Credit Market Daily #34

11-October-2022

Good Morning!

Testing Times…

Yesterday I joked the UK Gilts were having its own taper tantrum. There looks to have been some contagion with Treasuries also opening higher.

It looks as though Gilts are looking ahead to Thursday when the BoE will remove its backstop and we will find out if the pension funds have positioned themselves to avoid the margin call doom loop that the BoE stepped in to prevent.

The BoE announced a repo facility yesterday. This would help provide liquidity to banks if and when clients are hit with sudden cash calls. A good initiative you would think?

It looks like market participants are looking for a bigger bazooka:

“We suspect the new measures are insufficient and do not fully recognise the long-term nature of the challenges,” said Daniela Russell, head of UK rates strategy at HSBC, who described the BoE’s moves as a “sticking plaster”. She added: “The market reaction so far has been far from encouraging and is a sign of how precarious the situation may still be.”

FT, UK gilts sell off as Bank of England fails to soothe market. 10-Oct-22

I commented that the intervention by the BoE, essential as it was, added more complexity to an already complex situation – akin to adding another spinning plate to a juggler who is already spinning too many.

The BoE still has 3 more days of auctions in which to regain the market’s confidence, it could make a statement about being ready to intervene again and/or it could cave and keep the backstop in place for longer.

The point is this – expect more (with a non-zero chance of a lot more) volatility, but one way or another the BoE will be forced to bring that spinning plate down in one piece. ( As I write, they have just announced they will widen the scope of their purchase programme to include index-linked gilts)

Xover has already widened back out to 650bps which is at the wides of the 550-650bp range I thought we would occupy – there is a chance we touch 670+ without further statements from the BoE.

Given the basis, Xover spread less the Index spread, is still +32 (10yr average -70bps) my thinking is that it is cash credit spreads that need to play catch up.

We also had Brainard and Evans of the Fed speaking at separate events. Their messaging was actually less hawkish of late with Brainard calling for caution and reminding investors that they would be data led.

Evans wants to raise rates at a pace that means they can get to a pause in hikes and avoid overshooting.

Overall the tone certainly was more balanced, but it certainly doesn’t augur a change in expectations for a 75bp hike in November.

(There was a fantastic Blog post by Florian Kronawitter that I flagged in the what we are watching segment of CMD#30, which discusses how Gilts impacted the USD and treasury market and why the financial system will struggle with higher rates – I recommend you have a read if you haven’t already.)

The Q4 HY investor Survey results are out and I will be posting them on the blog page later this morning!

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Credit

High Yield

As yields inflate I wanted to have a look at the Relative value of GBP High Yield vs. European High yield.

Looking at the yield differential between the Bloomberg GBP HY Index and the Euro HY Index – it is 369bps currently, has a mean of 268 bps and a pandemic high of 369bps.

We sit 1.98 Stdev from the mean (the Index history only goes back to 2016).

So close to Pandemic wides and at close to 2 standard deviations GBP high Yield looks cheap and comparable to the pandemic wides.

GBP HY Yield Differential to EUR at series wides

However, looking at the differential in Z-spread GBP high yield looks less compelling.

With the current difference (GBP HY- EUR HY) of +87bps, we are sitting below the mean of +109bps and well below the pandemic wides of +242bps.

When looking at the standard deviation we are on the wrong side of the mean at -0.48 Stdev.

On this basis, GBP HY credit risk looks expensive.

Taken together, along with GBP HY’s overall wider and lower price distribution (see CMD #33) overall I think GBP HY looks relatively cheap to Euro on an all-in-yield basis.

The caveat here is that GBP HY credit risk could underperform materially on any risk blowout and by all accounts should continue to drift wider pointing to yet higher all-in yields.

In terms of yesterday’s moves, high yield continued to outperform rate-sensitive investment-grade but underperformed equities for the first time in a while.

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Market Summary:

The European high Yield Index moved +10bps (Z+615) in line with Xover.

Sterling and Dollar High Yield moved +3bps (699) and +6bps (Z+509) respectively.

The High Yield market is open with Fedrigoni and Enquest out with a Euro and Dollar deal respectively.

The Enquest new issue is to take out its 2023 bonds, which is positive and in line with management guidance.

Leaders and Laggers

MPW look to be down on the back of news they are going to carry out a $500mm share buyback.

Investment Grade

In terms of performance – rates continue to dominate – and Investment Grade underperformed High Yield, as well as Equities in Europe.

The New issue market remained closed.

Now onto something more interesting…

The GBP Corporate Agg Index is yielding 7.12%.

Looking at the spread between GBP and Euro Investmentgrade – the current difference value of 242bps is at the 99.6th percentile or 3.32 standard deviations from the mean of 124bps.

So on this basis, GBP Investment-grade looks cheap.

GBP Investment Grade yields reach recent highs, yield spread between EUR IG is large

However – when we look at credit spreads the relationship is much more normal.

The difference in credit spreads is only 17bps, compared to pandemic wides of 37bps and an average of 28bps.

The IG Z spread differential is less impressive

Like High Yield, GBP credit risk looks slightly expensive relative to European Corps.

Again, given the level of all-in yields, there is some protection against spread widening at these levels. But I do expect credit spreads to drift wider as company fundamentals deteriorate.

So – the caveat of a potential spread blowout on a risk event still holds as it does with GBP high yield.

Finally to round it all off let’s compare GBP high Yield to GBP Investment Grade ins spread terms (duration aside, they share the same benchmark curve).

The current difference Z spread difference GBP HY – GBP IG stands at 461bps, a paltry 0.13 standard deviations from the mean of 429bps.

So GBP investment grade appears to be relatively cheap vs. its HY sibling:

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Rates

Rates had a bad day yesterday with curves all wider on the day.

This morning we are opening up tighter in Gilts, with the BoE announcing it will also buy index-linkers and the 10-year Treasury is back under 4%.

I expect more volatility this week with the BoE keeping a lid on things in the medium term.

10-year Treasuries, Gilts and Bunds yield 396bps, 447bps and 234bps respectively.

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Equities

Equities were down c.50bps in Europe yesterday and are currently -70 to -90bps in Europe and the FTSE is down -115bps.

US futures are down roughly -80bps (despite the softer FED speak)

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Today’s Events

Eco Data

UK Jobs data, Italian Industrial production

Today’s Reporting

None

What Has Caught Our Eye

Why GBP/USD is going lower

This is a good watch – Brent Johnson explains why he expects GBP and JPY to move lower against the USD – essentially you can try and control bond yields and defend FX but ultimately he sees currency as the relief valve that has to give if you central bankers want to avoid causing more mayhem in the bond markets.

GDP Growth is a Much Better Predictor of Earnings Growth than Wall Street

This tweet says it all – long-term company growth cannot outpace GDP and GDP is a much better predictor of Earnings growth than analysts.

Analysts look to be pretty good at predicting revenue, but profit is where analysts have a trickier time (which is fair enough) but interesting to see GDP growth is a much better predictor.

Back to your spreadsheets!

Fed Hikes in Context – not so much Slow and Steady Wins the Race

Mean reversion, earnings growth edition:

turns out (unsurprisingly) using GDP as a proxy for earnings growth is far more accurate than analysts' overly optimistic projections…

h/t @verdadcap pic.twitter.com/QtTkn9iLCT

— Rex Salisbury (@rexsalisbury) October 10, 2022

This is from the always excellent Visual Capitalist. It shows just how brutal the pace of hikes has been compared to history.

Performance

High Yield

Investment Grade

Rates

Equities