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Still negative directionally and defensive on a relative basis
Despite hopeful headlines on European policy developments over the past
week, we remain skeptical that comprehensive new measures are
imminent. The policy response to escalating market pressures looks
destined to be administered in small doses until there is no other choice
but to respond more aggressively. This policy path implies that volatility
and spreads will remain elevated for the foreseeable future. For longhorizon
investors who can endure mark-to-market volatility, we think
current valuations are getting more attractive, especially in light of the
robust state of corporate balance sheets. Even if the economy experiences
a mild recession, we do not expect defaults and downgrades to be
remotely close to their previous peaks. We maintain our negative
directional bias and defensive posture on relative value, favoring BBB nonfinancials
in IG, and favoring higher-rated credits in HY.
European bank spreads: Bond indices understate the pressure
Relative to the peaks of the post-Lehman period, European bank cash
spreads today are higher than what bond indices would suggest. This is
due to evolving compositional differences, both by country and by rating,
between the cash market today vs. 2008. After controlling for maturity,
rating and issuer country, we show that both covered and senior
unsecured bond spreads are trading well above their peaks of 2008 and
2010 – in contrast to simple index comparisons, which appear to show
spreads still below their peaks. We do not think this situation can continue
for long without eliciting a more muscular policy response than we have
seen to date. We think the best (and perhaps only) way to do this is by
injecting additional capital into the banking system. We are watching for
signs of this policy development more than any other.
Europe still stands in the way of spread tightening
The European sovereign debt crisis, alongside softer global growth, remains the
overwhelming top concern of market participants (and ours as well). We continue to think
that pressure on European and US banks resulting from the European sovereign debt crisis
will prevent any sustainable rally in credit spreads. As we often point out, sovereign risk and
slower growth are mutually reinforcing. For this reason, we are feeling incrementally more
pessimistic about the policy challenges that lie ahead due to today’s downward revision to our
house view for economic growth – especially for Europe, where we are now calling for
recession by the end of 2011 (“World growth slows as Europe stagnates,” Global Viewpoint,
Oct. 3, 2011).
To briefly summarize these views, our economists now expect global GDP growth to slow to
3.5% in 2012 (from 4.2% previously). By region, we now expect GDP growth in 2012 of 1.4% in
the US (from 2.0% previously), 0.1% in Euroland (from 1.3% previously), and 7.3% in the BRICs
(from 7.8% previously).
In addition to creating additional headwinds for global risk appetite, the slower growth outlook
poses special problems for Europe. This is because it implies an even more challenging set of
fiscal choices, especially in the periphery economies, and thus narrows the range of feasible
policy choices. Until we see more solid evidence of decisive policy measures, we will keep our
negative directional bias and continue to recommend defensive credits on a relative basis. In IG,
we favor BBB non-financials vs. financials. We also remain relatively bearish on HY vs. IG, a
view that we are currently expressing via our long CDX IG vs. CDX HY decompression trade.
Finally and within HY, we favor the high end vs. the low end of the market and still recommend
expressing this view via our short CCC CDS basket vs. CDX HY trade.
Against this increasingly challenging economic backdrop, a number of new policy options
are circulating in the wake of the G20/IMF meeting last week. These include larger-thanexpected
haircuts on the Greek debt (and subsequent recapitalization associated with this)
as well as plans to “ring fence” Greece and other program countries to prevent spillovers
to Spain and Italy. The proposal that appears to have gained the most traction is leveraging
the EFSF through the ECB. But as Huw Pill explained in last week’s European View
(“European crisis measures -- weekend developments in Washington,” Sept. 25, 2011), an
imminent new package of bold measures seems unlikely. In particular, proposals to modify
the scope of the EFSF face resistance from German officials.
The risk, in our view, is that policy remains constrained by domestic political
considerations, resulting in only incremental policy measures. The record to date suggests
that half measures can buy time, but ultimately they give way to a saw-tooth escalation of
systemic fears. This policy path strongly suggests that spread and volatility will remain
elevated for the foreseeable future. For long-horizon investors who can endure mark-tomarket
volatility, we think current valuations are becoming more attractive, especially in
light of the robust state of corporate balance sheets. Even if the economy experiences a
mild recession, we do not expect defaults and downgrades to be remotely close to their
previous peaks.
