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The Home Stretch - High Quality Credit Spreads

FICC Podcasts Nos Balados 30 novembre 2022
FICC Podcasts Nos Balados 30 novembre 2022

 

Disponible en anglais seulement

Dan Krieter and Dan Belton discuss whether the recent rally in credit will be sustained into the new year or is merely another bear market rally. Other topics include 2023 supply projections in high grade and SSA markets, preferred positioning along the spread curve, and the potential for a wave of rating downgrades in 2023.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello and welcome to Macro Horizons High Quality Spreads the week of November 30th, the home stretch. I'm your host, Dan Krieter, here with Dan Belton as we discuss the durability of the recent rally and credit into year end and begin to lay out our expectations for the path of corporate supply in 2023.

Each week, we offer our view on credit spreads, ranging from the highest quality sectors such as agencies and SSAs to investment grade corporates. We also focus on US dollar swap spreads and all the factors that entails, including funding markets, cross currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode, so please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at dan.krieter@bmo.com. We value and greatly appreciate your input.

Well, Dan, after an impressive rallying credit spreads, 10 straight sessions of narrowing following the release of the October CPI report, spreads have finally taken a bit of a bounce here and moved a couple basis points wider in the past of couple days. But all told, since year today peaks on October 12th, spreads are something like 30 basis points narrower now, and I think it's instructive now to view the recent rally and spreads in the context of the other bear market rallies we've had in 2022 to try and figure out if this is just another one of those and spread's going to go wider again from here or if we have now put in the peaks for the cycle.

So one key differentiating factor in the current rally versus the three previous ones of this year is we have started to see a significant improvement in primary market executions, really, for the first time this year. And that's despite heavier than expected supply during November. It's not going to go down as one of the heaviest Novembers of all time, but it's going to finish in the top five.

Dan Belton:

 

Yeah, and relative to expectations, certainly, we expected about 75 billion in supply in November. We sit here on the last day of the month and we are at 101 billion in gross issuance and that beat in supply has been made possible, certainly, by a much more favorable primary market reception to this issuance. We've had new issue concessions have averaged around 11 basis points this year. Over the month of November, they've fallen to about six basis points. Certainly, the most supportive month in primary markets in quite some time and I think a lot of this has been driven by the risk on sentiment following the October CPI print, coupled with the Fed's willingness to downshift to 50 basis points, the market taking that as some sort of pivot. We'll see what we get from Powell both this afternoon and then later on in December with the much anticipated FOMC meeting.

But I think it's worth noting here that if credit spreads continue to trade sideways are a little bit wider from these levels. The level at which they bounced earlier this week at 130 basis points in the Bloomberg Barclays Index and 140 basis points or so in the ICE BofA Corporate Index is very similar to levels where credit spreads bottomed in the other, you call them, bear market rallies and credit that we had in June and August. So I think that's worth noting just that this is about the narrowest credit spreads have traded in the second half of this year after bouncing at similar levels earlier in June and August.

Dan Krieter:

 

Yeah, it's a good point. Looking at the chart and spreads, that does form a very clear resistance level now, in terms of credit spreads at those levels you laid out and you talked about the performance in primary markets. It's been very impressive, but I want to talk a bit about some of the secondary market metrics during this, rather, which haven't been nearly as supportive. And to talk about those, I'm going to rely a little bit here on trace volume data, which gives us the breakdown of client sells versus client buys in the IG market every day. And sitting here on the last day of November, we're going to close with the heaviest proportion of clients selling since July. And that's saying something in a year that's been typified by, obviously, more clients selling than buying and November's going to go down as one of the heaviest months of client selling.

So from that vantage point, the recent rallying credit hasn't had as much durability, perhaps, underneath? I don't want to rely too much on those numbers. The historical correlation between client flow and spreads is not super strong. I mean, it's in the context of a 0.2 Correlation, so not nothing, but not a extremely predictive variable. But it's worth noting, at least in the context of dealer IG inventories, which are now near their highest levels of the year, and I think that's notable heading into the end of the year when obviously, dealers are trying to get balance sheet down ahead of year end window dressing. That's supported historically with December being, by far, the largest month of reduction in dealer inventories of the year. That's not surprising.

But given where we are with elevated dealer inventories and unlikely that's going to come down before the end of the year, that says, to me, that we could see some weakness in credit spreads in the weeks ahead and we turned neutral last week after a tactical overweight. We turned overweight in anticipation of credit investors sort of viewing the Fed's down shift in the path of rate hikes to 50 basis points as something of a Fed pivot that's played out. Now, as we look ahead, we have some technical weakness into the end of the year.

Dan, how are you viewing the path for credit in the next, say, three months?

