes to "Mathematics" and "Superstitions" relating to Friday the 13th, the interval between two Friday the 13th is respectively 27, 90, 181, 244, 272 or 426 days. Therefore they can be an interval of more than a year between two Friday the 13th. Interestingly enough it happened on the 13th of August 1999 and the 13th of October 2000. What we find amusing is that the infamous "Dot-com" bubble saw the NASDAQ peak on Friday the 10th of March 2000 at 5132.52, very close to the middle of this rare interval and the birthday of yours truly which was on the following Monday. Given next Friday the 13th will be next January, could it be that we will experience the "peak of the market in the middle of both dates therefore on Monday the 12th of September this year? We wonder and yet it seems we ramble again, this time towards "Superstition" and are left "guessing".

In this week's conversation, we would like to look at the narrowing gap between US and European Investment Grade Credit as well as the impact of the ECB's global corporate bond buying binge programme aka CSPP (Corporate Sector Purchase Programme) is having to "credit quality". We will also as well "revisit" our US CCC "credit canary" indicator.

Synopsis:

• Macro and Credit - When the ECB starts playing with "credit quality"
• Macro and Credit  - The "CCC credit canary"is still pointing towards "exhaustion" in the credit cycle
• Final chart: The world was poorer in terms of yield in the government space, thanks to the ECB it's spreading into Euro denominated corporate credit

• Macro and Credit - When the ECB starts playing with "credit quality"

One of the prime effect of the "buying corporate credit binge" from the ECB has lead to a significant increase in effectively "zero coupon issuance" in the Investment Grade space such as the latest 2020 issue from Unilever as per our most recent conversation:

"To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB." - source Macronomics, May 2016

We also added at the time:

"The recent decision by the ECB will no doubt boost the rally into credit in Europe into "overdrive" and as expecting we are already seeing more and more large corporate issuers issuing de facto "zero coupon" thanks to our "Generous Gambler" aka Mario Draghi. As we pointed out in our previous missive before going for our R&R, it seems to us that the ECB is failing because it is enticing the money "uphill" namely into "bond speculation" where all "the fun is",  not downhill, to the real economy. Flow wise this exactly what is happening. The "fun" is in the bond market and particularly in the European investment grade market" - source Macronomics, May 2016

What is of interest is that thanks to its global corporate program, not only EM Corporate will benefit from the ECB's "generosity" which will no doubt trigger "mis-allocation", but, US issuers have been coming in drove to European shores thanks to "Reverse Yankees" issuance.

When it comes to issuance, obviously from a "flow perspective", at least in Europe, Investment Grade credit has been the prime beneficiary of the latest policy as indicated in UBS Global Credit Comment note on EUR credit from the 10th of May entitled "Who's issuing and what are they doing with the capital?":

"Euro IG issuance strong, HY weak 

The ECB CSPP has given the Euro IG primary market a kick start in March. We have since seen a pick up in BBB and BB issuance coupled with a tightening of spreads and smaller new issue premiums. Issuance in the Auto and Telco sectors YTD is already above the total issuance for 2015. There have been surprisingly few debut issuers in IG and we do not expect a radical change in issuer behavior on the back of CSPP. HY issuance has failed to benefit and is lagging far behind IG and last year's issuance. 

What is being done with capital? 

Issuance programs and borrowing needs are usually pre-determined, so we don’t expect CSPP to radically alter issuer behaviour. We will probably have to wait until these recent borrowings filter through the cash flow statements to find a real trend.
We have looked at the cost of capital of corporates refinancing themselves via bonds compared to dividends yields. Here, we see that the majority of 2016 issuers have a much higher dividend yield than bond yield." - source UBS

As expected, the "yield hunters" have been front-running the ECB's move which have led to a significant compression in credit spreads in the process.

What is also of interest to us is that given the on-going deleveraging of the European banking sector, there is of course a transformation of the "corporate funding process" given that thanks to banks bloated balance sheets and on-going reduction of assets, issuers have to rely more on the bond market rather than on the traditional loan market, which in some way marks an "Americanization" of the European corporate bond market as indicated by UBS in their note:

"The slow transformation of capital structure in Europe from bank loans to credit continues. Although about 79% of funding is still from banks (Figure 2) the trend toward a more US-like funding model is clearly underway after an acceleration in 2009.  

