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STATE OF AFFAIRS
A fragile state of stability got hold of the markets last week. The Investment Grade (IG) corporate bond sector took the lead in this market restoration. This bodes well, as it might allow us to avoid the complexities of a credit crunch and a resulting insolvency crisis.
Primary issuance experienced a record-breaking week, as EUR 40 billion of new paper has been introduced to the market. The oil and gas sector was responsible for about a third of this volume (TOTAL, BP, OMV and SHELL). The glut in new issues over the past two weeks puts year-to-date EUR issuance at 115 billion, a truly unprecedented amount.
The EUR High Yield (HY) primary market has been closed for 6 weeks now. Price discovery remains challenging. Rating agencies have increased their downgrading efforts across financial and non-financial issuers. The HY ratings drift (i.e. the difference between upgrades and downgrades) has hit a depressing low of -25%. The low in ratings drift during the global financial crisis (GFC) of 2008-2009 was -35%. Last week’s Euro area composite PMI print of 29.7 (down 22 points from February) seems to indicate that we will most probably revisit these lows. Today, the PMI weakness has been led by the services component. This is, again, in stark contrast with the GFC, where manufacturing was leading the slide. In the US we observed a reopening of HY primary issuance, a small positive. EUR HY Default expectations for 2020 range between 6% to 8% (compared to 7% realized during the GFC). The markets will require fiscal support over the next two to three years in order to prevent high and sticky future default rates.
The ECB’s Corporate Sector Purchase Program has had a highly favourable impact on eligible corporate bonds. The performance gap between eligible and non-eligible paper is likely to be persistent.
The dividend freeze across the banking and insurance sectors, as per the advice of the ECB, was spread supportive for senior paper of tier 1 financial institutions. Financial credit of Tier 2 or Tier 3 smaller institutions continues to underperform. The picture across Tier 2 dated subordinated paper has been mixed. Bullet Tier 2 outperformed callable structures as call probabilities went down. Uncertainty across AT1 paper remains significantly high. If this deeply subordinated sector priced extension risk higher, we have not reached the bottom by far. Pencil in another 5pp to 10pp drop if banks do not call their outstanding AT1 capital.
As in 2008-2009, we have observed a higher sense of urgency by the US central bank. Although we applaud the ECB’s efforts, it pales against the FED’s aggressiveness. Not only has the FED used almost all the tools in its arsenal, its measures’ repercussions have had a global reach. The FED wanted to stabilise the rout in USD liquidity and funding across emerging market (EM) economies. In doing, so it cemented the USD as the world’s one and only true reserve currency.
US 10 year rates closed the week at 60bp, down 7bp compared to Friday, 27 March. US 30 year wrapped up at 1.20%. However, as expected, the main message was that rates volatility came down a lot. Most central banks have engaged in QE. As a result, this has created a situation that can be characterised as global ‘implicit’ yield curve control. We expect that, once market participants have accepted that rate setting across the yield curve is in the hands of central banks, there will be a further period of rate volatility suppression. The MOVE index (the VIX index for bond markets) dropped to a 1 year average of around 75bp after an extreme high of 164bp on March 9. US TIPS were not as strong as they had been the previous week. However, the FED has been highly active in this sector as well, and we expect that break-even rates will continue their ascent once the US COVID-19 infection growth rate flattens out. Since the US has been lagging, we expect this to occur by the end of April, or early May. We call for neutral duration positioning in US Treasuries.
German 10 year closed at -45bp. The ECB purchase program was unable to keep intra-EMU spreads stable. Italian, Spanish and Portuguese spreads to German bunds widened. The opening made by the Dutch prime minister to offer temporary help by funding a corona debt instrument is nothing less than an insult for badly stricken countries in the South of Europe. There is a sense of tiredness among EMU government bond investors. Not even a humanitarian crisis of this scale can get EMU heads of state to agree on a robust and long-term fix. Yet institutional investors demand a European safe asset, as well as a highly liquid Eurobond market with sufficient depth. A market size between EUR 1 trillion to EUR 2 trillion would not only push EMU member countries to increase the responsibility of their funding programs, but the increased credibility of the European Stability and Growth pact would also reassure investors. In the meantime, the ECB will be required to do the heavy lifting by trying to smother small bushfires. Effectively, the ECB’s balance sheet has already mutualised EMU government debt. Confronted with a political status quo, the ECB president Lagarde will be pushed to increase intervention if she wants to avoid a sequel to the 2011-2012 European debt crisis. Within the EMU government bond sector we manage around the duration neutral point.
