Credit Strategy With Mahesh Bhimalingham

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August 26, 2020

 The State Of High Yield….

European High Yield Online spoke with Mahesh Bhimalingam Chief European Credit Strategist For Bloomberg Intelligence.

Returns, Vol, Hedges, RV, Defaults and more were discussed. Here is what Mahesh had to say about them:

High Yield In Context

EHYO: “Welcome Mahesh – Thanks for taking the time to be with us today. First off – big picture where is High Yield in the context of the broader markets right now?”

MB: “So I’m very glad to talk about the most interesting part of European credit now. European high yield as you guys know, has taken a pretty big hit when the lock down happened, we lost about 20% of it depending on which index you look at. From that rough, one year hence returns about 2x to 2.25x of what it lost in the crisis. Now we’ve tested it against all the 6/7 crisis we’ve had in history in Europe, and I have to say the relationship is quite amazing. I said near perfect fit literally all the dots line up on the line. I’m not saying this time, it will, but it actually tells you if you lost 20%, you are looking at about 40-45% return from the bottom. Right now, how much have we done till now? We’ve done about you know 20-25% since the trough which means there is still ample return opportunity in in European High Yield.”

Now where are we in terms of in terms of spreads? It may not look a lot compared to the 9% it was at the end of March, but I do believe that 440 basis points gives you ample spread compression. So just to give you an idea. We were at about 3%/300 basis points before Corona happened; so there is 140 basis points of compression opportunity times, duration plus carry we’re looking at c.15%. We probably may not hit the 40-45%. When I said ‘remaining’ from now till March next year, because that’s when the 12 months from that rough end, right? So I’m not as negative as some of the commentators in the market are.”

Positive Drivers:

“The reasons for that are pretty significant. 1. Central bank backstop. 2. Government government bonds, particularly the Bund, OAT, even the GILT, they all pay next to nothing, in fact negative right now. So if you’re a fixed income portfolio manager, especially with the central bank buying government bonds and some corporate bonds. You do not have much of a choice you if you have to perform, you need to be in credit. So yes, investment grade will get bulk of the bid, but once you have made your basic allocation to IG, some of that money will be seeking High Yield, especially we are at 4.4% vs. 9%, it is not so scary as it was then.So that’s Part 1.”

“Part 2. Lockdowns are ending in most of the places everything is reopening. We printed negative GDP growth rates in Q2. I expect most of the European economies to print positive GDP numbers in Q3 because that is on the back of re-openings and fiscal stimulus. And we also had the EU rescue deal. Agreed, despite some heavy odds against it so. Economic good news is upcoming and rel val vs. Govvies remains extremely attractive. Equities have outperformed so much – some of that money is coming back into Fixed Income to protect their capital”

“So you know, I am still looking at, you know, from now until next March,10% plus returns for High Yield”

Defaults – real threat or Bogey Man:

EHYO: Standard and Poors estimate the 12month trailing default rate in European High Yield will peak at 8.5% in June 2021 or 63 issuers vs. the 23 YTD (more than 2009). How do defaults fit in your outlook?

MB: “I strongly disagree with it. I really don’t care, what I care is default within the index, which is what investors invest in. So if you look at the euro high yield index, how many defaults have I seen in the last three four months? Index defaults are very low, so you’re telling me that it is going to be 10 times what we’re seeing right now?”

“I strongly disagree, so I’m I’m not saying the defaults are going to stay at this abysmally low levels. They will pick up, but I get the maximum,. I probably think we’ll see a 4% default rate, not 8.5% default rates, particularly in the index in the index. I don’t think we’re going to see hefty default rates. So overarching, I do not believe that European high end is going to have, you know, very pretty dreadful next six months. In fact, we published on it in our second half outlook. It might be volatile, but it will be positive.”

How to get Long Vol in High Yield:

EHYO: “You talk about volatility, and one of the questions I would have is how does a high yield investor get long volatility. What are the best ways to be positioned for an increase in volatility?”