Our view remains that pressure on corporate credit spreads will persist until market
concerns about the fragility of banks are addressed. We continue to think the best way to
do this is by injecting additional capital into the banking system. We are watching for signs
of this policy development more than any other.
If not for Europe, we would be much more constructive on current valuations (see “Bearish
on spreads, bullish on fundamentals”, The Credit Line, Sept. 16, 2011). In the short-term,
however, funding conditions for banks need to normalize before volatility can fall and allow
“search for yield” motives to resurface. And as we show below, the evidence on the
pressures facing European banks in the bond market looks quite bleak at the moment
A closer look at European banks’ long-term funding cost
In our August 19 Credit Line (“Growth down, risk off”), we argued that in contrast to the
fourth quarter of 2008, money markets are less likely to be the epicenter of a crisis this time
around. This view remains intact and we think this is an important reason why the severity
of a double dip recession would be milder than in the fourth quarter of 2008 (see also the
arguments in “How much downside?” US Economics Analyst, Sept. 30, 2011).
Indeed, some of our favorite metrics for short-term funding stress (e.g., commercial paper
issued by foreign financial institutions and large time deposits on US subsidiaries of
foreign banks) appear to be falling at a slower pace, presumably due to the reactivation of
the USD swap line between the Fed and the ECB. Since we expect future policy will remain
similarly aggressive with respect to future signs of money market distress, we think there is
(much) less risk that the funding market will freeze up as it did in 2008, and hence much
less risk of a sharp spike in credit defaults and spreads.
That said, we think current spread levels and declining equity values pose an unsustainable
risk to the European banking sector. The pressure is clearly visible in the CDS market,
where the iTraxx Senior Financial index has recently traded close to all-time highs (see
Exhibit 1, darker line). In the cash market, by contrast, index-level spreads appear to paint a
somewhat less gloomy picture. For example, the spread on the iBoxx senior unsecured
bank index, though clearly wide at around 285bps, is nonetheless 75 bps below its post-
Lehman recession peak of 360 bps (see Exhibit 1, lighter line).
But there is more to this evidence than meets the eye. Anecdotal evidence on individual
bank bond spreads led us to suspect that the relative resilience of the cash market might be
an artifact of evolving compositional differences, both by country and by rating, between
the cash market today vs. 2008. Anecdotal evidence also suggested to us that many banks
in the periphery countries were replacing senior unsecured bonds with covered bonds in
their capital structures. These “survivorship” and “substitution” biases, if large enough,
would obviously understate the pressure on senior unsecured markets.
We find that such biases are in fact large. To control for the above biases in the index, we
used a large cross-section of benchmark covered and senior unsecured bank bond spreads
from the EUR iBoxx index constituents. We then use factor regressions to construct bond
portfolios having similar characteristics (country, maturity and rating composition).
Exhibit 2 plots the change in spread levels since January 2007 using indices that control for
these compositional changes. In contrast to the (relatively) comforting impression
conveyed by Exhibit 1, our indices show that, adjusting for compositional differences,
banks’ covered bonds and senior unsecured bond spreads are trading near record-high
levels, well above their peaks reached during the post-Lehman period.
To further investigate the effect of compositional changes by country, we constructed
domestic bond portfolios having similar characteristics in terms of rating, maturity and the
same weights of covered vs. senior unsecured bonds. Exhibit 3 shows the pressure is
elevated across the board, with Spain and Italy deteriorating the most.
The current trajectory of spreads suggests to us that systemic risks continue to escalate at
a robust pace. We do not think this situation can continue for long without eliciting a more
muscular policy response than we have seen to date. Our view is that such a response will
ultimately come, particularly given that senior bank debt ranks pari-passu with deposits in
most European jurisdictions. However, in assessing when we might expect such a policy to
arrive, we think the answer remains “not yet”. The greater risk is that policy makers,
constrained by domestic political considerations, will be forced to err on the side of doing
too little rather than doing too much. And we think policy will likely continue on this path
until the fear of market collapse exceeds the fear of domestic political considerations. We
therefore remain bearish on the near-term direction of volatility and spreads.
