Macro and Credit - Voltage spike

"The trouble ain't that there is too many fools, but that the lightning ain't distributed right." - Mark Twain

Watching with interest continuous records being broken in the surge in equities indices in conjunction with continuing flows in credit and tightening credit spreads, we reminded ourselves for our title analogy of what a "Voltage spike" is. While an energy spike, is measured not in volts but in joules; a transient response defined by a mathematical product of voltage, current, and time, the current melt up in asset prices is measured daily by the indices reaching new record highs. Yet, hard macro data at least in the US continues to be on a soft side hence the continuation in the flattening of the yield curve.

In this week's conversation, we would like to look at the flattening of the US rates market which followed a somewhat disappointing Nonfarm payrolls number last Friday.

Synopsis:

• Macro and Credit - Is the rates market pricing the end of the US cycle?
• Final charts - Econ 101 - Higher demand leads to tighter credit spreads

• Macro and Credit - Is the rates market pricing the end of the US cycle?

The slightly weaker tone coming as of late from the US job market has led to somewhat a "Voltage" spike" in the sense that there is indeed a growing disconnect between what the US rates curve is currently telling us and the unabated run in risky assets as investors have truly decided to "carry on". 

As we have clearly highlighted in our recent musings, as the credit cycle is slowly but surely turning, we do expect a significant final melt-up in asset prices. Until inflation rears again its ugly head and central banks have to counter it by hiking aggressively, it is difficult with current inflows and apart from an exogenous event to be bearish in the short term. Therefore we remain "Keynesians" as the animal spirits switch to "euphoria", yet we are also medium term "Austrians". As we have repeated in numerous conversations, we are more concern with the second part of 2017., Italian elections in the 3rd quarter will be important to scrutinize particularly in the light of unresolved issues with the Italian banking sector and their nonperforming loans (NPLs) woes. 

Clearly as of late, some financial pundits have been puzzled by the significant rally in both bonds and equities in a sort of goldilocks scenario playing out for the leveraged crowd and "risk-parity" players alike. This "Voltage spike" warrants close monitoring and maybe some sort of "surge protection" being set up given the level of complacency in this low volatility environment. In relation to the growing disconnect between the US yield curve and equities, we read with interest Bank of America Merrill Lynch's Global Liquid Markets Weekly note from the 5th of June entitled "Let's hope the rates market is wrong":

• The rates market is pricing in a high risk of the end of the US cycle. The stability of rates markets could be a warning rather than a reassurance for carry trades.

• •Either way, the high implied end of cycle risk in US rates is not just at odds with equities, but is a risk for commodities, EM, breakevens and the periphery. Internal inconsistencies

The rates market is pricing in a considerable chance of the US economy rolling over. The fact that UST 10y rates have traded in a very tight range for the last two months has been interpreted as a reassuring signal for carry trades everywhere. In fact it should be a warning signal. Rates are where they are, not because the world economy is in a sweet spot with growth neither too hot nor too cold, but because the market is caught between having to reprice rates lower (a high implied risk of rate cuts for next year) or higher (price out end-of-cycle risks, price in an active Fed and a deteriorating supply-demand gap for fixed income). If the US rates market is right, then the rest of the FICC space, let alone equity markets, are mispriced.

Commodities don’t do well in a slow-down

Commodities are cyclical, and our bullishness in crude is predicated in part on the cycle remaining intact – but moving beyond this tautology, we analyse the performance of commodity strategies below. Commodity beta works best in high and rising nominal rates macro regimes, but underperforms in rising real rate environments. Commodity alpha strategies on the other hand would be at risk in a scenario where inflation fails to get traction. Commodity alpha is therefore exposed to the global reflation trade being aborted, while commodity beta would be at risk even if the cycle remains intact, but the Fed moves ahead of the curve.

EM is goldilocks squared

In our recent discussions on EM we have primarily focused on the risks to EM from higher rates, given our short duration bias. However, the end-of-cycle risks priced by the US rates market are an even bigger risk to EM. For the EM carry trade to remain successful, rates need to stay low, which given the secular shift in supply demand dynamics for fixed income, and the US in particular, is a tall order, longer term. Crucially, however, pricing out the end-of-cycle risks in US rates, by themselves, would be a challenge to EM. And not pricing them out would suggest that the cyclical support for a bullish EM story falls away.

EUR breakevens are hoping for global reflation

Following the US election, long-dated EUR breakevens repriced as aggressively in the euro area (EA) as in the US and remain close to the ECB’s target. We have been bearish breakevens all year, since we believe the ECB is exiting policy accommodation prematurely and do not see any reason to be optimistic about a trend change in the EA’s inflation dynamics. But if the cycle in the US is slowing down, as suggested by the US rates market, then there is even less reason to be hopeful that this repricing of EA inflation risks to be sustained – leaving aside the fact that even for the US our economists see headline inflation slow considerably. The EA remains leveraged to global growth (Chart 2).