Structurally this transition could be helpful for growth in the Eurozone as bank balance sheets could be freed up to fund SMEs rather than mid- to large-cap firms (for example see this speech by Yves Mersch in 2014). The ECB is therefore likely to remain supportive of this structural transformation.

The structural trend is clear, but how are we doing so far in 2016? There is good news and bad news: IG is keeping track with 2014 and 2015 (Figure 4) whereas HY is lagging far behind (Figure 5).

Euro IG issuance over the first four months of 2016 was €191 bn, the second highest figure on record for the first four months of the year. Issuance in April was the largest in any April since 1999. Up until early March, 2016 issuance was below last year for the same period. Then came the announcement by the ECB to include non-bank corporate bonds into the QE programme, which proved to be a game changer. Issuance picked up sharply and the week following that announcement was the largest week of issuance on record at ~€30 bn. For more information on the ECB CSPP please refer to our earlier publication (ECB CSPP: Additional details). In contrast HY lags far behind previous years, with €9.8 bn printed to the end of May which is just a fifth of issuance to end of May in 2014 (€46.1 bn) and 2015 (€50.6 bn).

European credit has benefitted from an increase in popularity this year amongst ETF investors. Fund flow data shows that ETF investors returned to European credit funds in March, following nine months of flat AUM. The €1 bn March inflow into European HY ETFs was the largest on record.

At the same time, the concession on new paper has been eroding given this sharp increase since March. Yields have fallen and the gap between corporate and government bond yields has been squeezed. We have seen A1/A+ rated corporate issuers print paper with a 0% coupon and 0.08% yield in April.
Although issuance terms are clearly better since CSPP was announced, we have not seen a radical change in issuer behavior. Issuance programs and borrowing needs are usually pre-determined, and we do not think this will lead to a substantial increase in debut issuers." - source UBS

Whereas we indicated in April in our conversation "Paradise Lost" and also in early March in our conversation "The Paradox of value", that, 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, it seems to us that, relative to European Investment Grade, it has lost some of it appeal as clearly indicated in the gap closing between US and European Investment Grade as per UBS's note:

- source UBS

This is most likely due to global issuers such as US issuers conceding to the siren call of the ECB which thanks to the current level of the strong negative EUR/USD basis seems to be irresistible as per UBS's note:

"US issuers benefitting from low European rates 

At the moment the EURUSD basis swap is strongly negative, but given the yield differential between the US and Europe it is still relatively cheap for US issuers to swap their liabilities from EUR back to USD (Figure 9).

Combined with a central bank that is not only keeping risk-free rates low but also offering to buy the bonds of foreign issuers (assuming they meet eligibility requirements) this makes a compelling case for US issuers. It also allows for diversification of funding.

Over the last three years reverse Yankee issuance has been around a fifth to a quarter of all IG EUR issuance. This year the reverse Yankee issuance year to date is close to the total issuance for the whole of last year so it looks like US issuers are making use of the favorable conditions in the Eurozone.

These issues could also qualify for the CSPP provided the criteria is met, including issuing the notes in euros through a local European subsidiary." - source UBS

So not only is the ECB continuing to support the "deleveraging" process of the financial sector in Europe and providing "cheap financing" to both European Governments and Corporates alike, it is now as well providing "cheap funding" to the rest of the corporate world! It seems that the terms we used last week about an "epic credit bubble" forming are nowhere close to just "superstition".

From a "flow perspective" as we pointed out last week, the "fun" continues to flow "uphill", leading to a "frenzy" in bond market speculation, but for now, not really flowing "downhill", to repeat ourselves, to the real economy. This buying spree is materializing in "flows" as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 13th of May entitled "IG credit in the limelight":

"The X factor 

High grade credit has definitely got the X factor, as the ECB embarks on corporate- QE from next month. Flows into the asset class saw a strong U-turn over the past nine weeks. Outflows seen over the first weeks of the year are now almost erased.
On the contrary outflows continue from equity funds, as investors struggle to see inflation or earnings picking up any time soon. Moreover, on the other side of the high quality fixed income spectrum, government bond funds have barely seen any inflows in the same period as high-grade credit is in the limelight.
High grade funds had yet another week of inflows, the ninth in a row. On the other hand, high yield fund flows turned negative, erasing the gains from the previous couple of weeks. This was the highest outflow from the asset class in six weeks.

