Credit Market Daily #30

05-October-22

So – we might be seeing a softening in the labour market.

We have ADP numbers in the US today and Non-Farm Payrolls Friday and I would look for confirmation/ support of the turnaround from them.

This may mean the “beginning of the end” of hiking is in sight, but this is something that is going to take months to unfold and near-term hikes will not be impacted.

Finally – when we get there it will be because Central Banks have caused a recession in order to kill inflation.

The S&P 500 is still above pre-pandemic highs, liquidity is being withdrawn. Economically, politically and in terms of global security are we in a much better place than we were then?

S&P 500 – still above pre-pandemic levels – is this right?

All of this has not mattered in the last decade given Quantitative Easing. I think central banks want to close the door on this chapter and we are moving towards an era of higher rates and higher inflation.

Either way, we have 3 to 6 months to go in terms of really finding out what the end game is.

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Credit

High Yield

High yield credit has a strong day – outperforming investment grade, but underperforming equities.

European, Sterling and Dollar high yield indices returned +111bps, +102bps and +131bps. Higher beta single Bs and CCCs both outperformed on the back of equities’ sugar high.

In spread terms European, Sterling and Dollar high yield indices moved -26bps,-19bps and -44bps respectively.

Xover was c.-37bps tighter on the day breezing through the 600bps level to end the day at 589bps.

Looking at the raw basis – the difference between Xover’s spread and the Z spread of the European High Yield Index shows that Xover has been excessively cheap relative to history.

In the pandemic blow out the cash index underperformed Xover with the basis hitting extreme lows and then it has steadily risen to Monday’s high before collapsing towards more normal levels.

The 2 takeaways for me are:

1. Implied extreme positioning and or illiquidity was being priced in Xover.
2. Cash spreads have yet to really blow out and are likely to continue their leak wider with the basis normalising.

In terms of catalysts for a violent blowout in cash spreads, I have the use of a nuke in Ukraine, Central Banks overtightening and causing some form of systemic failure or very rapid acceleration of recessionary signals.

None of which are my base case.

Xover-HY Cash Basis:

Leaders and Laggers

Not much to see here except Metal Corp’s continued swan-dive in price on the back of its delay in refinancing €70mm of debt (see default rates discussion in “What Caught Our Eye” below).

Investment Grade

European, Sterling and Dollar Investment Grade returned +41bps, +52bps and +40bps on the day, with spreads -8bps, -6bps and -4bps respectively.

Lower rated A/ BBB credits outperformed.

We saw €7.75bn of new issuance yesterday with EDP (Baa3/BBB/BBB) and Smith and Nephew (Baa2/BBB+) both issuing €500mm, 7-Year deals.

In terms of demand, the Smith and Nephew deal was initially advertised at mid-swaps +225bps and priced 40bps tighter with order books of €4.2bn.

Similarly, the EDP deal was marketed at mid-swaps +175bps and priced at mid-swaps +120, 55bps tighter and order books were €6.5bn.

Order books c.8x and 13x new issue deal size are certainly healthy and bode well for issuance to continue.

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Rates

The Gilt curve continued to steepen, in a continuation of Monday’s price action.

The bank of England bought no long-duration bonds in auction down from the £22mm purchased on Monday and a clear sign that they believe they have created stability in the long end.

Yields declined between -8 and -11bps with the belly tightening most.

10-year Treasuries, Gilts and Bunds yield 363bps, 386bps and 186bps respectively

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Equities

A very strong day for equities across the board was helped by the interpretation of the US JOLTs data and the extremely bearish sentiment and positioning.

European equities were up between +300bps and +400bps on the day, the FTSE returned +257bps.

The S&P500, Dow Jones and Nasdaq returned +306bps,+280bps and +334bps respectively.

At the time of writing futures are down roughly -40bps in the US, and -30bps in the UK and Europe.

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Today’s Events

Eco Data

European, German, Italian, French, UK and US service and composite PMIs and the ADP employment change figures in the US.

Today’s reporting

Grenke

Tesco

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What Has Caught Our Eye

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Default Rates

Bloomberg reports that Moody’s says that default rates in the US and Europe could grow from 2% to 7.8% and from 2% to 6.5% respectively under their most pessimistic forecast.

The main drivers of this would be limited liquidity (ability to refinance) and worsening trading conditions.

Weak documentation – covenants – could be a saving grace for issuers as it will give them more flexibility in how they deal with financial distress. (This is not what you want to hear as a Senior Secured lender)

This article from ING credit puts their base estimate for default rates in Europe and the US at 4.5-5%.

ING see weaker margins on the back of a recession as a main driver of defaults along with inflation and supply chain weakness and the much-increased cost of funding.

Positively, they point to the relatively large amounts of cash that European corporates have on their balance sheet

Rating Agency Default Scenarios

Scenario / Rating Agency	Moodys	S&P
Base	3.3%	3%
Pessimistic	6.5%	5%
Severely Pessimistic	9.4%	n.m.
Optimistic	2.7%	1.25%

“Somewhere between a mild recession and a full recession is in line with the thinking of our own macro-economic experts. Hence when analysing the chart below we look at the difference between the forecasted mild and full recession levels compared to 2019. Thus any sector that has a forecasted leverage below the 2019 level could be considered better set to weather the storm, while any sector that has a higher leverage forecasted above the 2019 level has more of a likelihood to underperfom.”

ING, 23-Sep-22

Leverage Forecast By Sector

Finally, this article from Standard and Poors’ puts historic default rates and the transitions between ratings in context.

We are moving from a low default environment to a higher one, with the pandemic having served to clean out weak companies – the default rate in Europe for ’21 was 0.8%.

A couple of charts that stand out are below. The amount of high yield issuance has increased on the back of easy money:

Regional default rates were worse in Developed vs. Emerging Markets:

Don’t forget that Default rates increase exponentially between rating buckets. Pay attention to High Yield, Investment grade is a snoozefest.

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Florian Kronawitter’s latest post – Tremors

This newsletter is a must-read/ subscribe.

In it, Kronawitter explains why he believes today’s financial system cannot with higher rates and the BoE’s intervention is a sign of things to come, with the Fed likely to be forced to reverse course on tightening given the impact tightening will have on the markets.

Topically, he looks at the scale needed to reduce job vacancies vs. unemployed from its ratio of 2.1x to less than 0.7x historically. This puts the JOLTS euphoria in context:

“Looking at historical precedent, a spectacular recession twice as deep as the financial crisis would be needed to reduce job vacancies by ~5m, for a still tight 1:1 ratio, at which point some slack might be created in the labor market – I am not sure whether this is a realistic scenario“

Florian Kronawitter

For those who don’t have the time to read the article now the conclusion is this:

“Conclusion: Outside of US households, pretty much everyone is overlevered, from EU governments to UK pensions to US commercial real estate. US interest rates will need to rise further to tame inflation driven by US consumer spending. This will cause more turmoil, as overlevered entities struggle to adjust to higher rates. In an interconnected world, this will eventually reach US credit markets, which will likely, eventually force the Fed to pause”

Florian Kronawitter

Performance

High Yield

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Investment Grade

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Rates

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Equities

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