Periphery, still caught between a rock and a hard place

We have been bearish the periphery since last autumn, arguing that the ultimate victim of a more hawkish ECB would not be the Bund market, but BTPS. The periphery faces a mechanical repricing as the ECB steps away from artificially supporting prices, as well as higher risk premia given questionable debt dynamics on an inflation trajectory below the ECB’s target. However, what has supported the periphery so far is the fact that activity data has outperformed on a global basis. But as argued in the inflation discussion above, the euro area remains a highly leveraged bet on global growth. If the cyclical outlook in the US deteriorates as implied by the rates market, the last remaining argument for being constructive on the periphery would fade very quickly." - source Bank of America Merrill Lynch.

Obviously the price action particularly in the long end of the US yield curve in conjunction with serious inflows into Investment Grade credit as well, has put back into the forefront the MDGA trade (Make Duration Great Again) which we mentioned back in April in our conversation "Narrative Paradigm".  Clearly, if indeed the bond markets is not buying the "reflation" story anymore and US data continue to veer on the soft side, then indeed from a tactical allocation, it makes sense to turn more positive on the duration front.

In this credit cycle, clearly investors not only have taken on more duration risk but, given the performance of beta and in particular the beta segment such as in High Yield CCC, credit risk has been embraced in full making sensitivity to price movements much more significant to "Voltage spike". We agree with Bank of America Merrill Lynch's take from their note in relation to the growing disagreement between rates and equities, someone eventually is wrong:

"Not sustainable

Rates and equities are pricing two very different scenarios for the US and the world economy more generally. Rates are pricing a very slow pace of Fed hikes and the end of the tightening cycle after only one more hike next year, with a relatively high probability for a US recession. Equities, on the other hand, are the only Trump trade still alive and, at all-time highs, are pricing fast growth ahead. Implied market volatility is also at historic lows, suggesting no concern about a sharp adjustment. US data is mixed and do not give a clear indication of whether rates or equities will have to adjust. The FX market is more consistent with what the rates market is pricing, or the USD should have been stronger, in our view.

However, this is clearly not sustainable, in our view. We expect a reality check in the months ahead, most likely after the summer. We have been warning that although market volatility could remain low this summer, it will increase right after, as this fall is packed with events—more Fed hikes (or not), unwinding Fed balance sheet, possible Yellen replacement, US tax reform, ECB QE tapering and policy sequence, German and possibly Italian elections, and Brexit negotiations. In a good case scenario, the USD will have to appreciate against the JPY and rates will sell off. In a bad case scenario, equities and EM assets will sell off." - source Bank of America Merrill Lynch

We do share similar concerns for the second part of 2017. For the time being, markets have climbed numerous wall of worries so far in 2017 (French elections) and apart from an exogenous factor such as a geopolitical event, it is hard to turn significantly bearish. As John Maynard Keynes aptly put it: 

"The market can stay irrational longer than you can stay solvent."

While no doubt in our minds that eventually the "perma-bear" crowd will be right, namely that China will face some credit crisis at some point, markets will tank and what is overvalued will deflate accordingly, credit will widen and distress credit will show up again, at the moment, we do think we are moving towards the "euphoria" stage. 

Whereas as in our late 2015 musings it was evident that the shape of the high yield credit curve was pointing out to trouble ahead for credit in early 2016 and by extension equities thanks to the rapid depreciation in oil prices and weaker earnings, as things currently stand, regardless of the narrative of some doomsday pundits, it is hard for us for time being to see the catalyst. If inflation rears back its ugly head, it will be a different story for many asset classes rest assured. 

Looking at several indicators we track such as indicators of aggressive issuance such as the ones published by Bank of America Merrill Lynch, clearly CCC issuers have regained access to the primary market for the time being including shale players it seems (16.4% face value of the market):

- source Bank of America Merrill Lynch High Yield Chartbook

Another indicator we look at is Cov-Lite issuance as a percentage of market size. Since 2014, the market seems to have been cooling-off slightly (we are not talking about the much discussed subprime auto-loans here):

- source Bank of America Merrill Lynch High Yield Chartbook

Inflows are still pouring in Fixed Income including in the beta play such as High Yield simply because the percentage of negative yielding assets remain elevated at 17% based on Global Fixed Income Index (GFIM):

- source Bank of America Merrill Lynch High Yield Chartbook

High Yield fundamentals have improved with nearly all issuers reporting Q1 earnings and EBITDA growth is much better with ex-commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain according to Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch High Yield Chartbook

The on-going "Voltage spike" clearly shows that 2017 is playing out as a reverse 2016, namely strong performance in the first half of the year and much more caution for the second part. That's our scenario and it seems to be playing out accordingly so far. We do share with Bank of America Merrill Lynch's High Strategy team their cautious stance for the second part as indicated in their strategy note from the 2nd of June entitles "Looks aren't everything":

"High yield fundamentals continue to improve

With nearly all issuers having reported Q1 earnings, we once again take the opportunity to examine credit fundamentals across the high yield universe. For the 5th consecutive quarter, year over year revenue growth improved and jumped from 2.36% to 8.90%, the best reading in 3 years. Energy saw the biggest improvement with 31% top line growth, although Technology (+21%) and Commercial Services (+11%) saw double-digit gains as well. On the opposite end of the spectrum, Transportation, Capital Goods, and Media saw declines of 11%, 4%, and 1% respectively (Chart 1).