Government bond fund flows remained volatile, recording an outflow over the past week (after a brief week of inflow), the highest in nine weeks.
Away from QE eligible assets, equity fund flows recorded their fourteenth week of consecutive outflows, the longest streak since 2007. Last week’s outflow raised the total outflows for the year to over $31bn." - source Bank of America Merrill Lynch.

From a "flow perspective" and "leverage cycle" and "relative value", European High Yield boast more favors from investors although it offers lower credit spreads (but less leverage than US High Yield) as well as strong support from retail inflows into ETFs. It seems the "Great Rotation" from equities to bonds is running unabated making so far "flow wise" Investment Grade" the big winner of this "flow process", no superstition there, just plain facts.

But if indeed ECB is playing the "pumping up the issuance volume" game in the credit space, then something is going to give, and that is credit quality given in most recent years CFOs in Europe have been more "defensive" of their balance sheets compared to the US and its "buybacks bing" financed by "cheap credit" (hence a faster rise in leverage and deterioration of credit metrics). When it comes to the "quality risk factor", we have to agree with UBS's take from their recent note:

"Deterioration of credit quality 

As the European credit market has matured and grown since 2004 the quality of credit issuance can be broken into three phases. From 2004 to 2009 average credit quality improved slightly from A, peaking at AA- in 2009. In the next phase from 2009 to 2014 average credit ratings fell to BBB. In the third phase since 2014 credit quality has been on a slowly improving trend. But as we have noted above after the ECB's announcement of the CSPP quality has ticked downwards slightly to an average of BBB+. This recent trend is also visible in Figure 20 which shows issuance broken down by rating in the form of a heat map. Please refer to our recent piece on the credit quality of the iBoxx universe; European Credit: Fallen angels or rising stars?.

Which sectors are lagging/leading issuance in 2016? 

We are wary of a situation in which new issues are concentrated in one sector, as we saw in the US with energy producers over the last few years. This often signals a mis-allocation of capital and may end with a sharp correction as business conditions change adversely for that sector and capital is withdrawn, as occurred in the energy sector in the US. European sector issuance seems to be fairly well diversified. In Figure 16 is YTD issuance for each sector (excluding Financials) vs the average amount issued per year from 2010-2015.

Figure 17 shows the sectors sorted as a ratio such that 100% means we have reached the year total average issuance already in March.

- source UBS

Thanks to NIRP and its QE, the ECB is now following the same FED path in encouraging "oversupply" and a "credit bing" which will no doubt entice further "mis-allocation" of capital in conjunction with a deterioration in credit quality and credit metrics it seems, no "superstition" there either we think.

Moving on to our "CCC credit canary" indicator which we have discussed on numerous occasions, whereas High Yield in Europe is still supported by "flows", particularly in ETFs as discussed above, the fall in issuance in this bucket, in conjunction of a significant drop in CLO issuance point, we think towards exhaustion in the credit cycle.

• Macro and Credit  - The "CCC credit canary"is still pointing towards "exhaustion" in the credit cycle

As we pointed out in October 2015 conversation "Bouncing bomb", low quality speculative grade net issuance has fallen sharply in a replay of late 2007 as the stimulative effects of past Fed quantitative easing wears off as shown in a recent chart from Bank of America Merrill Lynch's monthly chart book:

- source Bank of America Merrill Lynch

As we pointed out last week in our conversation "Sympathetic detonation":

"Every single time the "CCC Credit Canaries" have been less and less "able" to tap the primary markets, the High Yield default rate went significantly upwards. As we have told you before, cost of capital, "hiking" or "not hiking" by the Fed is going up in an environment where issuers have weaker fundamentals, falling EBITDA and higher leverage which is not a good "credit recipe" for "total return players" (which by the way have a significant exposure in dollar terms) as well as for "forward returns" on the asset class itself." - source Macronomics