MB:  “You know what we’ve also published on this in terms of which volatility is more effective for investors to buy, so the three especially relevant for credit investors are equity vol, rates vol, and credit wall. Credit vol tends to be very inefficient in the sense it tends to be very expensive, it tends to be very skewed and very illiquid. If you want to buy options on the itraxx, which is the best [instrument for ] credit vol, the skew tends to be very hefty especially on the buying side.You tend to pay at least 20-30% more than what you should be paying because of the illiquidity.”

What’s the best Hedge:

MB: “Of all the three [equity, rates & credit] and actually the best in terms of bid-ask is rates vol. So I would recommend people who want to be buying vol to look at rates vol. The Cheapest tends to be swaption vol if you want to buy fixed income vol. Credit vol is very low by the way. Itraxx vol is probably 1/3 to half of where it was in June. if you want to hedge, you can partially hedge using the Itraxx, but not fully as you’re not going to get your returns.”

EHYO: “OK, so basically you are saying short Xover, Short Main – those would be the best credit hedges?

MB: “Yes, I mean liquid because, see, index TRS is a niche product. Very illiquid. The most liquid hedging instrument available within credit is definitely the Itraxx indices. You should buy after September. 20th as the role dynamic is going to kick in. What’s going to happen is people know that the new index is going to come in on September 20th. So there is this artificial tightening. Unless unless the world is ending, by the way, of course CDS Indices will widen. But that is extremely extremely rare. It is like once in 10 rolls it rarely happens. So this time, given that Lockdowns are ending and economies are reopening, I expected a traditional roll in which indices artificially tight. Which means if you are short, you’re going to bleed.”

Basis:

EHYO: “What are you thinking about Cash-CDS basis trades and Curve trades as a way to put on credit risk neutral trades that earn you a return?

MB: ” So the Basis has definitely come back quite aggressively from the lockdown which tends to happen. So whenever liquidity is very very poor and you’re in a crisis, high yield cash tends to significantly under perform CDS. Right, so the crude basis was around, you know, 600 basis points then, it is now around 300 basis points. Right, So what has happened?  It has compressed. What do we think will happen in the next 20 days days? I have to say CDS should outperform cash because of the role significant roll down. Six months of roll down happens in in one month basically. So I would expect the 320 basis points differential toblow up to about like 350. After that., I would expect that number to keep grinding down. Just to give you an idea where were pre -Corona: We were around 200 we went to near 700 and now we’re at minus 325, I expected to blow up to 350 then expected to compress later”

Curve Trades – Prefer 5s10s to 3s5s:

EHYO: “What are about curves – anything to do there?

MB :” It’s fantastic!. You are asking me the questions we’ve published today. We pointed out that curves have significantly flat and which is typical crisis behavior, right? The front end sells off big time and hence curves are flatter. If you move further to now, what happened is the curve has gradually steepened overtime, but we’re still nowhere close to what we were pre Corona. So my view is still that curves will continue to steepen. So 3s5s should steepen, 5s10s should steepen. They’re both around 1.7x. They both can get to 2x remember, which is where we were Pre Corona. I’m not saying we’ll get to two straight away, but we will get towards two. Also, the role helps curve steepen significantly because you roll down six months in nearly a month and I just said so the roll should help. I expect the 1.7x spread ratio to get towards 1.85x And after that you know it depends on economic scenario. I don’t think it will get to 2x, but I think there is room for 1.7x-.85x on both 3s5s and 5s10s.”

EHYO: “What is the best way to express the trade?

MB: “If you wanted to put on a steepener I would prefer the 5s10s

Volatility to Pick Up?

EHYO: “As we head into year end there are plenty of catalysts – Hard Brexit, US elections, Resurgence of Covid, Unwind of Government support, default rates creeping, Larger companies have been able to access funding easily, smaller companies less so and lending standards , despite the excess liquidity have tightened. How do you think about these catalysts?

MB: Equity and rates vol have been slowly creeping up. So if you look at the [Move Index] end of July was about 40. Now it’s about 48 is it something to really worry about? Not necessarily, but it could be. Markets are generally starting to price in a bit higher vol, tight rates. Markets are starting to think about it. But overall, you still have to realize you know if you look at the same Move scale, it was around 165 and now we’re at 48, so obviously we’re not in this in that sort of highly volatile regime markets. I would I wouldn’t say are totally complacent. They are aware, and I do believe that.