EBITDA growth proved resilient as well with ex-Commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain. This translated into a modest natural deleveraging across the ex-Commodities universe, where net debt to EBITDA levels fell to 4.18x compared to 4.52x at their peak last year. Finally, the US HY issuer weighted default rate continued to fall and now stands at 4.53%, just slightly above our 4.0% forecast for the end of 2017. Given this improving fundamental backdrop—the best we have seen in several years—do we think high yield’s 15 month long rally will extend into the 2nd half of this year?

Don’t eat the forbidden fruit

We view this as unlikely. Although healthy fundamentals may create temptation to invest in riskier pockets of the market, we think political uncertainty and an economy that struggles to gain momentum will likely cause a selloff later this summer. With 0.5% real wage growth, falling used car prices, negative C&I loan growth, and little capex investment, we find many similarities between today’s economy and that of 2013/2014 and question the ability for additional compression in such an environment. Additionally, given rich valuations, we think upside is limited here, particularly in high beta/lower quality paper. Instead, our bias is to reduce exposure to CCC risk and move profits into higher quality paper." - source Bank of America Merrill Lynch

As we indicated last week, we monitor very closely consumer credit trends in the US for the time being. Also we have voiced our concerns as well in various conversations with the negative trend in C&I loan growth more indicative on how the "real economy" is behaving. Given the significant outperformance of beta in the credit space and in particular the CCC bucket, we do have difficulties in seeing more upside from there but clearly Keynes earlier quote comes to mind in a NIRP world. 

In our book, when it comes to the slowly but surely turning of the credit cycle, the sequence always starts with a flattening of the US yield curve, then, financial conditions grind tighter and some highly leverage players credit start widening, before the impact reach more players and credit spreads start to widen, defaults rates start creeping up and then of course the rosy tainted glasses eternal optimist crowd in the equity space finally gets the story right, and equities reprice in the end. Obviously, we are not there yet. Liquidity providers aka central bankers are still deeply involved in the "wealth effect" game, which makes this current "bull market" still the most hated in history particularly with the latest "Voltage spike" we are seeing with new record levels being reached.  

Credit wise we continue to expect credit spreads to go tighter, that is until the flow of liquidity provided by our generous gamblers diminishes. Clearly we are not there yet as per the final chart below.

• Final charts - Econ 101 - Higher demand leads to tighter credit spreads

When it comes to looking at additional indicators of interest when it comes to "Voltage spike", while we already discussed some fundamental indicators, we continue to look at inflows in the asset classes as an indication of the direction of credit spreads. Our final chart comes from Bank of America Merrill Lynch Credit Market Strategist note from the 2nd of June entitled "All news is good news" and displays the record inflows being the driving force for tighter credit spreads:

"Econ 101

Economics 101 dictates that under certain assumptions higher demand creates higher prices (tighter credit spreads) and increased supply. The US high grade corporate bond market satisfies these assumptions, as inflows to HG bond funds and ETFs are tracking a record $130bn YtD, up about $85bn from the same period last year (Figure 27).

Supply for the first five months of the year is $650bn, just $25bn above last year’s pace. Acknowledging that this story is highly simplified, it nevertheless represents one of the key reasons high grade credit spreads have tightened 11bps this year to 119bps – making good progress on the path to our year-end target of 105bps (Figure 28).

 - source Bank of America Merrill Lynch

Given Bondzilla the NIRP monster is "made in Japan" and is finally back after 5 months of uninterrupted selling with the most recent weekly capital flows data showing Japanese investors bought 732 billion yen ($6.6 billion) of foreign bonds last week, bringing total buying in the past four weeks to 3.696 trillion yen ($33.3 billion) you shouldn't be surprised by the "Voltage spike" in US Treasury yields and credit either. So get ready to MDGA, just a thought...

"I just go where the guitar takes me." -  Angus Young AC/DC

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!

Macro and Credit - Under pressure

"A financial crisis is a great time for professional investors and a horrible time for average ones." - Robert Kiyosaki, American, author

Given the additional strains shown in recent days in various markets, and that last week we went for another musical analogy from the 80s, the troubling gyrations in the credit markets with the significant widening of some solid Investment Grade issuers, made us this time around choose for this week's title analogy Queen's famous 1981 "Under pressure" song featuring the recently departed great singer David Bowie. 

While we have been warning long in advance the debilitating state of the credit markets and in particular the High Yield market, what is of concern to us, as of late is that fragility is now showing up as well in some parts of Investment Grade credit markets. For sure the CDX IG 100 bps t-shirt has been picked from the closet where it had been collecting dust since the hayday of the Great Financial Crisis (GFC).

