Credit Market Daily #39 %author %

24-Oct-2022

Good Morning!

Another 2 Day issue – last week proved very difficult in terms of publishing. Normal service is to resume tomorrow.

This week we will return to the Central Bank cycle with the ECB expected to hike 75bps on Friday. We have a raft of PMI data, consumer confidence, Inflation in the form CPIs and the Fed’s favoured measure the PCE.

Additionally, earnings season continues to roll on, and I am focussing on outlooks, how they are handling cost inflation and guidance changes.

This week is heavy in terms of reporting with over 50+ High Yield names reporting including Very Group, Boparan, Ardagh, Chemours, Ineos, Cemex, and Hertz to name a few.

What has Changed?

Liz Truss is Gone, New PM Within the Week
Detail of BoE Auctions
Moodys puts the UK’s Credit rating on Outlook Negative

New Broom Incoming

Liz Truss’ exit marks another step forward in restoring the UK’s fiscal credibility and with it normalising Gilt Yields.

The new Prime Minister will be announced this week and the leadership contest is designed to ensure a smooth handover with only 3 candidates able to run.

Rishi Sunak is the bookmakers’ favourite and would be perceived as a safe pair of hands.

Boris’ announcement he is bowing out of the competition is likely to bouy markets. (Gilst are opening a whopping -20bps tighter across the curve). With Penny Mordaunt being the only other candidate the competition can be decided quickly.

Gilts initially rallied on the news of Truss exit but ended Friday wider with the 10-Year Gilt ending back above 4% (now 3.8%).

Thursday’s price action saw the front end sell off most, with the 30-year the only maturity tighter. Friday’s moves in the Gilt curve saw the belly of the curve underperform.

Some uncertainty remains – will Jeremy Hunt remain as chancellor? Will his new plan still stand at the end of the week? But overall markets like the headlines around the leadership contest.

A more medium-term source of uncertainty is whether a General Election becomes necessary given how unpopular the ruling party is.

The good news is the Fiscal Fiasco Factor (FFF) priced into UK risk continues to decline.

The table below shows the spread between UK CDS (36bps, down from the peak of 49bps) and German CDS is only 8bps and well within 1 standard deviation of the 5-year average.

Looking at the spread between 10-Year Gilts and Bunds we have tightened significantly but remain 2.5 standard deviations higher than the mean of 100bps or on the 98th percentile.

The Gilt-BTP differential is back to normal.

Measure (bps)	Fri 14th Oct	Fri 21st Oct	Change	Spread 5-Year Average	Current Spread Z Score
UK CDS – German CDS Spread	15	6	-9	5	0.12
10 Yr UK Gilt – 10 Yr Bund Spread	199	164	-35	100	3.14
10 Yr UK Gilt – 10 Yr BTP Spread	-45	-69	-24	-76	-0.4

Source: Bloomberg

The bad news is that inflation is running at over 10%, rates will have to rise, the cost of living crisis will not abate for some time and the UK is heading into a recession in 2023.

So, whilst rates may normalise, credit spreads and corporate profits are likely to move higher and lower respectively, over the medium term.

In the very near term, I suspect we will be in a holding pattern until a new PM is announced, with the decline in the FFF seeing Gilts yield normalising further.

The Fed and Bank of England will meet on the 2nd and 3rd of November in less than 2 weeks, and the ECB on the 27th Oct this week.

So Central Banks will exert upward pressure on rates, mainly in the front end with volatility will remain elevated.

No rest for the wicked.

Boe Auctions – “Softly Softly Catchee Monkey”

The BoE posted details on QT for the quarter.

Overall the picture is supportive with the focus on short and medium-maturity Gilts being sold back into the market.

There will be 8 auctions, each selling £750mm of gilts for a total of £6bn which is less than the £10bn expected.

The BoE looks to be firmly moving in the direction it wants but is certainly not looking to cause volatility as it starts tightening its balance sheet.

This is good.

Moodys Puts UK on Negative Outlook

The change in outlook to negative from stable is driven by:
1. Heightened unpredictability in policymaking amid weaker growth prospects and high inflation; and
2. Risks to the UK’s debt affordability from likely higher borrowing and risk of a sustained weakening in policy credibility.
Moody’s, 21-Oct-2022

No real surprises as to why Moody’s is following Fitch and Standard and Poors in putting the UK’s Aa3 (AA-) rating on negative outlook for downgrade.

The good news is that Rating Agencies give a 12-18 month horizon to resolve the outlook.

You can argue that a General Election is the ultimate reset in terms of re-establishing political and fiscal credibility, a new PM with clear party support will go a long way to achieving this.

Credit

High Yield

Week to date the European, Sterling and Dollar High Yield Indices have returned +16bps,+142bps and+33bps respectively.

Year to Date the same indices are down -14.89%, -14.21% and -15.64% respectively.

High Yield has outperformed the main equity indices with the Euro Stoxx 600 down -18.25% year to date, the FTSE 250 down -25.94% and the Russell 2000 down -24.09% over the same period.

Similarly, it has outperformed Investment Grade. Our investor survey expects to reverse this with Investment Grade looking relatively cheap to its high-yield peers on a risk-adjusted basis.

Overall I think we continue to see High Yield outperform Equities, with risk assets heading continuing to head lower, with US equities with the most to catch up to pre-pandemic levels

In terms of spread performance on the back of Liz Truss’s resignation, there was little initial reaction, the Sterling index -3bps tighter (775bps) and the Euro index +2bps (609bps) on the day.

Friday’s price action saw a catch-up with GBP -15bps tighter outperforming EUR and USD which were +8bps and +10bps on the day.