We conclude by noting that despite the fairly ominous implications of Exhibits 2 and 3,
short-term funding pressures on European banks have been alleviated by their access to
ECB repo funding. This is one reason why we are not holding our breath for a “shock and
awe” policy moment. If current market trends continue, as our European economics team
thinks likely, the number of banks wholly dependent on ECB repo funding will likely
continue to grow.
While this funding support from the ECB likely reduces the short-term risk of systemic
shocks, it also reduces the incentive to make politically difficult policy choices. Such policy
inaction likely implies higher long run risks. It could, for example, remove banks from
market discipline, allowing them to accumulate higher future losses. Or put in credit terms,
we think the ECB's short-term funding policies will meaningfully reduce short-term "jump"
risk by shifting the risk further out the curve.
If policy makers abandon the ECB to a position where it is forced to choose between
providing continued funding to banks and sovereigns versus precipitating a potential
systemic event by refusing such funding, we think it will continue to choose the former. But
sooner or later, policy makers will face incentives to act. In one possible scenario, a greater
number of banks on ECB “repo life support” could force greater recognition that policy is
failing, and hence higher odds of political consensus for a more sustainable policy
response.
But until more powerful incentives of some sort emerge to elicit more decisive policy
action (which may yet arrive on the back of rapidly escalating market pressures), we are
braced for wider spreads and greater volatility.
Trade recommendations
Open: Short CCC CDS basket vs. CDX HY16 at a 1:1 ratio. In our August 19, 2011,
Credit Line “Growth down, risk off”, we recommended buying protection on a basket
of 16 CCC-rated names and selling protection on CDX HY16. The trade reflects our
concern that the anemic trajectory of final demand could cloud the growth outlook of
the broad economy and thus pressure the over-leveraged low-end of the HY market.
Open: Long CDX IG16 vs. CDX HY16 at 3:1 ratio. In our August 19, 2011, Credit Line
“Growth down, risk off”, we recommended going long a CDX IG16 vs. CDX HY16 at a
1:1 ratio. The trade reflects our view that the rapidly declining growth expectations and
the rising sovereign pressures would likely persist. In such an environment, we think
IG will likely continue to outperform its beta to HY.
Our views across credit
Downgrades, defaults and recovery rates. We forecast that the US 12-month trailing HY
default rate will hit 3.2% by the end of 2011. This benign view on defaults reflects the
outperformance of the corporate sector relative to the broad economy as well as the
accommodative stance of monetary policy. Consistent with our low default rate forecast,
we expect the average recovery rate on unsecured debt to be near its historical average of
around 40%.
Ratings. We continue to recommend the “down in quality” trade for investment grade
nonfinancials. We are comfortable with the fundamental risk in wider spread names since
corporate balance sheets are in good condition and corporate profit growth in both the US
and Europe has been outperforming GDP growth. On the other hand, we would move
higher in quality for speculative grade bonds amid a larger tail risk distribution. Our
concern is that the low end of the HY market could be disproportionately affected by the
sporadic large outflows. We think risk-reward tradeoffs are more favorable in double-Bs
and single-Bs.
Sectors. We think financials offer the best value among investment grade credits, however,
we would move up in quality. Financials are clearly a high-beta sector in this recession and
recovery, and they have the most exposure to the tail risk of any escalation of the crisis in
Europe. But longer term we maintain our long-standing view that, as a net result of the
evolving regulatory environment, financials will eventually trade tight to non-financials. In
HY, we think the interaction of slow growth and rising pressure on European sovereigns
and banks will continue to put the most growth-sensitive areas of the market under
pressure.
CDS-cash basis. The CDS-cash basis has slightly backed up in the past few weeks. We
think the negative macro basis reflects pressures on bank capital and hence on the effective
funding terms available for basis trades. Risks to bank capital have recently been
increasing as macro conditions soften and the European sovereign debt crisis once again
faces negative headwinds. The CDS-cash basis will only resume its tightening trend once
the ongoing pressures start subsiding.