In this particularly long conversation we will again discuss the significant rise in idiosyncratic risk and the spillover into the Investment Grade markets and the potential consequences as well as some points of weaknesses in the Energy sector which are worth highlighting from a "bear" market perspective and explain the rational behind the boom and bust of the commodities' bubble.

Synopsis:

• Credit - More spillover from High Yield into Investment Grade
• Credit and Oil hedges - a paradox
• Credit and the Oil and Gas sector - it's scary out there
• Final chart - Credit on the brink of a blowout – watch global recession risk

• Credit - More spillover from High Yield into Investment Grade

As we pointed out on our Twitter feed recently, if you think there is no contagion/stress in credit then, looking at the significant large standard deviation move in terms of CDS 5 year widening of Rolls Royce, a solid single A, following its outlook cut by S&P from stable to negative is a harbinger of the deterioration in credit:

 - graph source Bloomberg

While, from a flow perspective we have yet to see significant outflows in that space from the easily scared "retail crowd", we are monitoring closely the situation and we think you should too. Whereas the weakness so far in Investment Grade in particular has been relatively muted, it could potentially get nasty fairly fast. In terms of flows monitoring, we have read with interest Bank of America Merrill Lynch's take in their Follow the Flow note from the 15th of January entitled "Counting Casualties":

"An outflow week for most asset classes 

The year has not started on a positive note. Fund flows continue to point to the downside in fixed income, and equity fund flow shows signs of weakness too. Equity funds were hit by outflows last week; the first in 15 weeks.Starting with credit, outflows were recorded across the rating spectrum. High grade flows turned negative again, after a brief week of inflows at the start of the year. High yield was on the same trajectory and outflows mounted to more than $1.5bn. This was the sixth week of outflows, and the highest one in three weeks. 

Elsewhere in the fixed income world, government bond funds had a second week of small inflows, amid broader risk aversion.Money market fund flow was also on the positive side and saw a third week of inflows, as investors looked for “safety”.Equity funds were not shielded from the sell-off storm. For the first time in 15 weeks, the asset class recorded an outflow, however marginal, which is also the largest in 20 weeks.Global EM debt fund flows also tipped back to negative, after recording two brief weeks of inflows." - source Bank of America Merrill Lynch

We have repeatedly pointed out the similarities of the late cycle to 2007, when it comes to the buyback binge inducing a rise in leverage, loose covenants and large issuance of Cov-lite loans, as well as record M&A, all indicative of a late stage in the credit cycle. From a comparative point of view we would like to point out to Bank of America Merrill Lynch's chart from their Monthly Chart Portfolio of Global Markets note of the 20th of January entitled " Welcome to 2016: Risk off grips world markets, so chart it":

"Sobering chart: High yield OAS breaks out like its late 2007/early 2008

The Barclays US Corporate High Yield Average OAS is widening out of a 3-year bottom. The last time this high yield spread widened out of a similar bottom was late 2007/early 2008 when the spread completed a 4-year bottom and continued to widen out. This was just prior to the depths of the 2008 financial crisis. We view this as a US equity market risk. A move back below the 5.50-5.30 area is needed to call this high yield OAS breakout into question." - source Bank of America Merrill Lynch.

We have warned you well in advance of the contagion risk in numerous conversations and told you that at some point credit spreads would continue to come "Under pressure", which could lead, we think to additional contagion from High Yield to Investment Grade.

Of course there have been plenty of reason at the start of the year with most risky assets coming simultaneously "Under pressure" as indicated by Société Générale in their Credit Strategy Weekly note from the 15th of January entitled "Not the best start for sure":

"2016 could have started better:  

The start to the year could have been better. Concerns over China, oil prices performing poorly, worries about EM and more idiosyncratic risk worries have hammered the markets and credit has not been immune. Spreads in IG are already some 15bp wider than at the turn of the year and the total return in IG is already down to -0.29%. But the results are even worse elsewhere. Equities in particular are down 8%, EM is starting to drop hard, commodities are depressed and since sovereigns don’t pay much we believe that this environment will help credit in general. Yes, the start to the year could have been better, and with the current volatility, spreads will continue to slide, but when you see InBev in the market with a $45bn 7-tranche transaction with orders of about 110bn, well it just shows that the appeal for credit remains very strong. 

What could go right? 

The cycle of China worries, weak oil, falling stock markets and rising credit spreads was very much in evidence this week. Credit had been a relative outperformer since the middle of December, and the big size of the InBev book gave hopes to some that it would stay that way. But US high yield markets are leading global credit markets at present, and fears of defaults in the US market (due to cheap oil, but also to weak growth) are driving up US high yield spreads.

Oil goes up 

The decline in oil has been driven by the supply side, but what if oil were to rally due to changes on the demand side? Investors do expect US shale supply to drop as companies default, though we ourselves think that this year’s US defaults are likely to be lower than the market expects, since companies probably have enough liquidity to limp through this year. A bigger supply shock could take place due to political risk in the Gulf. Recent tension between-Saudi Arabia and Iran has not had an impact on oil prices, but if it were to get worse, then oil prices could bounce off $30/brl. 