While the rally seen as of late as been "significant" in terms of performance as shown in the below table from Bank of America Merrill Lynch displaying the month to date returns for the month of April, "flows" in US High Yield are indicating further deterioration ahead and one would be wise to starting taking his chips out of the proverbial poker table we think, us not being "superstitious" but, you might be running out of "luck" soon:

- source Bank of America Merrill Lynch

"Flow" wise, apart from Europe, as far as US High Yield is concerned, is showing "contagion" from the ETF sphere (The iShares iBoxx High Yield Corporate Bond ETF HYG, the largest high-yield ETF, had $3.6 billion in redemptions in six days ending May 6) to the mutual funds sphere according to Bank of America Merrill Lynch High Yield Flow Report from the 12th of May entitled "Outflows spread to open-ended funds":

"HY non-ETFs see first outflow since Feb 17th 

US HY recognized its second consecutive weekly outflow, again led by ETFs which lost $691mn or -1.8%. As was the case last week, the ETF redemptions were limited to HYG with other notable HY ETFs not experiencing equivalent outflows. As such, we believe these redemptions were used to gain exposure to the underlying bonds making up the ETF and do not consider it an overly bearish signal for the market. However, open-ended funds also experienced net redemptions last week with a $91mn (-0.1%) outflow, their second negative print since February and third consecutive weekly decline. In our opinion, the outflows from open-end funds are a much more negative sign and provide yet another reason why we believe the recent rally may have already seen its end." -  source Bank of America Merrill Lynch

Given the significant performance of High Yield during the month of April, it would be reasonable, we think to start booking some profit.

Also, the latest Senior Loan Officer Lending survey points towards additional tightening. Deterioration in non-bank lending standards illustrate an overall tightness in US financial conditions and therefore signal a downside growth risk to the US economy. At least this exactly what the flattening of the US 2-10 yield curve is telling you as of late! The tightening in lending conditions can be seen below in another chart from Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch

With tighter lending conditions default rates may rise materially through 2016, which will continue to weigh significantly on US High Yield and the issue is not confine only to the Energy sector.

But, as pointed out in our October 2015 conversation, simply tracking bank lending standards is not sufficient to gauge how the corporate credit cycle is evolving hence our "CCC credit canary" issuance indicator. Also, in our conversation "The False Alarm" in October 2013 we stated:

"If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator." - source Macronomics

We will re-iterate our 2013 advice for credit investors, watch CCC default rate going forward. Because it matters, more and more.

In relation to our "CCC credit canary" concerns, we read with interest UBS's take from their Global Credit Comment note from the 10th of May entitled "Decoding the US triple C debt concerns":

"Decoding the US triple C debt concerns 

The amount of lower quality, risky corporate debt is a crucial input to assessing the inherent structural risks in global credit markets. In rating agency parlance this is synonymous with the proportion of triple C rated debt, and the bulk of which lies in the US. Our prior research has flagged the substantial rise in triple C issuers outstanding since the 1990s, peaking last year at 42% of all issuers, up from 14% and 18% in 1999 and 2006, respectively (Figure 1).

That said, investors have consistently pointed to lower estimates in the mid double digits and inquired about how to reconcile the stark divergence. Below we decode the discrepancies and discuss the key takeaways.
In short, the current estimates are lower if one considers only the high yield bond universe, utilizes index (or average) ratings and weights the universe by debt outstanding. This mosaic suggests triple C concentrations in the 15% context, above the 12% and 9% observed in 2006 and 1999, respectively, but below the 30% peak in 2008. We attempt to build on to that lower estimate using different permutations around the calculation for triple Cs to illustrate the components; i.e., we can perform a rough sum-of-the-parts analysis to build up from 15% to 42%. 

