13th June 2016

CDO-like bubble in all but name

MARKET CLOSE:
FTSE 100
6,116, -116
DAX
9,835, -254
S&P 500
2,096, -19
iTraxx Main
78bp, +3.5bp
iTraxx X-Over Index
334bp, +13bp
10 Yr Bund
0.02%, -1bp
iBoxx Corp IG
B+143bp, +0.5bp
iBoxx Corp HY Index
B+476.5bp, +4bp
10 Yr US T-Bond
1.64%, -5bp

A sense of déjà vu…

The trade has to be to play the game. Don’t stand in the way of the ECB. The economy is effectively busted if zero/negative rates, negative yields and free cash fail to get us started. bubbleThe political elite won’t help our cause, as they have rarely made the “right” decisions because these are usually too painful for too many. So where are we? Recall the CDO (collateralised debt obligation) boom in the 2003-2008 period. Credit spreads dropped to record low levels into it. Equities were riding high. The global economy was growing at its fastest pace in many a decade. The bubble couldn’t burst because if it did, leveraged asset structures were constructed in such a way that the pain would be spread and we would all take a little hit. There was to be no concentration of risks. It was supposed to go up forever as the use of synthetic products mushroomed, and not come back down. That was the theory, but we got it wrong. We miscalculated – or rather couldn’t calculate – the amount of leverage in the system. In a sense, because that systemic leverage buildup was impossible to quantify, many of us dismissed it. It blew up spectacularly. It’s not quite the same this time round, but nor is it totally different.

Now again there is a massive bubble being created out of the most “risk-free” of all assets: government bonds. Our economies and bond markets are either Japanifying – and there is more to go in terms of lower for longer, or there is going to be some great economic miracle that bursts this bubble and creates yet another financial crisis. Or rather exacerbates the current financial crisis, because that is what we are right in the middle of.

And because we can’t see the end, and are afraid to bet against it as that will impact performance, we trade into it. We add risk. In credit, we go down the credit curve and longer in duration to squeeze the extra pips of performance. Once we get that performance and as the market tightens up some more, we double up. May as well keep going, we’re all in it together.

Squeaky bum time through the summer

So the warnings of an asset bubble being created in government bond markets are increasing, and even coming from ECB board members themselves. The OECD is looking for more rate cuts by the ECB (deeper into negative territory), while the Brexit debate is now on a knife-edge but shifting towards the Leave side of the equation. Stocks closed out last week very nervous, taking a pummelling, with most European bourses off by over 2%. The 10-year Bund yield printed at a record intraday low of 0.009%, the Gilt at a record low of 1.213%.

The equivalent US Treasury visited a recent low of 1.63%, while the 2/10s differential compressed to print an intraday post-crisis low of 89bp as the curve flattened. That curve spread is now the lowest since the financial crisis began (back in the dark days of 2007). These are horrible numbers from a historical perspective, but they reflect our reality of endemic weakness on macro. Signs of a return to sustainable growth will bring their own headaches – and most likely another financial crisis (see above) – followed by more of the current drudgery as we resume sinking to the bottom. That’s something for the longer term and another day; for now, we should be trading the ECB. Adding and/or increasing risk exposure.

Where’s all the IG corporate supply suddenly gone?

The ECB’s bond purchase programme does represent some sort of nirvana for borrowers, but it seems like someone forgot to tell them. Or corporate borrowers have done their homework and know they can bide their time. No one issues into the programme as such. They issue because it is there and ought to treat the ECB as another investor – albeit one which assures them cheap funding for ever!

ContourGlobal led the deals on Friday

ContourGlobal led the deals on Friday.

Anyway, since the ECB entered the fray last Wednesday, just €600m of eligible debt has been printed by a single borrower (Bunge Finance), while we have seen over €2bn of HY debt issued. If that was the sole intention/or threat of the ECB’s purchases, it has worked! On Friday, three borrowers – ContourGlobal (€550m), Otto (€250m) and Titan Cement (€300m) – got through €1.1bn of investor interest.

Good riddance to that week!

The DAX index lost 380 points in the final two sessions of last week. The 10-year Bund yield fell 5bp last week to a new record closing low of just 2bp, and the 10-year Gilt yield fell to a closing low of 1.236%. Brexit, macro risks, fear, greed, warnings shots, political inaction and deflation – take your pick, or pick them all. There is a lot wrong at the moment. There is always some hope that recovery is not so elusive, which is why we don’t go lower in a straight line (yields or stocks). But our reliance on the US to work its magic is starting to erode any confidence we might have had left that it will all be OK. The path of least resistance, the pain trade, is in full flow. Anyone short government bonds, for example, is feeling the crunch.

In the corporate bond market, the IG market market closed 0.5bp wider at B+143bp (Markit iBoxx index), while the index yield edged a basis point lower to a new annual low of 1.20%. High yield was slightly weaker too. It seems like the weakness and panic elsewhere had an impact on the secondary market after all, but this weakness was extremely moderate. iTraxx Main closed at 78bp and X-Over at 334bp as the cost of insuring debt increased into the weakness in stocks.

Have a good week. Back in the morning.

Suki Mann

A 25-year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on Credit Market Daily.