How to position for it 

The big winner from such a scenario would be US high yield markets, and particularly the energy sector. The big loser would be Saudi Arabia. Selling US high yield protection at 525bp and buying 5yr Saudi protection at 200bp would make sense under this scenario.

Monetary policy gets easier worldwide 

Our US economists expect rates to rise three times this year, with the next hike expected to come in March. Of course, if the turmoil in emerging markets begins to provoke concerns about deflation in the US, this could stay the Fed’s hand. A reversal in monetary policy in the US would impact USD credit, but it might have an even bigger impact on rates in Europe and elsewhere, since market participants might begin to wonder how other central banks would keep their currencies soft if US interest rates are no longer likely to rise. The zone with the biggest pressure on clients to meet their interest rate targets is still Europe, so European credit could be the biggest beneficiary. By contrast, concerns about the lower limit problem in Europe would come back in a big way, and the European credit curve relative to ratings would flatten.

How to position for it

If monetary policy eases – starting in the US, but spreading elsewhere – then the bonds that would benefit most would be longer-dated BBB credits in Europe. By contrast short-dated high quality credits (of single A or above) would do poorly.

Reallocations from EM cease 

One big driver for the recent EM weakness has been portfolio reallocations from EM to DM markets. These may be getting close to ending. Our bigger fear is that two other reallocation trends happen in EM this year. The first is that DM banks lend less to EM customers; the second is that EM companies issue fewer corporate bonds in dollars, and more in local currencies. Both trends would increase pressure on EM currencies in the short term and that could rebound on credit (although EM corporates in USD might be a beneficiary). If this trend develops more slowly than we, or the markets, expect, then we could see EM currencies improve and global credit markets also do better. 

How to position for it 

Ironically, we think developed credit markets seem more sensitive to emerging market currencies at the moment than emerging market credits. The big beneficiary of successful EM issuance in dollars ought to be EM bonds, however, and the best performers probably would be beleaguered Latam oil credits.

But is this likely to happen? 

Of the three scenarios above, the most likely at the moment seems to be the second one. However, since easier monetary policy might also spur growth hopes and drive oil prices higher, the first scenario could come about as a result of the second. We therefore think that investors looking for the upside in corporate bonds should invest in US high yield (which has sold off the most, and represents the best value), and in European IG (which would be most sensitive to another move lower in yields)." - source Société Générale

We do agree with the second point, namely additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdosis", we think.

When it comes to credit and what is getting us concerned is the deterioration of market internals as highlighted by DataGrapple's team in their latest blog post:

"Believe it or not, despite a 10bps widening of iTraxx Main (ITXEB24) - from 86bps to 96bps -, buy side institutions have (almost) not bought protection on that index last week. They only cut their long risk positions by the equivalent $0.4bln across the 8 most recent series. That probably goes a long way in explaining the stubbornly negative basis (the difference between the quoted value of the index and its theoretical value) of ITXEB, as investors rushed to buy single entity CDS on the energy sector. The reach for protection on oil related names was even fiercer in the US (the sector is whopping 85bps wider at 455bps in investment grade over the past 5 sessions). So fierce that even a reduction by a third of long risk positions in CDXIG – from $36.8bln to $22.9bln across the 8 most recent series – and a 12bps move wider – from 97bps to 109bps - did not prevent the basis to reach the most negative levels since the Great Financial Crisis. That trend only accelerated today, and the basis of CDXIG25 stood at almost 1% at the European close." - source DataGrapple

The stubbornly deeply negative basis between single names and indices clearly indicates there is potential for more widening for the credit indices going forward and warrants as well close monitoring we think.

The question that comes to our mind of course, given the last violent episode in credit spreads coming under pressure was 2011 is if indeed "this time it's different"? To a certain extent it is. The epicenter of the pressure in 2011 on credit spreads, was coming from the financial sector coming under relentless pressure which run its course when the ECB initiated its LTRO program back in December 2011. This time around, Itraxx Financials CDS 5 year index remain for the moment well below the Itraxx Main Europe Financial 5 year CDS index, indicating that the pressure this time around is building up more into specific buckets of the corporate part, namely the Energy sector. This is as well indicated in Bank of America Merrill Lynch's Relative Value Strategy note from the 20th of January entitled "The anatomy of a sell-off":

"This time has been differentOther than the crisis years, the only other time IG and HY have been at or above current levels is during the 2011-12 period (Chart 1 and Chart 2). 

But in our view it would be a mistake to characterize the indices in their current state as being akin to their 2011-12 avatars. We believe the difference is largely due to the systemic nature of the sell-off then and the prevalent view today that credit issues are largely idiosyncratic and isolated to a few names/sectors.

The source of portfolio dispersion in IG in particular has been the commodity sector. As Chart 4 shows, non-commodity IG continues to trade relatively tight. Even with the index at 110, IG index minus the commodity issuers CDS results in a portfolio at 69bp.