Structured credit. Leveraged loans and CLOs have been underperforming over the past
few weeks. While we think that fundamental default risk in AAA CLO tranches is low, the
on-going pressures on the banking system are likely to weigh on near-term performance.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Still negative directionally and defensive on a relative basis
Despite hopeful headlines on European policy developments over the past
week, we remain skeptical that comprehensive new measures are
imminent. The policy response to escalating market pressures looks
destined to be administered in small doses until there is no other choice
but to respond more aggressively. This policy path implies that volatility
and spreads will remain elevated for the foreseeable future. For longhorizon
investors who can endure mark-to-market volatility, we think
current valuations are getting more attractive, especially in light of the
robust state of corporate balance sheets. Even if the economy experiences
a mild recession, we do not expect defaults and downgrades to be
remotely close to their previous peaks. We maintain our negative
directional bias and defensive posture on relative value, favoring BBB nonfinancials
in IG, and favoring higher-rated credits in HY.
European bank spreads: Bond indices understate the pressure
Relative to the peaks of the post-Lehman period, European bank cash
spreads today are higher than what bond indices would suggest. This is
due to evolving compositional differences, both by country and by rating,
between the cash market today vs. 2008. After controlling for maturity,
rating and issuer country, we show that both covered and senior
unsecured bond spreads are trading well above their peaks of 2008 and
2010 – in contrast to simple index comparisons, which appear to show
spreads still below their peaks. We do not think this situation can continue
for long without eliciting a more muscular policy response than we have
seen to date. We think the best (and perhaps only) way to do this is by
injecting additional capital into the banking system. We are watching for
signs of this policy development more than any other.
Europe still stands in the way of spread tightening
The European sovereign debt crisis, alongside softer global growth, remains the
overwhelming top concern of market participants (and ours as well). We continue to think
that pressure on European and US banks resulting from the European sovereign debt crisis
will prevent any sustainable rally in credit spreads. As we often point out, sovereign risk and
slower growth are mutually reinforcing. For this reason, we are feeling incrementally more
pessimistic about the policy challenges that lie ahead due to today’s downward revision to our
house view for economic growth – especially for Europe, where we are now calling for
recession by the end of 2011 (“World growth slows as Europe stagnates,” Global Viewpoint,
Oct. 3, 2011).
To briefly summarize these views, our economists now expect global GDP growth to slow to
3.5% in 2012 (from 4.2% previously). By region, we now expect GDP growth in 2012 of 1.4% in
the US (from 2.0% previously), 0.1% in Euroland (from 1.3% previously), and 7.3% in the BRICs
(from 7.8% previously).
In addition to creating additional headwinds for global risk appetite, the slower growth outlook
poses special problems for Europe. This is because it implies an even more challenging set of
fiscal choices, especially in the periphery economies, and thus narrows the range of feasible
policy choices. Until we see more solid evidence of decisive policy measures, we will keep our
negative directional bias and continue to recommend defensive credits on a relative basis. In IG,
we favor BBB non-financials vs. financials. We also remain relatively bearish on HY vs. IG, a
view that we are currently expressing via our long CDX IG vs. CDX HY decompression trade.
Finally and within HY, we favor the high end vs. the low end of the market and still recommend
expressing this view via our short CCC CDS basket vs. CDX HY trade.
Against this increasingly challenging economic backdrop, a number of new policy options
are circulating in the wake of the G20/IMF meeting last week. These include larger-thanexpected
haircuts on the Greek debt (and subsequent recapitalization associated with this)
as well as plans to “ring fence” Greece and other program countries to prevent spillovers
to Spain and Italy. The proposal that appears to have gained the most traction is leveraging
the EFSF through the ECB. But as Huw Pill explained in last week’s European View
(“European crisis measures -- weekend developments in Washington,” Sept. 25, 2011), an
imminent new package of bold measures seems unlikely. In particular, proposals to modify
the scope of the EFSF face resistance from German officials.
The risk, in our view, is that policy remains constrained by domestic political
considerations, resulting in only incremental policy measures. The record to date suggests
that half measures can buy time, but ultimately they give way to a saw-tooth escalation of
systemic fears. This policy path strongly suggests that spread and volatility will remain
elevated for the foreseeable future. For long-horizon investors who can endure mark-tomarket
volatility, we think current valuations are becoming more attractive, especially in
light of the robust state of corporate balance sheets. Even if the economy experiences a
mild recession, we do not expect defaults and downgrades to be remotely close to their
previous peaks.