First, calculating triple Cs based on issuer versus debt weightings accounts for roughly 8% of the difference. This likely reflects the reality that abnormally low yields and robust credit inflows allowed more issuers to tap speculative grade bond and loan markets; given rating agencies assign ratings based on business and financial risk profiles, smaller firms by nature suffer more on the business risk profile assessment. However, we do not take much comfort in this fact in that we struggle to envision an environment where smaller defaults do not cascade or coincide with larger defaults. We view the surge in smaller lower quality issuers as consistent with commensurate increases in other non-index eligible corporate funding such as private placements, P2P and like non-traditional issuance that has manifested itself to satiate the reach for yield. And historically, issuer and debt weighted default rates have been fairly highly correlated (Figure 4).

Second, our analysis suggests about 8% of the differential is due to index or average versus Moody's ratings. How can Moody's ratings suggest nearly 50% more triple Cs than that of S&P/Fitch (on a debt weighted basis)? Macroeconomic assumptions do not appear to differ materially; neither is particularly non-consensus in their economic or profit assumptions. It is not the case of one industry or sector (e.g., energy, metals/mining) that largely explains the discrepancy; in aggregate, commodity-related industries only comprise about 30% of all triple Cs (and the result is similar whether we use index or Moody's ratings). Nor do differing recovery ratings appear to be a key factor. In short, Moody's may take a more conservative approach, but it appears broad-based and not unwarranted. Perhaps they are closer to in-line with market expectations, but by nature rating agencies are never ahead – but rather typically woefully behind. 

Third, the remaining 11% is due to inclusion of HY bonds and leveraged loans versus HY bonds alone. The LL universe expanded aggressively in the prior cycle driven by LBO activity, and the space grew substantially again driven by sponsor-led M&A and releveraging actions. In practice, many leveraged loans rated single B effectively encompass issuers with triple C default characteristics offset by secured collateral to lower the loss in default.

But will the theory work in practice? There are some reservations. First, realized recovery rates are already disappointing expectations. Trailing 12-month secured loan recoveries are averaging $57 (versus $70 modelled), while unsecured bond recoveries are $25 (versus $40 assumed) even absent a high default, recessionary environment. Part of this is due to peak earnings and multiples facilitating excessive corporate leverage, a phenomenon we have documented previously which ultimately depresses recovery rates based on normalized firm values. Second, the number of covenant-lite loans has risen from 20% to 70% in this cycle. These structures are largely untested, but they typically lack proper covenant and collateral packages. The risk is that these loans recover more akin to secured bonds (averaging $47) than secured loans (averaging $57, Figure 5). 

Third, the number of loan-only leveraged loans have risen from 5% to 30% post-crisis. These are loans without bonds to absorb losses below them and, in turn, could suffer lower recovery rates. Fourth, we believe leveraged lending and other regulations will tighten funding requirements for distressed borrowers in a downturn. The basic premise is banks are crucial providers of liquidity in stress as they are less mark-to-market sensitive; conversely, many new capital providers stepping in will not have such a luxury. And finally, recovery rates are strongly negatively correlated with default rates, which we expect to be near record levels given the higher proportion of lower quality bonds and loans and high degree of default correlation (Figure 6).

Distressed supply will come not only from advanced, but increasingly from emerging markets given structural risks in EM corporates.

In short, most metrics of lower rated debt in this cycle are above to materially above that witnessed in prior cycles at this stage. Investors analyzing the lower versus higher estimates should largely dismiss differences due to semantics such as rating agency selection or default weightings, in our view, which account for roughly three-fifths of the total. While it is true that roughly two-fifths are due to the surge in (lower quality) leveraged loan issuers, we do not take too much comfort in trading higher default risk for lower losses in default as we feel the latter will likely disappoint versus expected recoveries – akin to what is precisely happening now." - source UBS

It is not a question about being "superstitious" but given the "size" of our "CCC credit canary" in conjunction with Cov-lite loans, and we would like to repeat what we said in our conversation from May 2015 entitled "Cushing's syndrome":

"On the subject of "Overmedication", for us it means that the fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets meaning that in the next downturn, we expect the recovery rates to be much lower than in previous cycles!" - source Macronomics, May 2015 

Furthermore the strong "relief" rally in the High Yield Energy sector doesn't change our opinion in the lateness of the stage we are in the credit cycle. We can also point to another chart from Bank of America Merrill Lynch that clearly shows the deteriorating trend in US High Yield. For instance the chart below shows the trailing 3 month migration rate for US Investment Grade and US High Yield:

- source Bank of America Merrill Lynch

So one might rightly ask, where do we go from here with your "CCC credit canary"? We would like to point out to Bank of America Merrill Lynch's take from their recent High Yield Strategy Chartbook note from the 4th of May entitled "Back to where we started":

"Where do we go from here? 