In HY, the distinction between the non-commodity and the admittedly smaller commodity exposure is not as stark

In a similar vein, the low beta portion of the IG portfolio has barely participated in the sell-off. In fact, until the end of last year, it even managed to ‘decouple’ from the widening in the index, deigning to join in only in the last two weeks:

As a proportion of overall portfolio spreads, the contribution of low-beta names is now the lowest in over three years as commodity-related issuers dominate the tail: 

The distinction between the spread moves in the tail relative to the rest of the HY portfolio isn’t as stark as in IG, but the spread contribution of the non-tail names is on the lower side compared to the last 5-6 years:

Single-name volatility within the HY portfolio has increased in recent months, with the proportion of names experiencing more than a 50bp widening each week, similar to that observed in 2012. The distressed ratio too has ticked up, from around 14% in October to 18% now." - source Bank of America Merrill Lynch

Conclusion:
While in High Yield there has been pretty much an overall deterioration with some contagion and spreads widening in sympathy with the Energy sector albeit at a slower pace, it remains to be seen how long Investment Grade is going to hold the line. So far, apart from the "sucker punches" à la Renault or Volkswagen and more recently with Rolls Royce, it appears to us that we are more into an early 2007 scenario for the time being (but things could escalate quickly still). As long as outflows remain muted in the Investment Grade bucket, Investment Grade remains resilient for now. Yet, the overall tone of the market suggest to us that financial conditions continue to tighten thanks to the battering of the Energy sector which will no doubt put lenders towards a more cautious stance, which will accentuate therefore the tightening conditions we are clearly seeing in the High Yield space (it started already with our "CCC credit canary" and recent LBOs tentative are struggling to place debt).

Moving on to the significant widening in High Yield Energy following the continuous fall in oil prices, we find it interesting the divergence in hedging policies between High Yield issuers and Investment Grade issuers. We will address this important paradox in our next bullet point.

• Credit and Oil hedges - a paradox

Whereas Brent crude oil prices have relentlessly falling in recent weeks following a disappointing OPEC meeting on December 4th, we had to wait until Thursday to finally see a significant rebound in oil prices as well as in risky assets, with a vicious short covering rally in which "Le Chiffre" aka Mario Draghi played a magnificent part, no surprise, him being a poker prodigy in comparison to the much more lame players at the FED.

As we correctly pointed out in our December conversation "Charles law", 2016 is already showing its capacity in inflicting serious volatility and damages in a very short time frame:

"2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016." - source Macronomics, December 2015

But, when it comes to assessing credit and oil hedges, it seems that High Yield issuers and Investment Grade issuers have had difference risk approach as indicated by Bank of America Merrill Lynch in their Global Energy Weekly note from the 8th of January entitled "Can oil prices find a floor?":

North American producers remain notoriously under-hedged in 2016… 

Despite a last minute rush to lock in hedging deals last November and December, we believe that North American crude oil producers remain notoriously under-hedged on their 2016 crude and nat gas price exposures:

Back in June 2015, we argued that North American companies (both high yield and high grade) were under-hedged for 2016 by 640 million barrels relative to 2014 levels (see The billion barrel question). We now estimate that less than 200 million barrels have been hedged since then. In other words, another 440 million barrels of oil would still need to be hedged in 2016 to match 2014 hedging levels:

…and unhedged for 2017 too, suggesting more selling pressure 

True, given the sudden collapse in longer-dated oil prices, many companies have little incentive to hedge at the present time as their production breakeven costs are typically higher than today’s forward crude oil prices. In broad terms, high yield energy companies (Chart 5) have higher hedge ratios than their investment grade peers (Chart 6).

Partly as a result of their higher sensitivity to funding cycles, levered high yield energy companies have tended to hedge a larger portion of their production regardless of price. However, the gap has widened meaningfully this year, as high grade companies have largely stopped hedging all together, presumably deciding to “tough it out”.

Most hedging activity has now moved to the options markets… 

Interestingly, those high grade companies that have indeed decided to hedge production in recent months have done so using collars, an option structure whereby the producer typically sells a call to finance the purchase of a put, rather than swaps:

A collar will typically provide a lower level of protection in a falling market, so the change in hedging structure may be related to producers holding a more constructive price outlook than the market. In the high yield space, the most common hedging structure is still a swap, but the use of options has increased (Chart 8), with credit-constrained counterparts likely recurring to the outright purchase of put options.

…and more US oil & gas companies are now filing for bankruptcy 

With leverage ratios exceeding on average 4.3x, compared to last cycle highs of 3.9x, oil is “no country for old men”: 

Many high yield companies are finally starting to get into trouble. Bond yields for CCC+ rated energy companies have spiked to 30%, while the average bond in a non-investment grade E&P company in the US is now yielding 16%. Given the challenges to refinance, it is perhaps no surprise that in the third and fourth quarter of 2015 at least 20 US oil and gas companies filed for bankruptcy, largely exceeding the levels reached in 2H2008 or 1H2009:

Put differently, financial distress is here and it is finally starting to bite." - source Bank of America Merrill Lynch

Collars provide limited upside and downside protection by putting ceilings and floors on prices. Typically favoring collars only works in periods of moderate volatility and may be preferable to swaps because there is less exposure to loss if prices continue falling. The paradox is that Investment Grade companies have been using a lower level of protection offered by Swaps and have as well been far less agressive than their High Yield peers in "protecting" their production level.

