15th Feb 2016

Japanification of the € corporate bond markets, what happened?

MARKET CLOSE:
FTSE 100
5,708, +171
DAX
8,068, +215
S&P 500
1,865, +36
iTraxx Main
118bp, -8bp
iTraxx X-Over Index
464bp, -22bp
10 Yr Bund
0.26%, +7bp
iBoxx Corp IG
B+191.7bp, -0.8bp 
iBoxx Corp HY Index
B+668bp, +6bp
10 Yr US T-Bond
1.74%, +9bp

I wouldn’t be buying the dip just yet… After some of the moves we’ve seen these past few weeks, capitulation has become very topical. Capitulation in any asset class is a disorderly exit. Cash becomes king. Capitulation is mass panic, and in the corporate bond markets that means issuer credit curves ultimately invert (or bear flatten, see chart). Investors sell the “highest” priced assets regardless of spread, leaving short-dated, quality assets as the big underperformers. We’ve not even witnessed a hint of that – even in the CoCo bond market, credit curves are generally still upward sloping. For this to change, we believe a systemic financial crisis is needed, and at times it appears that we are willing for this to occur. The last time we saw curve inversion across the corporate bond market was in the 2008-2009 period when the “original” financial crash sowed the seeds for the current crisis. The front end took a battering as investors sold whatever they could (the best prices were for short-dated quality corporate bonds) in order to meet the torrent of fund outflows, as money made a dash for safety and quality. Lehman’s collapse meant that the potential for a systemic crisis was real (the rest is history). This time round, we don’t foresee a systemic crisis as yet. The central banks still have some ammunition left, and it would seem to us that right now we are adjusting valuations to more sensible levels as we come off the artificial QE-inspired bubble. QE, that is, is becoming less effective, but we could have further to go in terms of downside risk in this sense. Central banks have been dumbing it all down for several years, while politicians have failed to act. That means low rates “forever”, low yields forever (haven’t we heard that before?) and a need to get over this “correction”. Then we can look for macro to stabilise at lower growth levels and for an extended period, leaving corporate bonds to regain their lustre. Maybe that’s being too optimistic.

Double-A credit curve flattens as 2008 crisis rages

Rally justified, or just misleading into long weekend?… The equity markets rallied with gusto into the close of last week, but we think it was about closing out any (short) positions ahead of the long weekend (US closed today for Presidents Day). The eye-catching market news was around Deutsche Bank’s tender offer for €3bn of senior bonds. The tender, in our view, was not particularly aggressive and seems to have been more about intent and anchoring prices than actually buying bonds. For DB’s US$ bonds, it was essentially targeted at the long end, and we note that the 3.125% 21 and the 4.1% 2026 issues were only issued this year, at spreads T+157bp and T+200bp respectively (tender offer at +270bp and +322bp). Ouch. They couldn’t tender for any distressed AT1 risk without regulatory approval – which they probably wouldn’t get – while an operation to tender subordinated debt would take too long anyway. Overall, the market didn’t seem too excited, with sentiment seeing only a moderate rise in the 6% CoCo, for example, to around €74 cash price (noise, in other words). Eurozone GDP and industrial production in Q4 played out in line with forecasts (still very dire at 0.3% for both), while separately, Spain headed deeper into deflation territory in January. US retail sales in January surprised to the upside, while consumer sentiment as measured by the Michigan survey showed a dip in early February. The previous overnight falls in Asia were seen as being about playing catch-up, having absolutely no impact on Europe’s open and leaving equities to rally hard in the week’s final session. Oil prices rose by a huge 12%, leaving WTI up at $29 and Brent at $33 per barrel. Trading? It’s a mug’s game.

So what next?… Our view is that the central banks will stand up and be counted should the potential for a systemic crisis appear (even more QE – but less effective, ineffective rate cuts and so on). The markets will get temporary highs off any actions. We do, nevertheless, discount the possibility of a crisis of systemic proportions in 2016. If we can manage some calm, that could eventually lead to a resumption in credit spread tightening and a compression of sorts between high and low beta credit credit in IG, in the first instance. That’s because low yields and a low default rate into a not too hot/cold economy should encourage money back into higher beta credit. That would leave us with something akin to what we witnessed as a trend in the 2011-2014 period, although less aggressive. Back then, the interest in corporate bonds intensified to such a great level that we were looking at the “Japanification” of the corporate bond market (massive compression). That prospect is all but lost given the quite dramatic unwind in spreads since early 2015. It is difficult to see that previous level of compression returning. For now, stay cautious and add if conviction is resolute. Few are willing to step up in isolation, but they will be adding when everyone else does (safety in numbers), which unfortunately will mean risking disappointment on the crowding-out effect.

CoCos: A spectacular fall from grace

Credit markets need much more convincing… The iTraxx indices were the outperformers at the end of last week, likely as (profitable) short positions put on during the previous protection lifts were closed out. The cash market was much more circumspect, while many had an eye on the new issues of the day. In synthetics, Main and X-Over dropped by 8bp and 22bp respectively, to close at 118bp and 464bp. And that is from levels which were at multi-year highs in the prior session. In cash, the Markit iBoxx IG corporate index was barely tighter, while the HY sector saw more weakness as the index edged up to B+668bp/index yield at 6.43%. The last time we saw these kinds of index spreads/yields was back in early 2013. CoCos have been under heavy attack and have experienced a quite spectacular fall from grace in the space of a few weeks. The chart above shows how the yield on the Markit iBoxx CoCo index has risen by 60%, from a little under 6% at the beginning of the year to 9.6% now. On the issuance front, we had Klepierre print a 10-year maturity for €500m at midswaps+130bp. The €1.75bn book allowed the initial guidance to be lowered, but the deal still offered a 10bp new issue premium and was trading up on the break. United Technologies became the latest US borrower to visit, with a 3-tranche €2.2bn transaction, and the day’s two borrowers took us through the €10n issuance barrier for IG non-financial issuance this year, to just under €12bn.

Have a good week. Back tomorrow.

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.