Our view remains that pressure on corporate credit spreads will persist until market
concerns about the fragility of banks are addressed. We continue to think the best way to
do this is by injecting additional capital into the banking system. We are watching for signs
of this policy development more than any other.
If not for Europe, we would be much more constructive on current valuations (see “Bearish
on spreads, bullish on fundamentals”, The Credit Line, Sept. 16, 2011). In the short-term,
however, funding conditions for banks need to normalize before volatility can fall and allow
“search for yield” motives to resurface. And as we show below, the evidence on the
pressures facing European banks in the bond market looks quite bleak at the moment
A closer look at European banks’ long-term funding cost
In our August 19 Credit Line (“Growth down, risk off”), we argued that in contrast to the
fourth quarter of 2008, money markets are less likely to be the epicenter of a crisis this time
around. This view remains intact and we think this is an important reason why the severity
of a double dip recession would be milder than in the fourth quarter of 2008 (see also the
arguments in “How much downside?” US Economics Analyst, Sept. 30, 2011).
Indeed, some of our favorite metrics for short-term funding stress (e.g., commercial paper
issued by foreign financial institutions and large time deposits on US subsidiaries of
foreign banks) appear to be falling at a slower pace, presumably due to the reactivation of
the USD swap line between the Fed and the ECB. Since we expect future policy will remain
similarly aggressive with respect to future signs of money market distress, we think there is
(much) less risk that the funding market will freeze up as it did in 2008, and hence much
less risk of a sharp spike in credit defaults and spreads.
That said, we think current spread levels and declining equity values pose an unsustainable
risk to the European banking sector. The pressure is clearly visible in the CDS market,
where the iTraxx Senior Financial index has recently traded close to all-time highs (see
Exhibit 1, darker line). In the cash market, by contrast, index-level spreads appear to paint a
somewhat less gloomy picture. For example, the spread on the iBoxx senior unsecured
bank index, though clearly wide at around 285bps, is nonetheless 75 bps below its post-
Lehman recession peak of 360 bps (see Exhibit 1, lighter line).
But there is more to this evidence than meets the eye. Anecdotal evidence on individual
bank bond spreads led us to suspect that the relative resilience of the cash market might be
an artifact of evolving compositional differences, both by country and by rating, between
the cash market today vs. 2008. Anecdotal evidence also suggested to us that many banks
in the periphery countries were replacing senior unsecured bonds with covered bonds in
their capital structures. These “survivorship” and “substitution” biases, if large enough,
would obviously understate the pressure on senior unsecured markets.
We find that such biases are in fact large. To control for the above biases in the index, we
used a large cross-section of benchmark covered and senior unsecured bank bond spreads
from the EUR iBoxx index constituents. We then use factor regressions to construct bond
portfolios having similar characteristics (country, maturity and rating composition).
Exhibit 2 plots the change in spread levels since January 2007 using indices that control for
these compositional changes. In contrast to the (relatively) comforting impression
conveyed by Exhibit 1, our indices show that, adjusting for compositional differences,
banks’ covered bonds and senior unsecured bond spreads are trading near record-high
levels, well above their peaks reached during the post-Lehman period.
To further investigate the effect of compositional changes by country, we constructed
domestic bond portfolios having similar characteristics in terms of rating, maturity and the
same weights of covered vs. senior unsecured bonds. Exhibit 3 shows the pressure is
elevated across the board, with Spain and Italy deteriorating the most.
The current trajectory of spreads suggests to us that systemic risks continue to escalate at
a robust pace. We do not think this situation can continue for long without eliciting a more
muscular policy response than we have seen to date. Our view is that such a response will
ultimately come, particularly given that senior bank debt ranks pari-passu with deposits in
most European jurisdictions. However, in assessing when we might expect such a policy to
arrive, we think the answer remains “not yet”. The greater risk is that policy makers,
constrained by domestic political considerations, will be forced to err on the side of doing
too little rather than doing too much. And we think policy will likely continue on this path
until the fear of market collapse exceeds the fear of domestic political considerations. We
therefore remain bearish on the near-term direction of volatility and spreads.