Dan Belton:

 

Yeah, so before this rally really extended to a 30 basis point peak to trough, I thought credit would probably drift mostly sideways or even be pretty well bid into year end, just given generally supportive technicals. December is one of the more supportive months of the year for credit, and I thought that would likely carry credit into year end. And then in January, we might look to set some underweight positions.

But given how far this rally has gone, I'm expecting credit will most likely drift a little bit wider into year end. I don't think there's going to be any significant widening. I think the highs in credit spreads for the year are probably already in, but if we had to pick a level wider or narrower than current levels into year end, I'd probably expect credit spreads will finish the year a little bit wider than here, maybe around the 150 basis point or so level in the ICE index.

Dan Krieter:

 

Yeah, I could see a bit of a leak wider here, just given the technical factors talked about before, but I'm with you that I don't expect any outsize widening in credit into year end. And I think, looking ahead to next year, I think we get off to a pretty strong start to the year in credit, but perhaps the most important thing in credit markets now is that we're going to start transitioning into a new regime for what's going to move credit markets. We talked about this on a podcast a few weeks ago, but I think the conviction behind the idea is even stronger now that credit spreads spent much of the year reacting primarily to the path of inflation and the path of the Fed in its fight against inflation. And now with the Fed downshifting to 50 paces point rate high cadence and slower from there and whether terminal ends up on this side of 5% or slightly above, it's likely not going to make a huge difference either way.

Now, the market transitions away from trading inflation in the Fed to now beginning to trade the outlook for growth corporate earnings and whether or not the Fed is going to be able to achieve a soft landing. So when viewed in that context, I think optimism for a soft landing can stay elevated here for at least the next couple months. I think from the fundamental side, corporations are going to remain relatively well supported at least through the first quarter. So I think even if we get a bit of a backup between now and the end of the year, I think they could be retraced rather quickly in the beginning of 2023 and then it will depend on the path of corporate fundamentals and earnings. And I think that's where we continue to maintain a more bearish view in the long-term.

Dan Belton:

 

Yeah, and that's really the traditional driver behind typical credit spread widening events is a deterioration in corporate fundamentals, whether you look at it through earnings or through rating actions. And when we look at net rating actions on the corporate market as a whole, not just the investment grade market, which remain very supportive, but investment grade and high yield, we're starting to see rating actions deteriorate by their most since the end of 2020. And it seems very likely that this is just the beginning of what's likely to be a more substantial grading downgrade cycle as it trickles in from just the high yield space more and more into investment grade.

And so there's a very strong correlation between credit spreads and rating actions, and it's actually also a very timely correlation. If we look back at recent peaks in credit spreads, credit spreads typically peak around the same exact time that rating actions peak. So spreads don't necessarily front run rating actions. It's more that they happen contemporaneously. And if we expect rating actions to continue to deteriorate as the impact of the Fed's hiking cycle becomes more and more pronounced on corporate fundamentals, then it's likely that the next material move for credit spreads still lies wider.

Dan Krieter:

 

And just to support that point of view, looking at indicators of just pure credit risk, and I think IG CDX is the best way to look at that. CDX spreads are now trading about the midpoint of the year and well below not just the peaks of, say, 2008 or 2020, but also other periods of economic slowing, 2011, 2012, 2015, 2016, even 2018, which really wasn't a material slowdown as much as a fear of one. And we're below those levels from a purely credit concern standpoint. And I think, given what the Fed has told us that they're going to remain in restrictive territory for much longer than market participants have grown accustomed to, in fact even the pivot to 50 basis points in terms of rate high cadence has been met with a lot of easing in financial conditions, something that the Central Bank told us, explicitly, they didn't want to see the market due in response to the turn into 50 basis points.

So financial conditions are going to remain very tight, and I think that in the long-term, we have to see that credit concern component grow, but I don't think that's going to happen until Q2 at the earliest, maybe even Q3 of next year, which should give us an opportunity for some out-performance in credit in the beginning part of the year. So I think that's really what informs the neutral view on credit, and I'd actually rather express a view on the shape of the credit spread curve at this point, rather than the outright direction because I think that there's a pretty strong argument to made that the spread curve will likely flatten going forward for both technical and fundamental reasons.

First, on the technical side, I talked about the increase in dealer inventories for their highest levels of the year over the past few weeks. Since September, 70% of that increase in dealer inventories has come in the one to five-year bucket. So if we do see dealers start to reduce inventories and shrink balance sheet into the end of the year, it stands to reason that the front end of the curve is going to be more impacted just given that that's where dealer holdings are. And then from a fundamental standpoint, if we are seeing this idea that the Fed is pivoting and that the peak and absolute yields might be at the highest levels, we should start to see some more demand for longer duration from an all-in yield perspective.

And then even looking further into the future, if we start to see an increase in credit fears, we know that that should result in a flattening spread curve as well as near term credit concerns, obviously, are more pronounced at the front end of the spread curve. We've already seen the short-end belly spread curve flattened about 12 basis points in the past two months, but it's still at elevated levels compared to history, so I think that flattening tread could continue. So that's probably my favorite view on spreads at the moment as we maintain a neutral outlook for spreads in the near term.