Technicals Intact:

MB: “Year to date, net or gross apply which or where you want to look at it. Investment grade is at a record while high yield is about 10-20% below last year is not bad. By the way, companies are able to borrow, but it is not as free for all as in IG. I have to say it is recovered. I mean we April May June, April, may were bad for high yield relatively last year. June was good, July was decent. August. Obviously the market shuts down. expect September, October, November to be a decent issuance months once again below but I think you will still see you’ll still see you know 20% less than 2019 and I think that’s a decent volume.”

“The ECB is still buying a 12 to 16/17 billion gross of credit. Now you might say how they’re buying about 100 million plus total. What does 16 billion do? 16 billion does a lot. Trust me. It already holds about 24% all eligible’s right now. Now that brings us to the funding questions that you had. This has led to large corporates to issue, which mostly tend to be ECB eligible if they issue in euros. Being able to issue even even during March, even when wall, even when Corona was in full swing”

Lending Standards – Will Ease as Economy Opens Up:

MB: “Now that brings us to lending standards and what are banks doing now? Any decent size to corporate able to access markets will probably find funding cheaper in the markets, especially true for IG. Also true for some of the benchmark high yield. So for those guys lending standard straightening is less relevant.”

“For SMEs, the ones that are not public, yes, lending standards tends to be the key determinants of defaults going forward. There is pretty good correlation. But as and when economies recover I’m expecting probably another 3 four months as lockdowns completely come off. And hopefully we do not see this reinfection story that people are worrying about. After that, I expect lending standards to ease once again as banks need to do business. Currently they’re not so. It might be a temporary blip”

Brexit – limited Impact:

MB: “I think I think high yield specifically doesn’t care much about Brexit. Because UK based high yield some of it issues in Sterling by the way, so that is not relevant for the euro high yield market. Will it be so disruptive?  You need to realize some of the UK High Yield names are already near bust, so Matalan,Thomas Cook, you know, whatever troubles some UK names they’ve already gone into trouble so I’m not sure Brexit in high yield is going to be the disruptor. As people tend to fear, the main fear is though repeat lockdown. Repeat lockdown is a big worry, yes. But I think given given the government disposition right now, particularly Germany. I don’t think we’re going to get wholesale lockdown in Europe. I don’t think so.”

Government Support:

EHYO: “How do you think about the different government support schemes rolling off will impact High Yield? There is complexity with different countries rolling off or continuing and operating internationally”

MB: “I tend to split these kind of things in 2 parts: Part one is what does? What does all of these dynamics? And what do these dynamics imply for fundamentals? But what does this imply for valuation? There are two different questions, by the way.”

“What matters for valuation is demand and supply. Supply will be down compared to 2019 part one, Part 2, as I just said, if the ECB is buying 15 billion every month. You will expect, with 440 basis points over bunds, I do expect a pretty solid tranche of demand coming into high yield. As a result [of govt scheme unwinds] , fundamentals might not look great this year, but I think valuations will continue to hold, so it’s a bit of a nuanced question.”

“Yes, government fiscal plans which cannot last forever will end and hence they will impact High yield fundamentals a bit more than investment grade part one. But valuations may not necessarily follow their all that all that matters is actually monetary stimulus, not fiscal stimulus. So on  monetary stimulus, I do believe that the ECB will extend one more time,also the BOE, might extend one more time.”

Fallen Angels

MB: “We had a raft of fallen Angels, right? Because, some usual suspect industries like transportation and some of the consumer sectors. Consumer names got downgraded by rating agencies. Then hence fell down from the investment grade indices into High yield Indices. But what happened after May is quite interesting. June, July, August. We haven’t had much. So fallen Angel pace has significantly slowed down. It is probably 1/3 of what it was then. You’re seeing only probably one or two index fallen Angels, right, so? That’s a positive. If you’re an Investment Grade Portfolio Manager. It is also a positive if you’re High Yield portfolio manager because you are not forced to run behind these impending fallen Angels that are coming into your universe and it is sort of like an artificial supply.”