EUR and US IG corporate bonds have received our vote of confidence. We assess that, at current spreads, 250bp in EUR IG and 300bp in US IG, investors are correctly rewarded for the balance sheet and debt risk. We stick to our 225bp-275bp predictions for the remainder of 2020. However an early positive inflection point in the COVID-19 pandemic might temporarily push spreads below this bracket. In the longer term, we expect that IG credit spreads will seek a higher, more comfortable Credit Risk Premium (CRP). Today’s 250bp CRP is appealing compared to the 90bp we established on February 1. Beyond the 2020 COVID crisis, a 125bp to 175bp CRP range might clear funding requirements across financial and non-financial issuers.
EUR HY credit spreads tightened another 30bp this past week, even though the Itraxx Crossover index closed markedly higher at a spread of 608bp. One wonders to what extent the spreads have priced in defaults over a twelve month horizon. In order to find out, we have measured the average remuneration for investments in the HY market over and above the defaults: a HY “risk premium” calculation, so to speak. This risk premium has been around 287bps for European HY on average. With current spreads hovering around 800bp, and assuming a 35% recovery rate, the HY market prices in a one year default rate of 9%. Historically, one year default rates of over 9% have been very rare. As stated earlier, during the GFC, we reached a peak of 7% in the 1 year default rate. It is worth noting that people tend to look at 2008 as a framework which indicates how defaults could evolve going forward. We feel that this comparison is not completely correct for two reasons. Firstly, the structure of the market is different. Back in 2008, the lowest-rated companies (CCC and below) that were more prone to default, made up 12% of the indices, whereas now, this is only 4.6%. BB-rated companies now represent roughly 64%, whereas in 2008 that was only 53%. As such, the quality of the index has greatly improved. Secondly, in 2008, a lot of HY debt had been issued by aggressively financed leveraged buy outs. This is less the case today.
Emerging bond markets further stabilized last week. Local currency spreads (GBI-EM) tightened another 5bp to 485bp. Hard currency IG remained unchanged at around 360bp. Broad hard currency (EMBIG) widened 15bp (to 665bp), and Sub-Saharan Africa spreads in hard currency by 30bp (to 1010bp). Low-quality issuers, with high levels of USD liabilities, continued to widen. Outflows stabilized and EM ETF’s saw small inflows from retail investors.
EM FX in EUR terms experienced mixed results. The South African Rand (-3.2%), Mexican Peso (-2.4%) and Hungarian Forint (-2.4%) were the bottom performers, and the Russian Rouble (+6.0%), Peruvian Sol (+5.5%) and Philippines Peso (+3.8%) were amongst the top performers.
Apart from rate cuts, more and more EM countries have started to use other (non-conventional) tools, ranging from a distribution of food packages, external assistance (e.g. from the IMF) to full central bank QE. Countries with better healthcare systems and more accommodative fiscal and monetary policies will fare a lot better than those which do not have the capabilities to adequately contain the virus and lack the policy space to act decisively. Consequently, we have never been as selective, and patiently hold on to our high-quality defensive portfolio.
Another week has passed and we have concluded that markets have found some ground at the margins. The week ahead will be shortened by the upcoming long Easter weekend. Companies will also enter black-out periods as they prepare for Q1 results season. The US leads Europe in this regard. One should expect that the primary issuance glut will start to taper. As such, secondary credit markets might get some respite as they face less new issue premium pressure. Expect more stability in government bonds. High idiosyncratic risk will remain present in HY.
Economic data that will be published over the next 3 months will be appalling to both the EU and the US. The negative news flow with its talks of a global recession, has mostly been priced in by fixed income markets. However, we should not exclude another push lower in US long rates. Looking beyond the short-term, we can state that the shape of the economic recovery will decide the length of recovery across financial sectors.