30th May 2018

Good riddance to May

MARKET CLOSE:
iTraxx Main

69.3bp, -1.9bp

iTraxx X-Over

309.6bp, -7.1bp

🇩🇪 10 Yr Bund

0.37%, +9bp

iBoxx Corp IG

B+135.2bp, +0.7bp

iBoxx Corp HY

B+402bp, -3.5bp

🇺🇸 10 Yr US T-Bond

2.85%, +8bp

🇬🇧 FTSE 100 , 🇩🇪 DAX , 🇺🇸 S&P 500 ,

Midweek respite – much needed…

In case anyone missed it, a recap: Italy has no government, with a President trying to install a Prime Minister unlikely to succeed in cobbling an interim government together and all the while against an economy enduring a decade-plus long slump. Who can blame anyone for wanting to try something else? One can’t help getting political about it, but getting them to join the Euro-club was a mistake without the necessary flexibility to allow them and other ‘weaker’ nations to play under a looser rules regime – even if only in extremis. We came extremely close in 2012 to the Eurozone falling apart.
We’re on the brink again, and we’re going to see if the Northern European masters have the stomach for another fight, deep enough pockets and the will to do whatever it takes to keep the behemoth together in its current format. While those imponderables play out, the markets have taken their customary stance and decided it’s best to shoot first. And we can go back to Greece and how their own predicament was so shabbily handled for only a few clues as to how the current sense of crisis might evolve. Italy is 10x the size. It presents a whole of host of different issues. Size matters for starters.
Hence the intense sell-off in Italian debt and most other risk assets proportionate to how they might ultimately be impacted by the worst outcome. The worst case sees an Italian exit and all the kerfuffle around redenomination risk. But the potential of a parallel currency (so-called ‘mini-bots’) throws another variable bond investors will need to think about. Mind, an exit will leave us all staring into some kind of abyss which comes in the form of a financial crisis which would likely render the last one as a mere warm-up act.

The penultimate session of the month was a calmer one when set against the previous few, but edgy nevertheless. And this time, the US/China trade talk added a twist although news that the US was once again looking at imposing tariffs on $50bn on Chinese imports was greeted with a roll of the eyes. Here we go again. The calmness came after news emerged that talks were being rekindled in a last ditch effort between the Five Star Movement/League/President to form a new government, having previously failed amid acrimony and rejection on the choice of the economy minister by the President. Elections beckon if they’re unsuccessful.

Anyway, we had a calmer session as the extreme air of crisis lifted. US GDP for Q1 was revised lower to 2.2% from 2.3%, we had German inflation shoot higher on higher energy prices in May to 2.2% from 1.6% in April but all eyes were on prices. Equities moved higher, safe-havens were less in demand and prices edged down/yields higher and corporate bond spreads managed to stabilise (and only stabilise!). Primary was closed, again.


Where does credit stand in all this?

Italy matters greatly to corporate bond market investors. Firstly, Italian IG non-financial make up a high single-digit of the euro-denominated corporate bond market – and are a not so insignificant amount of the high yield and financials markets. Sentiment towards them matters and as we have already seen, there has been great contagion risk from CoCos issued by Italian to non-Italian/peripheral borrowers (largely on fear of an impending systemic crisis).

The early throes of this current drama doesn’t quite have all the periphery cast in the same light – Italy even managed to get a significantly large debt auction away on Wednesday, albeit at elevated funding levels – and we dare say that the primary markets are open to peripheral borrowers. We don’t think that they will pull the trigger though because they don’t need to, nor does it make sense to pay up just to show some bravado. A week of relative calm and silence on the Italian political front and we think even a blue chip borrower from Italy could pay up (a little) to get a deal away.

However, whilst that is all possible, the reality is that until we see some predictability return to the political situation in Italy, then we should not anticipate much by way of capital markets activity and we ought to expect spreads in secondary to remain elevated and at a premium versus non-Italian risk. We dare believe a few investors will lift some paper at cheap levels – liquidity permitting, and it might turn out to be a good opportunistic grab. But most will stay sidelined, finding it difficult to justify adding cheap paper here given the non-trivial probability that the crisis deepens from here.

As for the credit market as a whole, spreads have recoiled, and hard. There is no efficient exit for investors wanting or needing to reduce risk as the Street is about as non-accommodating as it has ever been. The Street’s trading balance sheet – used in the 1980s/90s/00s to absorb the first block of bonds to come out, is no longer available given the more onerous capital requirements needed to hold risk. So we tend to overreact immediately with a material disproportionate widening in spreads to most event risk as the Street takes on a defensive position (is bid-less).

Recognising that technical dynamic means at worst paying up and buying some protection, and at best waiting and sitting it out. Reducing Italian risk makes sense by either buying single name protection or selling cash bonds, while any recovery in the situation will make it easier to get back to neutral of overweight by adding BTPs. The negative daily marks will hurt, but the probability of a snapback is real too. It doesn’t help that many are limit long portfolio cash this time, given the poorest levels of primary activity in years.


That’s it for this week

The month’s performance is going to be greatly affected by the last week’s events. Those events might shape how the rest of the year looks too, but few ought to make any rash, major asset reallocation decisions right now. Any repositioning/hedging will have been taken already. The numbers, though, are not going to make good reading for most, although rate market investors will have clipped a decent performance.

Hopes of that new government in Italy allowed the markets some respite, and we managed a bit of a rally as a result. Stocks moved higher with the Dax leading the pack in Europe, up almost 1%. The US recoiled on Tuesday, but was up by over 1% at the time of writing, on Wednesday. The DAX is still down year-to-date having been higher a week ago, while the S&P is positive both year and month, to date.

There was a recovery in Italian debt prices, with BTPs leading the way. The yield on the 10-year, surging to a multi-year intraday high in a whippy session Tuesday at 3.38%, managed to recover another 19bp to 2.92% by the close. The 10-year Bund yield rose 9bp to 0.37%, the equivalent maturity US Treasury was up at a yield of 2.85% (+8bp) and the Gilt yield rose 6bp to 1.26%.

Credit was also tentatively in recovery mode, the first port of call being the synthetic indices where protection costs declined a little. The moderate moves left Main at 69.3bp (-1.9bp) and X-Over at 309.6bp (-7.1bp).

It was a similar story in cash, but with no significant snapback. We trod water at wider levels leaving the Markit iBoxx IG cash index a small up at B+135.2bp (+0.7bp) while the high yield market index closed at B+402bp (-3.5bp).

With Thursday being a holiday across Germany and Friday having the markets waiting for the non-farm payrolls number as well as potentially the confidence vote in the Spanish government, this week’s business is effectively concluded.

Have a good day.


For the latest on corporate bonds from financial news sources, click here.

Suki Mann

A 30+ 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 CreditMarketDaily.com.