“That, in terms of amount of fallen Angels – the way we look at it is you look at the amount of debt that is rated Triple B minus. Write anything about that you don’t need to worry. So triple B minus there is about 246 billion euros right now, of which. 85 billion euros is on negative outlook with at least. With at least one rating agency. And out of the 85 billion euros, euros, 6 billion euros is on negative watch, which is imminent. Danger of downgrade, but you need to realize the 6 billion [Easyjet, Accor] is less than half of what it used to be, because most of the downgrades that need to happen, whether it is a Shaeffler or whether it is a Valeo.”

“But other than that you know the future fallen Angel potential in the near term seems to be small. People might be looking at, you know, the total fallen Angel count for this year. Yes, we published that as well. Yes, it is a five year record, but you need to dig deeper into it. If you look at the monthly pace as I just said, it is about 1/3 of what it was.”

Fallen Angel Premium – The Valuation Consequences

MB: “More importantly, valuation consequence: the Falling Angel pace has dropped, but if you look at Triple B minus [spredas] versus index valuations, the ratio has significantly crept up. The ratio was around, you know, 1.4x -1.5x now it’s around 1.8x”.

“Another way of looking at it is where is the entire triple B band trading versus the single A Band . Right, the BBB to A has also crept to you know, pretty wide levels. If you look at 2016 to now, and the ECB has more presence, the triple B premium has gone up. what do these two facts tell you? It tells you mark it still is demanding hefty fallen Angel premium.”

“That I have to say is in contrast to default premium. If you look at single B Valuation once is double B. I’m sure this is a future question of yours. No, so single B versus double B valuation has significantly compressed.”

“Now look at the dichotomy. Single B versus double B has compressed while Triple B versus Single A has widened. What does that tell you? It tells you that market is not as scared of default risk as it is scared of falling Angel risk right now. Even though Falling Angels are also dropping, just like defaults, the premium for fallen Angels hasn’t gone out. While premium for defaults has compressed significantly.”

Duration Risk – Falling Angels, BBs and IG tourists?

EHYO: “How are you thinking about duration risk in High Yield as we get supply from fallen Angels, BBs catch a bid from investment grade investors?”

MB: “Great, very good question. I am actually genuinely worried about duration risk going up, particularly in IG. Rates vol as as I just mentioned is my main worry rather than credit vol and duration keeps going up and going up, thanks to all this new issuance. It is not very encouraging if you are an IG portfolio manager.”

“IG duration went up to an All Time High. It just came down thankfully, but is still very high. The same worry is not as true in high yield because we tend to actively refinance through calls, right? So the duration doesn’t tend to be that high. In fact, highly index duration is sort of middling because we look at from 2016 to now. Now, the reason why I keep saying 2016 for any historical analysis is. QE started in 2016. I tend to look at that as the new regime we are in. So if you look at one 2016 why he duration is somewhere in the middle. It is not too high.”

“So how do we play duration in investment Grade Investment Grade? I do believe that you probably need to hedge the rate risk. Because rate moves are expected to be a lot deeper in the second half. The Bund is expected to widen a bit. The Gilt is also expected to widen a bit. All this is not going to look good in total returns. For high yield it’s less of a worry, you know because we have half the duration. Also, historically we are not that high. For high yield, I wouldn’t panic much on duration risk, but in IG I think you have to hedge.”

Cyclical Rotation?

EHYO: “When do you think Investors will start rotating into more cyclical sectors? How are you observing that/ observe that?”

MB: “You know this rotation tends to be, you know, in and out. Whenever we publish our monthly we we learn ourselves what’s going on. Yes, cyclical sectors have underperformed. Right? and also the sectors which have a lot of subordinated debt like insurance, underperformed, I am talking with in high yield, by the way, so transportation insurance, consumer underperformed. But now I have to say that catching up so transportation, insurance and consumer cyclical have been best sectors for probably two months in a row. Markets tend to be very, very dynamic on that in terms of news. So the terms of where we are doing on the virus and so on. So it’s very difficult to just call a sector for a six month view. It does, that seems to be very in and out. Monthly.