We conclude by noting that despite the fairly ominous implications of Exhibits 2 and 3,
short-term funding pressures on European banks have been alleviated by their access to
ECB repo funding. This is one reason why we are not holding our breath for a “shock and
awe” policy moment. If current market trends continue, as our European economics team
thinks likely, the number of banks wholly dependent on ECB repo funding will likely
continue to grow.
While this funding support from the ECB likely reduces the short-term risk of systemic
shocks, it also reduces the incentive to make politically difficult policy choices. Such policy
inaction likely implies higher long run risks. It could, for example, remove banks from
market discipline, allowing them to accumulate higher future losses. Or put in credit terms,
we think the ECB's short-term funding policies will meaningfully reduce short-term "jump"
risk by shifting the risk further out the curve.
If policy makers abandon the ECB to a position where it is forced to choose between
providing continued funding to banks and sovereigns versus precipitating a potential
systemic event by refusing such funding, we think it will continue to choose the former. But
sooner or later, policy makers will face incentives to act. In one possible scenario, a greater
number of banks on ECB “repo life support” could force greater recognition that policy is
failing, and hence higher odds of political consensus for a more sustainable policy
response.
But until more powerful incentives of some sort emerge to elicit more decisive policy
action (which may yet arrive on the back of rapidly escalating market pressures), we are
braced for wider spreads and greater volatility.
Trade recommendations
Open: Short CCC CDS basket vs. CDX HY16 at a 1:1 ratio. In our August 19, 2011,
Credit Line “Growth down, risk off”, we recommended buying protection on a basket
of 16 CCC-rated names and selling protection on CDX HY16. The trade reflects our
concern that the anemic trajectory of final demand could cloud the growth outlook of
the broad economy and thus pressure the over-leveraged low-end of the HY market.
Open: Long CDX IG16 vs. CDX HY16 at 3:1 ratio. In our August 19, 2011, Credit Line
“Growth down, risk off”, we recommended going long a CDX IG16 vs. CDX HY16 at a
1:1 ratio. The trade reflects our view that the rapidly declining growth expectations and
the rising sovereign pressures would likely persist. In such an environment, we think
IG will likely continue to outperform its beta to HY.
Our views across credit
Downgrades, defaults and recovery rates. We forecast that the US 12-month trailing HY
default rate will hit 3.2% by the end of 2011. This benign view on defaults reflects the
outperformance of the corporate sector relative to the broad economy as well as the
accommodative stance of monetary policy. Consistent with our low default rate forecast,
we expect the average recovery rate on unsecured debt to be near its historical average of
around 40%.
Ratings. We continue to recommend the “down in quality” trade for investment grade
nonfinancials. We are comfortable with the fundamental risk in wider spread names since
corporate balance sheets are in good condition and corporate profit growth in both the US
and Europe has been outperforming GDP growth. On the other hand, we would move
higher in quality for speculative grade bonds amid a larger tail risk distribution. Our
concern is that the low end of the HY market could be disproportionately affected by the
sporadic large outflows. We think risk-reward tradeoffs are more favorable in double-Bs
and single-Bs.
Sectors. We think financials offer the best value among investment grade credits, however,
we would move up in quality. Financials are clearly a high-beta sector in this recession and
recovery, and they have the most exposure to the tail risk of any escalation of the crisis in
Europe. But longer term we maintain our long-standing view that, as a net result of the
evolving regulatory environment, financials will eventually trade tight to non-financials. In
HY, we think the interaction of slow growth and rising pressure on European sovereigns
and banks will continue to put the most growth-sensitive areas of the market under
pressure.
CDS-cash basis. The CDS-cash basis has slightly backed up in the past few weeks. We
think the negative macro basis reflects pressures on bank capital and hence on the effective
funding terms available for basis trades. Risks to bank capital have recently been
increasing as macro conditions soften and the European sovereign debt crisis once again
faces negative headwinds. The CDS-cash basis will only resume its tightening trend once
the ongoing pressures start subsiding.
Structured credit. Leveraged loans and CLOs have been underperforming over the past
few weeks. While we think that fundamental default risk in AAA CLO tranches is low, the
on-going pressures on the banking system are likely to weigh on near-term performance.
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