More pain in the credit space
Senior Fixed Income Strategist
While many are off for Easter holidays, hoping that the bad weather that afflicted Europe during the last few weeks is over, others decided to stay in their offices to monitor a market that is not any longer as tamed as we have experienced in the last few years. Last week the Volatility Index spiked again above 20%, taking a toll on equities and pushing the S&P to close 5.80% lower while investors fled to safety, pushing down the yields of government bonds.
While the market was almost certain prior to the FOMC meeting that a hawkish Fed tone would put US treasury yields under further stress, and that the 3% psychological yield of 10-year US Treasuries might be touched, things didn't pan out like this and today 10-yr treasuries are trading with a yield of 2.76%. It is therefore clear that market sentiment is deteriorating and that investors are getting more concerned about the risk that they hold in their portfolio.
Tight credit spreads are screaming to us to open our eyes. With this I am not only referring to the worrying trend of flattening of the yield curve, I am also referring to corporate credit spreads and to the fact that investment grade credit spreads have widened faster than high yield spreads, giving clear signs once again that risk is expensive.
It is a real dilemma for bond investors accepting that IG spreads have been weakening more than HY spreads especially after the volatility recently seen in the market: However, this may simply be because of a worsening of credit quality in this space. At the moment, BBB- rated bonds, the lowest investment grade rating, account for approximately half of the IG market, and the average leverage of companies in this rating category has increased three-fold compared to two years ago.
This has happened as companies have been lining up to take advantage of favourable market conditions by issuing more bonds or refinancing existing debt. To make things worse, the merger and acquisition activity has picked up lately, meaning that IG companies looking to acquire or merge with weaker market participants now would face even higher leveraged than investors accounted for, provoking an increase of yields in this space. A good example can be the planned acquisition of AETNA by CVS. The big pharma retailer issued this month $40bn multi-tranche in order to finance the acquisition, however, investors soon realised that the overall leverage of the group would rise over 4x, thus they felt entitled to more yield.
Highly leveraged investment grade bonds may not be the only lurking risk for bond investors.
Another mysterious thing in the credit space is that people cannot yet explain is the sudden spike in short-term funding rates which normally measure how expensive it is for banks to borrow. The Libor–OIS Spread has been going up to levels previously seen in 2007 and market participants are worried that this may signal distress in the financial space as funding costs increase. Although this is most likely a reaction of the credit market after the intense Treasury bill supply in the short term combined with a gradual policy tightening by the Fed, it is important not to dismiss the trend.
As we outlined in the article published last week, it seems that banks are positioned to benefit from higher revenues amid higher interest rates and the widening of the Libor–OIS spread may be just a transitional moment that will not affect lenders in the long run. However, a rising Libor–OIS combined with a continuous flattening of the yield curve can cause serious problems to the banking sector and intensive business, as on the one hand, the ability of banks to be profitable by borrowing short-term and lending-long term is eroded, and on the other hand, companies suffer liquidity pressures.
Tesla might be a catalyst for a further widening of credit spreads. Moody’s downgraded the company to Caa1 yesterday, addressing concerns about production targets and liquidity pressure. The company issued bonds with a 2025 maturity last August with a spread of 320bps over Treasuries and now they are pricing 450bps over govvies. It seems that there is more room for widening as investors are quickly reassessing risk and investors are not willing to pay high prices for high-leveraged and highly risky businesses.
This should be an important wake-up call for investors. The market is giving plenty of mixed signals and this should be enough to alert investors and force them to open up their portfolio and consider risks objectively.
Among various risks we have identified the following to be the most worrying:
COCOs: These instruments are the most sensitive to volatility and credit degradation. Although since mid-2014 until today they have returned +35% , YTD they are performing poorly due to several factors including increasing interest rates and high volatility in the equity market that provoked a modest selloff of riskier credit names. With credit conditions worsening (look at the Libor-OIS spread and the flattening of the yield curve) we can expect this asset class to suffer bigger losses.
Weaker emerging markets: In the past few years emerging markets have issued more and more hard currency debt. Although the USD has been losing value from the beginning of 2017 until today, the Fed is on course to tighten monetary policy and this should support a stronger dollar in the long run. Tighter monetary policy will also lead to an increase in yields, which combined with a stronger dollar can cause considerable outflows in already highly leveraged economies. Another reason for weakness in this space is the so talked about trade war initiated by the US. This will make developing economies exporting to the US even more sensitive to other factors such as commodity prices.
BBB- rated bonds: as mentioned above, companies in this space have increasingly become leveraged compared to higher graded names. As interest rates are rising we can expect further volatility within BBB- bonds while higher graded bonds should tighten as they are perceived safer.
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