And then I think for the rest of the episode here, we can talk about some of our expectations for supply in 2023. We're beginning to put together our estimates for where corporate supply will land in '23 with supply for the rest of the year likely to be very light, I think only 20 or 25 billion for the rest of the year.

So I'll kick it to you to start with the IG market. Maybe talk about some of the main themes in 2022 supply, as well as what you expect to change or what will be similar heading into 2023.

Dan Belton:

 

Sure. So we sit here on the last day of November, and we have had $1.21 trillion in gross investment grade corporate issuance. We're expecting, like you said, another 25 or so billion, which would bring us to 1.225 trillion. And that puts us on track for the lightest year of issuance since 2019, both in terms of gross and net supply. So as we look back on 2022, I think you could most appropriately characterize the year in terms of investment grade issuance as very inconsistent and volatile, much like the broad market backdrop that we've seen this year. What I mean by that is if you look back at the monthly issuance, we've had some months featuring extremely heavy supply. We had the first quarter was the third heaviest quarter of supply on record. And then November, August have also featured very heavy issuance, but other months have been very light after the strong first quarter. The second quarter of this year was the lightest Q2 in a decade. September was also extremely light after being, typically, one of the heaviest months of issuance.

And before we dive into our estimates for 2023 supply, I think it's instructive to go through some of the themes that dominated high grade issuance markets in 2022. In particular, there's three themes that I want to talk about that were very prevalent this year. The first is risk aversion, second is volatility, particularly interest rate volatility, and the third is financial issuance. So with respect to risk aversion, we have seen very prolonged risk aversion in primary markets in 2022. We've had new issue concessions of 11 basis points on average in 2022. That's the highest we've seen in any year by quite a bit. The long-term average is about five basis points. And if you were look at the monthly average new issue concessions and rank them since 2016, we'd see that this year has seen the third, fourth, fifth, sixth, seventh and ninth highest average monthly new issue concessions. [inaudible 00:13:02] March and April of 2020 were really the only months that saw higher new issue concessions than this year.

So that's just a long and drawn out way of saying that not only were primary market executions unstable this year, but they were weak for a much longer period of time than we've ever seen before. And we saw that risk aversion particularly strongly among triple Bs. Triple Bs averaged an additional three basis points of concession over the rest of the market in 2022. And that's not typical of the dynamic we see in issuance markets. Over the long-term, triple Bs price to about the same concessions that other high grade corporates do. And this risk aversion actually led to less issuance from triple Bs. Triple Bs usually make up about half of high grade issuance markets. This year, they've accounted for only about 39% and that figure dropped to as low as 33% from July through October. So this risk aversion that we've seen throughout most of 2022 has led to some very durable differences in issuance patterns.

The second theme I want to talk about is interest rate volatility and how that's impacted primary markets. Interest rate volatility has led to a lot less supply than we're typically used to. We track the number of days, excluding Fridays, that bring no high grade issuance. We saw 43 of those this year, and that's 10 more than even the worst year of the Financial Crisis in 2008. And it's 18 more days of no issuance than we saw during any year since the Financial Crisis. This also resulted much less liability management. So calls and tenders of about 225 billion this year is the lightest that we've seen in almost five years. So this higher rate environment has led to a lot less activity, both on the issuance side and on the liability management side. And if we expect the Fed to remain on hold for much of 2023 as we do, that's probably going to spill into less issuance next year.

Finally, financial supply has been the dominant theme in issuance markets this year and for much of 2021 as well. We attribute most of that to QE, which has led to growing bank balance sheets, but this has likely already started to reverse as of the fourth quarter of this year, and we're expecting financial supply to start to normalize into 2023. So with respect to our 2023 issuance forecast, we're looking for between 1.25 and 1.3 trillion in gross IG supply next year, so modestly higher than we saw this year. We're looking for similar maturities next year, about 650 billion, and then marginally more active liability management. We're looking for about 250 billion in calls and tenders next year. So this spells about a 4% increase in that issuance.

And then just briefly, as for the drivers of supply next year, higher rates are likely to reduce issuance through two avenues. First, it's going to lead to less refinancing activity, and it's also going to disincentivize leverage among corporate borrowers. M&A activity is going to remain light next year as it was for most of this year, and then debt issuance for the purposes of stock buybacks is also going to spell lighter issuance than we've seen in years past.

In terms of the risks to this view, the biggest risk to potentially much higher supply than we saw this year would be a durable economic downturn that would lead to a recession causing borrowers to want to increase their cash holdings in the face of uncertain revenue streams. And this would be exacerbated by extremely light cash holdings among the corporate borrowers we track that have declined pretty steadily since the onset of the pandemic, and that's going to be an important theme to watch into the early part of 2023. But overall, the cross currents are roughly neutral in terms of pointing to light or heavy issuance, and we're expecting just modestly higher IG supply next year.