Perhaps nothing illustrates the irony of this rally better than recent bankruptcies of EXXI and MPO. These issuers ultimately succumbed to the oil glut, filing for Chapter 11 protection in April, even as their bonds rallied hard, with their single B bonds springing up 20 points from their Feb 11 lows until default. Other defaulters such as CHK too saw their exchanged bonds jump up to 60 points. Note that virtually nothing has changed in the context of default probabilities in the Energy space, as it would perhaps require oil sustainably above $50/bbl to alter any of their fates. Which begs the question, how long can a rally based on recoveries alone last? Not much longer in our opinion. Having said that, rising oil could continue to push even ex-energy spreads tighter. However in the absence of solid fundamentals (more below), we think that this too will be short lived and the high correlation of non-commodity HY with oil will ultimately fade.
An early read of Q1’16 suggests more deterioration of HY balance sheets. With a little over 100 reporters, YoY revenue growth is -0.3% (5th consecutive –ve quarter) while YoY EBITDA growth is -7.0% (6th consecutive –ve quarter). Ex-energy, YoY revenue growth is nearly flat while YoY EBITDA growth is slightly positive. Adjusted EBITDA YoY growth numbers too are underwhelming, with US HY posting its 3rd consecutive –ve quarter, and ex-energy growth turning negative for the first time since Q1 2013.

We are back to where we were in HY spreads four months ago, but our message hasn’t changed. In the context of poor HY fundamentals, lack of liquidity and rising defaults, central banks are the last remaining pillars of support for risk assets. Yes, they have surprised us so far this year in their ability to remain dovish, but even so, plenty headwinds remain and risk assets have more reasons to sell off than rally, especially from these levels. As such we view this rally as temporary and believe we could retest 9% yields on an ex-energy basis again this year." - source Bank of America Merrill Lynch

So, when you believe in things you actually do understand, therefore, you are not being "superstitious", you can indeed sidestep upcoming "risk-off" in the US High Yield space we think.

As far as credit is concerned in general and with the ECB's backstop in particular pushing you to invest in "zero-coupon" investment grade credit at the point of the sword, as per our final chart, negative yields are not only spreading into the European Government Bond space, it is as well spreading into the Corporate credit space.

• Final chart: The world was poorer in terms of yield in the government space, thanks to the ECB it's spreading into Euro denominated corporate credit

While in our previous conversation we started indicating how pandemic the NIRP virus had become in the Fixed Income world and in particular in the Government bond space in Europe, the ECB's CSPP is indeed accelerating the spread of the Negative Yield virus now to the Corporate sector as indicated by the below chart from Bank of America Merrill Lynch displaying the impacted on Euro denominated credit from their EM Credit Global note from the 9th of May entitled "ECB buying is positive for EM corporates":

"ECB says ‘go’ to more negative yielding corporate bonds 

How low can spreads for IG corporates go? Chart 3 below shows that already, about 10% of Euro-denominated corporates are negative-yielding, or close to EUR200bn. This number could move meaningfully higher once buying begins.
The quantity of negative yielding assets globally has reached almost EUR10trn, or about 24% of global EUR assets. The figure was about 13% at FYE15 and 11% at FYE14. This figure includes sovereign debt eligible for purchase (see BofAML index GFIM).

- source Bank of America Merrill Lynch

Just because we wrote this conversation on Friday the 13th and born on a "13th" day, for us, it isn't a question of being "superstitious" but, we do think this "epic bond bubble" will end badly...

"I had only one superstition. I made sure to touch all the bases when I hit a home run." - Babe Ruth

Stay tuned!