What is as well of a concern is the relative high debt level versus EBITDA, basically the overall level of leverage in the US Oil and Gas sector as per our next bullet point.

• Credit and the Oil and Gas sector - it's scary out there

Whereas by now many have awakens to the serious implications in the velocity of the fall of oil prices relative to the Oil sector, what is scary out there, regardless of the most recent rapid rebound in prices is the significant of leverage of the sector as a whole as depicted by Deutsche Bank in their recent note from the 18th of January entitled "Credit Stress intensifies":

- source Deutsche Bank

No surprise therefore to read earlier today that ratings agency Moody's had put 175 Energy and Mining companies and groups on review for a potential downgrade downgrade.

Of course, the one and only culprit for the fall of oil prices we think has been the impressive rise of the US dollar since 2014 as shown by Deutsche Bank in their report:

- source Deutsche Bank.

The trajectory of the US dollar in the coming month and the velocity of the movement will be essential in determining the level of further stress down the line.

Furthermore, as shown by Morgan Stanley in their Leveraged Finance Insights note from the 14th of January entitled "Making Heads of the Tail", credit being "Under pressure", it is essential to quantify the "stress" and of course the "default potential":

"Quantifying the Stress:  

First looking at valuations, a lower proportion of HY debt is currently trading sub $70 versus 2000 and 2008, at 17%. However, because of the size of the market, the par value trading at distressed levels today is $176bn, already greater than $120bn in 2000 but less than $313bn in 2008. By sector, 50% of distressed HY debt is Energy today, compared to 47% that was Consumer Cyclical in 2008, and 36% from TMT in 2000. 

Quantifying Default Potential:  

We finish by translating the distribution of the tail in the market into long-term default potential. Based on this analysis we get to a 5Y cumulative default rate going forward of 24% if we assume the cycle is turning –which is more modest than the 2008 and especially the 1999 5Y default cohorts. While we could argue for a lower 5Y cumulative default rate going forward (assuming the cycle is turning) when comparing the current tail in the market to 2000 and 2007, the volume of defaults will likely be much larger in almost any scenario given the substantially larger size of the market today. In Exhibit 11 we show a rough approximation of US high yield and loan defaults over the course of a default wave, which we put together in our 2016 outlook. For the purpose of this analysis only (i.e., not our actual forecast), we assume the default cycle starts this year, peaks in 2017 (9.3% HY default rate in that year), with elevated defaults for four years. We assume a cumulative default rate of 25%, comparable with 2008, but more mild than the 1999 cohort. 

From this analysis, we get to $627bn in US high yield and loan defaults over five years. Note this number is significantly larger than the volume of defaults in the last two cycles because US leveraged finance markets are so large. If this default wave were to be as severe as the late 1990s or worse, default volumes would clearly be larger." - source Morgan Stanley.

Of course because of the Fed's overmedication, the problem have grown "larger" for "longer, which could indeed spell for significant amount of losses over the next 5 years as calculated above by Morgan Stanley. When it comes to the stage of the cycle, we are not yet on "Nightmare in credit street" as we think, the latest moves are reminiscent of 2007, but are nonetheless trending towards 2008 when it comes to assessing the default risks induced by the collapse of the commodity sector thanks to the rise of the mighty US dollar.

What triggered the boom and now the bust you might rightly ask? For us, it is pretty straightforward and ties up to our "reverse osmosis" global macro hypothesis described in our August 2013 conversation "Osmotic pressure":

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - source Macronomics, August 2013

Of course there is more to it, and it is linked to the relationship between global interest rate gap and commodity prices. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011 as a reminder:

"Negative interest rate gap 

In order to assess the relationship between changes in monetary conditions and developments in commodity markets, a good proxy is the “global interest rate gap”, which is the weighted average of
the interest rate gap in each country with its corresponding GDP used as a weight. The interest rate gap itself denotes the difference between the real interest rate, defined as the nominal short-term interest rate minus headline CPI inflation, and the potential growth rate of an economy. If the interest rate gap is positive, meaning that the real interest rate is higher than the potential growth rate, then the financial condition is tight. Conversely, if the interest rate gap is negative, it means that the financial condition is lax, as the real interest rate is lower than the potential growth rate.
As shown in Chart 7, the global interest rate gap has become more negative, albeit fluctuating, which suggests that global monetary conditions have become accommodative over the observation period.

The interest rate gap in developed countries turned negative through the mid 2000s during the so-called “Great Moderation” period, and has remained in negative territory, reflecting accommodative monetary policies since the Lehman crisis. Also, the interest rate gap in emerging countries has become more negative throughout the observation period. Admittedly, by a nominal measure, monetary policies in emerging economies have been tightened with rate hikes since late 2009, preceded by a series of rate cuts after the Lehman crisis as was seen in developed countries. However, rates in emerging economies have not been hiked sufficiently fast, given the strong inflationary pressure and increase in real output growth. This “behind the curve” situation has caused the negative interest rate gap to widen in emerging economies.