Dan Krieter:

 

Great, thanks, and I'll just take a second to focus here on the SSA market, which had very similar drivers in 2022 that you laid out. Very light supply in SSAs. That's potentially an even more important consideration, given the impact that technicals has on the path of SSAs spreads. This year, we saw -54 billion in net SSA supply this year, easily the lowest amount we have on record and for the same drivers you laid out when talking about IGs.

Looking ahead to next year, SSA supply is going to be dictated by just two things, primarily, which is the size of borrowing programs from the SSA issuers and then the state of the cross currency basis and whether or not [inaudible 00:17:16] looks attractive to supernational and foreign organizations. And both of those factors should be roughly unchanged from this year. I think borrowing programs are going to see some variability, but there's going to be a lot of crosscurrents that cancel each other out.

I think if you look at the European borrowers, we're going to see heavier borrowing from some of those European SSAs with larger borrowing programs as Europe deals with an energy crisis and potentially, some more intervention on the energy front in Europe. But that should be offset to at least some degree by some lighter borrowing from some of the larger SSA borrowers who aren't focused on Europe, some of the supranationals, some of the Canadian provinces. We've seen borrowing programs come down pretty strongly among the [inaudible 00:17:50]. So net and net, I think that roughly cancels out and we should see borrowing programs roughly similar to 2022 size in the new year.

And then looking at the currency basis, I mean this year the basis was mostly neutral for most of the year. We had some periods where the dollar was attractive and then later on in the year, euros and other foreign currencies became a bit more attractive. I think looking ahead to 2023, there's an argument to be made that we should see dollars decline in attractiveness at the beginning of the year, but looking further ahead into the midpoint of next year and farther, if we see a global economic slowdown that starts to deepen, obviously, the dollars should become a more attractive funding currency. So I really think both of the two main factors that drive SSA supply are pretty neutral, so I'm expecting gross issuance in SSAs in 2023 to be roughly similar to 2022, but with less redemptions in next year. Net supply will increase. It should still be mostly supportive at or around zero, maybe slightly negative, but still strong at the -54 billion we saw in 2022, so a modest headwind from the technical perspective on the supply side for us [inaudible 00:18:52] in 2022.

But really, the big consideration for me with SSA technicals is the state of demand and what that means for January, which is obviously always the largest month of SSA supply of the year, by far. We talked earlier about the improvement in IG executions over the past couple months, particularly during the rally. It hasn't been that way in SSAs, even in covered bond executions, which are typically bought by SSA-type buyers because we know that the main buyers of SSAs, which are central banks and banks, have been somewhat constrained in their demand.

Central banks' demand for US seller assets has been notoriously light for the past couple months as central banks have been more in defense of little currencies. That could and likely will begin to change at the beginning of 2023, but it may not change in time for the big January supply wave. And banks, obviously, their demand has been a bit light, given large debt security portfolios that have substantial losses in them and the potential for some risk weighted asset constraints. So we've seen concessions for SSAs continue to increase while IG executions have improved. And I think even though demand from central banks and banks should improve in 2023, it may not be in time for the January supply wave.

And it's worth mentioning here, sort of the calendar perspective for January, looking ahead at 2023, is a bit more challenging. Lunar New Year holidays are going to fall in January this year, once again, earlier than normal. And we know that that's an important consideration for SSA borrowers, which means there's not that many open windows, if you will, for January. We could see the first half of the year, in particular, any open window be pretty crowded with SSA supply. And then given the headwinds for demand, I think you could see new issue concessions in the SSA market at pretty considerable levels for the January supply wave. So for SSA spreads, I think the leak wider we talked about for spreads in general into year end, I think that could continue in January. It might represent a pretty attractive buying opportunity for SSA investors if concessions are as elevated as we think they could be in the first month of the year.

So obviously, a lot to unpack there, but I think we could just end with the formal supply projection for the US seller SSAs in the $200 billion range next year compared to 185 billion or so this year by the time the end of the year rolls around, and that translates to that supply of between -10 and -15 billion versus -54 billion in 2022.

Well, Dan, I think that wraps up our episode for today, but for anyone who's still listening, first of all, thank you and congratulations. And second of all, quick programming note that we are going to be gone next week. We have a monthly podcast with the whole team midweek next week, so we'll be back in two weeks with our formal 2023 outlook for credit spreads.

Dan Belton:

Thanks for listening.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider.

This show is supported by our team here at BMO, including a FICC Macro Strategy Group in BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Dan Krieter, CFA Directeur, Stratégie sur titres à revenu fixe
Dan Belton Vice-président - Stratégie sur titres à revenu fixe, Ph. D.

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