Nimble Allocations:

EHYO: ” Does that surprise you? High Yield is thought of as an illiquid asset class, is it a function of cash balances?”

MB: “Thanks to the recovery and also banks having black record quarter in Q1 thanks to the vol. Also very good Q2, liquidity on bank trade around desks is pretty good actually. Right now I mean, not in August – I am talking about all the other months, is not that bad so as a result I think people were able to get in and out. Also remember the dodgy sectors did not issue much. As a result, I think people were able to get in and out depending on what the news is.”

Main vs. Crossover Ratio at the Highs:

EHYO: “Crossover to Main has reached high levels, I know this is something you have flagged”

MB: “We have hit all time high 6.4x on raw, as was 6.2 and it just fell to about 6x-5.9x and adjusted with crossover. Did recover, but the roll is coming up and the roll down in Main is a lot steeper than the roll down in crossover, so I don’t think we’re going to compress anymore. Until September 20th. Then the new series 34 will come up. And then you will see some compression in Xover versus Main, not now. So for the next 20 days 20 you are going to have this artificial ratio widening, even maybe 5.9 can go to six, but after that you will see compression assuming things are like what they are right now, you know no major lockdowns. Vaccine is getting developed, equities are alright, and so on.With the ECB Buying you will see compression after after September 20th but not now.

What Are High Yield Investors Missing?

EHYO: “As a strategist what is the most important metric or the most under underrated kind of analysis that you find when you’re talking. to High Yield Investors?

MB:”The most underrated thing is the [thing ]high yield folks tend to completely ignore, because they tend to be obsessed with balance sheets. And you know, covenants and so on. I totally sympathize with them. No, I totally want I think the right word is a. I feel a bit sad at [them] not looking at what is going on outside, which is essentially driving their world.”

“What’s happening with rates? What’s happening with ECB? Buying? How much government bonds are they buying? What is that leading to an raves and how much are they [ECB] buying in corporates? People tend to think ‘yes they are buying IG, but they don’t buy high yield’. It’s not going to influence us. Not true.”

What they [ECB] buy in investment grade has its significant indirect influence on what happens in your world. So if I’m high yield investor, please please pay attention to what where the Bunds first thing.Two, How much is the ECB buying in corporates? We publish a monthly deck you just read out that that’s fine. That will keep you up to date completely. How much are the buying? How much in primary? How much in secondary? How much of existing eligible’s do they hold? How much available issuance are they buying in their primary pocket? What percentage of QE every month, is corporate QE? All of this has a massive consequences on how credit trades.

High Yield doesn’t trade, especially given that its a puny 350 billion market. You don’t trade as an island. You trade off IG so keep an eye on that.

And that is the key driver, by the way, a full stop.”

Mahesh Bhimalingam

Mahesh Bhimalingam is the Chief European Credit Strategist for Bloomberg Intelligence. He covers European Credit markets, across all shades of Investment Grade, High Yield and Leveraged Loans.

Based in London, Mahesh has 19 years of experience covering Global Credit and Fixed Income across Developed and Emerging Markets. Prior to joining Bloomberg in 2019, Mahesh worked as the Global Macro Strategist for Numen Capital, a multi-strategy hedge fund identifying macro situations across developed and emerging markets. Before that, he was Global Head of Emerging Market Credit Strategy and Head of European Credit Strategy at BNP for nearly 5 years.

Preceding BNP, he was Head of European Credit Strategy at Deutsche Bank for 3 years. He spent 5 years at Barclays Capital where he was Head of Leveraged Finance Strategy and a European Credit Strategist. At the beginning of his career at Lehman brothers, he was a Mortgage trader and Structurer, an Emerging Markets Strategist and a European Credit Strategist. Mahesh brings extensive knowhow of credit derivatives and credit-equity-rates macro linkages across geographies to the BI franchise.
Mahesh holds a MBA from IIM (Indian Institute of Management) Ahmedabad and a B.Tech Engineering degree from IIT (Indian Institute of Technology) Madras.

 

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