Xover remained flat at 603bps over the 2 days, having been +11bps wider on the day post-UK retail sales, before rallying back with equities.

GBP High Yield Snapshot

GBP High Yield is only 7% off the wides seen in the last 12 months but a whopping 42% from the spreads in the Pandemic.

We discussed whether the Pandemic is the right benchmark in terms of where spreads could go in general in our Investor Survey Webinar and the short answer is yes.

However, I think the path will not be a jerk wider, but a slow rise over the next 3-6 months. (I think spreads of 800-900bps are very possible, 1000+ seems a stretch)

In terms of cheapness – looking at the Z-score of index spreads we touched 2 this week and have dipped back down to c.1.8.

A score of 2 and above is cheap on a standalone basis.

On a relative basis, the ratio of GBP BB/BBB spreads suggests that Investment Grade is cheaper. The 12 Month Z score for this ratio is currently -0.78 and suggests BBs need to cheapen up.

Finally, GBP break evens – spread/duration look attractive at 216bps but still off the Pandemic wides of 250bps.

Whilst medium term I stick with the view we move wider, GBP High Yield could outperform relative to EUR and USD HY given its recent underperformance.

GBP HY Spreads Touched 2 and rallied back to 1.8

BBBs look the better bet compared to BBs, looking at spread ratio Z scores

GBP Breakevens are relatively wide, offering protection, but can get wider

Euro HY Snapshot

Euro High Yield spreads are further from the recent wides than GBP High Yield of 15.6%, with a Z-score of 1.4.

The weighted average cash price of the index is comparable to that seen in the pandemic given the move in yields. The GBP HY index’s price is 7 points below pandemic levels.

With the ECB playing catch up in terms of hikes and the FFF declining in UK risk, it does feel like there is room for EUR risk to underperform on a relative basis near term.

The biggest takeaway when looking at Euro HY is just how cheap EUR Investment Grade credit is.

Compared to high yield. The BB: BBB spread ratio is trading at a Z-score of -2 much less in GBP where the figure is -0.78.

Euro BBBs are unambiguously cheap vs. BBs

Investment Grade

The European, Sterling and Dollar Investment Grade indices returned +41bps. +467bps, -107bps respectively on the week, with the sterling index benefitting from the huge rally in gilts.

As highlighted earlier in the week credit spread moves have been muted this week and overall I think this speaks to the market looking ahead with Central Bank action, earnings and weak economic data weighing on the indices.

The European primary market is open in Investment Grade and the Sterling market is also open for the first time in a month.

Northumbrian Water (Baa1/BBB/BBB) was in the market with a £400m 12-year.

Northumbrian Water was priced at UKT+235, with price talk at UKT+250 and books were a respectable 3x issuance.

GBP Investment Grade Snap Shot

GBP Investment Grade spreads are trading at a 12-month Z-score of 1.8, which is comparable to the move in High Yield spreads.

Spreads are much closer to their pandemic wides – only c.27% vs. 46% for their HY peers.

GBP IG breakevens are actually above pandemic levels at 35bps, whilst GBP High Yield is some way off this.

Sterling Investment Grade look’s cheap on a relative basis vs. GBP high yield.

On a standalone basis, a spread Z score greater than 2 is needed to declare the asset class super cheap vs. today’s cheap/ cheapish.

GBP Investment Grade Breakevens are above Pandemic levels.

European Investment Grade Snapshot

European Investment Grade is even cheaper on a relative basis compared to its high yield equivalent, and its current spread is only 6% off the recent wides which compares to GBP IG’s 15.7%.

In Z score terms, it is closer to the average spread with a score of 1.67 vs. GBP IG’s 1.8. I would imagine (need to do the work) that this is because Euro IG is a much larger asset class than GBP IG and it is less dispersed in general.

Similar to GBP IG breakeven spreads are above pandemic highs at 46, and the index cash price of 86 is well below the Pandemic equivalent of 99 showing how far yields have risen.

So just like GBP IG, there is a case to be made for relative valuations being cheap, but as with GBP IG, standalone valuations suggest there is some way to go to declare the asset class really cheap.

Rates

There was a brief hurray with Gilts initially rallying across the curve Thursday also sending USD and Euro benchmark yields lower. This was short-lived and we had a reversal, with the 30-year being the only tenor that rallied.

On the week the 30-Year Gilt has moved -49bps tighter or c.+6 points in cash terms. Moves across the rest of the curve have been more muted -8bps to -15bps.

Bunds bear flattened on the week whilst treasuries have bear steepened.

The move in Treasuries came as Fed speakers suggested that the pace of rate hikes would be discussed at next week’s meeting (see this WSJ article).

Equity markets took this positively, and rate markets pricing in higher medium-term inflation and lower near-term rates.

10- Year Treasuries, Gilts and Bunds yield 414bps, 380bps and 232bps respectively.

Equities

It was a mixed week for equities with the first half certainly better than the second half.

That said they are up on the week and have outperformed credit and rates (bar Gilts) with technicals remaining in place to support any bear market rally.

Friday saw US equities rally hard into the close on the lower Treasury yields.

This morning’s futures point to a mixed/ flat open with Hong Kong’s Hang Seng index down 6% following Chinese GDP coming in at 3.9% and Xi’s announced 3rd term.

The ECB, the Fed’s preferred inflation measure PCE and the UK leadership contest are likely to dominate in terms of catalysts this week.

Today’s Events

Eco Data

European, UK and US PMIs.

Today’s Reporting

None Today – But a big week ahead.

Credit Market Daily #39