9th Feb 2016

CoCos – “designed to fail”

MARKET CLOSE:
FTSE 100
5,689, -159
DAX
8,979, -307
S&P 500
1,853, -27
iTraxx Main
122.5bp, +6.5bp
iTraxx X-Over Index
460bp, +37bp
10 Yr Bund
0.22%, -8bp
iBoxx Corp IG
B+184.5bp, +5.5bp 
iBoxx Corp HY Index
B+629bp, +20bp
10 Yr US T-Bond
1.75%, -8bp

From commodities to European banks… Few would have thought we could repeat last month’s price action, but we are doing so, with the exception of oil prices. Equities are feeling the brunt of the market’s ire at the very difficult macro outlook, while – for now – oil prices seem to have found a floor, hovering north of $30 per barrel (Brent). Risk aversion is pushing government bond yields to record lows at the front end, while longer-dated paper (and here we mean the 10-year Bund) has just a little way to go before we see new lows (0.05% intra-day). Some are suggesting that should additional QE be announced, post-ECB (long end) bonds will sell off and yields will rise again – just as they did in Q2 2015. History ought not to repeat itself, and this will not necessarily be the case – indeed, we don’t think it will be. Back then, there was hope that China would be able to manage a soft landing, that the US rate increases would be into a sustainable growth dynamic and that the eurozone would piggyback on this. The good times would roll. It is quite evident that none of that has either been the case or will be the case this year. So, the DAX took a thumping on those growth fears, closing off the intra-day lows but still down 3.3% and everything else followed. The 2-year Bund resides at a new record low yield of -0.52%, and the 5-year and 7-year benchmarks did the same. In corporate bonds, well, we just crawled back into our shell and secondary activity ground to a halt. Where there was action, it was in synthetics, and while bank shares took a pounding, the liquid proxy in corporates – CDS – moved higher as the cost of protection soared (+10-15bp in the worst cases). Down the bank structure food chain – subordinated debt, and in particular CoCos – well, we again saw very poor price action. The likes of Deutsche Bank have been well flagged as under pressure after the huge Q4 writedown, but the contagion has spread. Deutsche’s CoCos are on average down 22 points YTD, while Unicredit’s 8% dollar CoCo is off an eye-wateringl 25 points. Quality has also been hit: HSBC’s 6% euro deal is off 8 points and Standard Chartered’s 6.5% dollar CoCo 10 points, while Swedbank’s 5.5% dollar AT1 is off 7 points. The former are at distressed levels, but the latter are holding up well. After all 90c+ on the dollar isn’t too bad in this market! All the price action has occurred since January (see chart below) while the index yield jumped 60bp in the session. Generally, this bank paper is faring badly because of increasingly dire economic outlook, and that was not most expected this year (including by us). Should these fears prove to be unfounded (unlikely), we could expect a sharp recovery in prices for most of them. Don’t bet on it just yet. All we need is one of the banks to announce a coupon suspension and the floor under this market will collapse. CoCos were supposed to be the “all-singing, all-dancing” capital product created to assuage regulators and fill the depleted capital bucket post-crisis to the new higher required levels. It’s suddenly become more costly for banks to issue them – if indeed they could – and not just for investors to hold. The key message is that CoCos are “designed to fail” without triggering a bank default.

CoCo Index Bond Yields

CoCo graph 9Feb16

It’s not about the oil, the oil, the oil… We capitulated. Simple as that. With stocks down as much as they were and government bonds bid up as much as they were, we would have needed oil down by 5%+ to suggest it was motivating the weakness. Oil prices per barrel might be going lower (we think $25 dollars will be upon us soon), but the session’s moves were simply about fear. Fear around the global economy – again. Even Treasuries saw 12-month lows in yields (10-year at 1.75%, -8bp). We couldn’t really point to poorer newsflow motivating the weakness, save for lock maker Assa Abloy flagging weaker EM demand in 2016. With the DAX off 3.3% at the close, that represented an incredible 16.5% loss YTD. Other markets fared as bad or worse. Oil was down just 1.75% per barrel on average. The aversion to risk assets saw peripheral bond yields gap higher with Italian BTPs in 10-years up at 1.68% (+12bp) and equivalent maturity Bonos at 1.74% (+11bp) as even the prospect of ECB buying failed to offer any comfort. Portugal was severely punished as the Socialists cancelled the national airline’s expected privatisation, with 10-year yields up at 3.36% (+25bp). For once, we had a real flight-to-quality trade going on which saw 10-year Bund yields down at 0.22%, 8bp lower in the session. Just 18bp left to drop before we see a new low. The S&P ended just 1.4% lower and well-off the lows for the day, but the lowest closing level for 2016. Hope for a better start today?

Credit markets get a deal… We managed to get BMW on the road, as it printed €1.25bn in a dual tranche transaction. A €500m 3.4-year floater at Euribor+65bp was added to with a €750m 6-year fixed deal at midswaps+85bp. At the final pricing terms, the book was just 2x oversubscribed. Safe name, solid company and somewhere to park that cash. The running total for IG non-financial issuance YTD is now up at €9.25bn, and we do have a slew of US borrowers lined up for deals as soon as the market permits. That was not the day’s story though. It was the weakness in credit markets that was best evidenced through the iTraxx indices which saw highs of 122.5bp, 465bp and 140bp for Main, X-Over and Snr Fins, respectively. Basically they tracked equities and the lower stocks went, better protection buyers (for hedging and/or speculation) pushed the indices higher. At the close, Main was left at the session highs of 122.5bp with X-Over at 460bp – or YTD, +45bp and +137bp, respectively. Ouch. In cash, we saw severe weakness on low volumes and flows, and much of it coming from higher beta sectors (CoCos, for example). The Markit iBoxx index ended 5.5bp weaker at B+184.5bp and the widening represented the worst day of pricing action this year (surpassing mid-January’s carnage). The IG index is now 30bp wider (we expected it to tighten by 20bp in 2016). The IG corporate index yield was unchanged at 1.74% owing to the rally in the underlying. In high yield, it was a shocker. We saw a severe repricing with index spreads back up and equalling the year’s wides at B+629bp.

What’s left to say, try and have a good day. I’m free for lunch.

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.