10th February 2016

CoCo woes tempt elephant trade

FTSE 100
5,632, -57
8,879, -100
S&P 500
1,852, -1
iTraxx Main
120bp, -2bp
iTraxx X-Over Index
462bp, +2bp
10 Yr Bund
0.23%, +2bp
iBoxx Corp IG
B+187.8bp, +3bp 
iBoxx Corp HY Index
B+645bp, +15bp
10 Yr US T-Bond
1.73%, -2bp

Looking for the next elephant trade?… At the peak of the financial crisis in 2008, parts of the the corporate bond market had collapsed. Tier 1 financial paper was trading at distressed levels and the HY market, very much in its infancy in Europe, had completely closed down, with severe price destruction. On the verge of a global financial catastrophe, the pricing action was coherent and entirely normal. Back then, it was the result of the unwind in systemic leverage bought on by the multi-year CDO/structured product boom, and it left us on the cusp of a systemic tragedy. One could easily argue that the ensuing years illustrate that it was indeed a tragedy. Central banks (the Fed) saved the day as they cut rates hard, effectively poured liquidity into the global financial system – and boom. The recovery in financial assets, with a systemic financial crisis averted, saw to it that 2009 was a great year for the recovery of distressed priced corporate bonds, with a rally of a kind never seen before. From March that year, subordinated debt and high yield markets witnessed ‘option-like’ returns as prices recovered sharply (see chart below). The Markit iBoxx HY index shows that this sector returned over 70% in 2009 as prices recovered off distressed levels (insert link). T1 returns were greater, as core European national champion T1 bank paper recovered from trading down at 20c on the dollar to as high as 90c into the end of 2009. Some will be thinking we might be able to trade a quick turn in the CoCo bond market now. Prices need to drop much further first to replicate 2009 – and they might not. But if they do, we can assure you that a coupon somewhere has been switched off, and there would be panic around the asset class. Anyway, we might be on the cusp of a financial crisis – or an existential one – for this fledgling product class, but the right words somewhere, a miracle return to sustainable growth – or just a miracle – and the hope would be that we rally off the current lows. The temptation to get involved is clear given some of the price action, but the lesson is to wait: prices likely have further to drop, and remember that the decision whether to make coupon payments resides in extremis with the regulator. We don’t think there’s the proverbial “elephant trade” in it yet.

2008-2009: Sub financials collapse and recovery

Weds Chart

Hope dies last… Asia reacted to Monday’s European carnage by playing catch-up and moving sharply lower (Nikkei dropped 5.4%), but offered little new in terms of an additional directional bias for the opening of Tuesday’s session here. Bereft of any meaningful newsflow – although the December industrial production numbers for Germany were a shocker (-1.2% vs expectations of +0.5%) – markets were managing to tread water through the morning session. Then we got direction. Equities, having played out in a narrow range, suddenly dropped on little discernible news. Government bonds were better bid again and the iTraxx indices pushed higher on the follow as protection costs rose. Once again, there was no blaming oil as prices actually held steady for most of the session, brushing aside the IEA’s latest report that the oil glut will only grow this year and prices would sag some more as a result. Stocks led the way, cash credit didn’t really come out for air and the primary market was closed. Some of the moves are ugly, but we haven’t capitulated yet, in a sense it is still too orderly. Hope dies last, but hope is still burning. Whether we go over that cliff, is yet to be seen. Anyway, the European bell-weather index, the DAX, set a new intraday low at 8,772 (at this level it was down almost 20% YTD) while others moved 2% or more lower as any earlier hopes of a calmer “let’s take stock” session were dispelled. The US opened sharply lower, recovered, played out a choppy session finally in the black and gave some impetus to the rest of the markets which then managed to close off the lows.

Impossible to trade, so don’t… As mentioned already, we have highlighted the very volatile nature of the markets in all asset classes. Oil for instance was up for most of the day and has closed some 6% lower for Brent and back with a $30-handle, and lower for WTI ($28.30). The dollar was zooming at $1.13 versus the euro. And with the US$ up at $1.13 it will be extremely unhelpful to the ECB but will likely make any decision to cut the deposit rate further (and more QE) for them much easier. The corporate bond market came under some intense pressure – marked wider quite aggressively, especially in HY. Here, we saw the Markit iBoxx HY index at B+645bp (+14bp in the session) and easily the wides by far for the year (last 12-months). A year ago, we were over 200bp tighter (the default rate hasn’t picked up and supply has fallen). The yield on the index jumped to 6.19%. These are ultra defensive marks. IG was not spared with the index spread up at B+187bp, or 33bp wider YTD. And yet, there would be demand for a new deal. Work that one out. returns in IG credit are still positive! Main closed out a touch better at 120bp and X-Over was a smidgeon higher at 462bp. And after all that, US stocks closed out flat.

That’s enough for now. Back tomorrow. Have a good day.

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.