Relationship between global interest rate gap and commodity prices 

Global commodity prices are negatively correlated with the global interest rate gap, as seen in Chart 8. 

This is because rising commodity prices increase inflation, decreasing the real interest rate as a result. If the rise in commodity prices is driven by the narrowing of the global output gap and the intensity of the price surge is too strong, however, the real interest rate needs to be raised by central banks in order to tame inflationary pressure. Such a principle of central banks would lead to a positive correlation between global commodity prices and interest rate gap, and the increase in real interest rate then would cool physical demand for commodities and dampen the rise in commodity prices. But what Chart 8 shows is that monetary policy stance of central banks have not satisfied that principle on a global basis, and hence easier monetary conditions have boosted commodity prices.

For individual central banks, the fluctuation in global commodity prices may be an exogenous supply shock. Even if a single central bank attempts to counter the fluctuation in commodity markets, it may achieve nothing other than making the domestic economy more unstable. In other words, for each central bank, an independent action to tame global commodity markets may not be an optimal choice. This reluctance of each central bank to counter rising commodity prices, however, could cause them all to be collectively worse off, because it is likely to accelerate the surge in commodity prices and thus to expand the negative global interest rate gap. The failure of this collective action leads to a higher-than-expected increase in demand for commodities. This vicious cycle may develop self-fulfilling expectations of a further appreciation in commodity prices, thereby driving commodity prices above the equilibrium level justified by supply-demand conditions (as proxied by global output gap). The experiences in several countries also suggest that accommodative monetary conditions, as characterized by the negative interest rate gap, enhance the risk-appetite of investors and induce “yield-seeking” investment flows into financial asset markets. Eventually, this process may increase the probability of an economy becoming trapped in a bubble." - source Bank of Japan, 2011 paper.

Quod erat demonstrandum. When it comes to the boom and bust of the commodity bubble and our "reverse osmosis" theory playing out. This also ties up quite well with "the return of the Gibson paradox" we discussed in October 2013:

"What of course has been of interest is the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - source Macronomics.

QE2 (November 2010 to June 2011 = peak gold prices) and negative real interest rates from the US triggered massive flows towards Emerging Markets and commodities. The start of the tapering stance of the Fed and the road to normalization and "positive" real interest rates" in the US triggered the "reverse osmosis": Massive capital outflows from Emerging Markets, a massive surge in the US dollar and a collapse in commodity prices.

Overall the Fed is entirely responsible for the commodity boom and bust bubble. The negative interest rate gap of its QE, also put the risk-appetite of investors into overdrive and induced massive “yield-seeking” investment flows into financial asset markets. That simple...

Now the conditions are ripe for an epic credit blow out in Emerging Markets, in particular those who borrowed generously in US dollars as per our final chart and bullet point.

• Final chart - Credit on the brink of a blowout – watch global recession risk

If indeed our "reverse osmosis" theory is playing out, then indeed a further rise in the US dollar will be the catalyst for some countries experiencing major issues.

As the Osmosis definition goes:

"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell."

Given many Emerging Markets have been struggling in stemming capital outflows as of late, we believe some will experience "excessive osmosis" and the country will eventually "burst" (default). Our final chart comes from Bank of America Merrill Lynch's Emerging Convictions note from the 21st of January entitled "Black gold down"

"Credit on the brink 

The benchmark EMBI sovereign spread has risen to the top of the 15-year range and is now likely to either retrace or target the blowout levels of the 2001/02 or 2008/09 crises (Chart 7):

In most cases, spikes in the current level did not last long, as they resulted in a global policy response or value buyers emerging. So the crucial question here seems to be the likelihood of a full-fledged crisis scenario.

The key to this question is likely whether the negative side effects of the commodity shock will be severe enough to raise global recession risks. The Chart above shows the EM credit crises of the past 15 years were associated with US manufacturing ISM below 45, the level that is almost always associated with a GDP recession.

Our house economic and oil view implies that the world economy – and thus EM credit – will pull back from the brink. Our DM economists emphasize that the economy outside manufacturing remains robust. Our oil team has argued for a temporary dip to the mid-20s on China, Iran and the warm winter, but continues to expect a recovery above $40 by 2Q as demand grows and US supply contracts. Again, the crucial risk to this oil view would seem to be whether the oil supply shock mutates into a global demand shock.
If this view is correct, commodity credits look oversold. Nigeria stands out because it is already wider than during the Euro crises and post Lehman. Russia is wider than during the Euro crisis but below the Lehman levels, though it now has a flexible rouble. South Africa is close to its post-Lehman level. Among the commodity importers, Turkey is trading at the same z-spread as during the previous global financial stress periods. CEE remains tight vs historical blowouts due to improved fundamentals." - source Bank of America Merrill Lynch

Place your bets accordingly...

"But all bubbles have a way of bursting or being deflated in the end." - Barry Gibb, English musician.

Stay tuned!