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Under the Hood - High Quality Credit Spreads

FICC Podcasts 20 juillet 2022
FICC Podcasts 20 juillet 2022


Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the recent recovery in credit spreads and whether market technicals have fully rebounded. Topics include the return of high grade supply and what it means for future issuance, record low primary dealer positions in corporates, and the impact of net client selling interest.


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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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Disponible en anglais seulement

Dan Krieter:
Hello, and welcome to Macro Horizons, High Quality Spreads for the week of July 20th. Under the hood. I'm your host, Dan Krieter here with Dan Belton. As we take a deeper look at the recent rallying credit spreads and discuss why the improvement risk sentiment may not be as strong as it seems.

Dan Krieter:
Each week, we offer our view on credit spreads ranging from the highest quality sector 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 email directly @dan.krieter. K-R-I-E-T-E-R @bmo.com. We value and greatly appreciate your input.

Speaker 2:
The views expressed here are those of the participants and not those of BMO capital markets, it's affiliates or subsidiaries.

Dan Krieter:
Well, then it's been two weeks since our last appearance here on the High Quality Spreads edition of Macro Horizons. We had a full team round table last week. And I must say that in the two weeks since our last recording, things have improved remarkably, especially considering last week's CPI report, you wouldn't have thought that would be a bullish indicator for spreads but we have seen a significant improvement.

Dan Belton:
Yes. Spreads are about 15 basis points narrower than they're year to date highs which they touched in the first full week of July. And we're really coming off of these levels that were driven by technicals primarily. We talked a lot about the technical weakness in the high grade market. Specifically over the second half of June into when spreads touched their highs on July 5th. Credit spread index is we're out about 21 basis points while IG CDX, was only four basis points wider over that period. So we really saw this reluctance to add on new positions and credit feed into secondary market spreads. We had very light supply for all of the second quarter and that really culminated with light issuance in June. Net selling and secondaries according to trace data was really prominent in June as well. And just a really down our tone that fed into market technicals in the IG market, really culminating in the end of the second quarter. Things have gotten a little bit better now. I still wouldn't call technical supportive, but things are looking somewhat rosier in the high grade market.

Dan Krieter:
Yeah, we talked last week on potentially turning bullish on credit spreads in the long term while maintaining a near term bearish view. And a big reason for that bearish view was the state of technicals. And you mentioned then, they have improved significantly. And certainly the primary market has thought this week being the best example of that with a supply that's going to end up approaching 40 billion. The heaviest week in the primary market since the week ending June 3rd. And it's not just that issuance has come back. I mean, we've seen demand metrics also improve, concessions have come in. And this week, we're on track to finish with concessions in the low double digits which, well from an absolute level, still not very supportive. It's certainly better than what we've seen in the past two months. So things are getting better.

Dan Belton:
And it's not common that we talk about heavy supply, meaning supportive technicals. But really in the current environment, we've seen such light supply due to reluctance of investors to add new positions and really elevated new issue concessions averaging 20, 25 basis points week over week. And so just the reopening of primary markets is counterintuitively a positive development for credit.

Dan Krieter:
Yeah, but I do think we should look a bit under the hood and try to figure out if we are out of the woods here. Because it's only last Monday that we saw MUFG and BPCE group come to market with two financial issues that averaged 27 basis points in concession. Which was the highest concessions we have in a single day with at least five billion in issuance since early 2016, excluding the pandemic, of course. And that was only a few sessions ago. So it's difficult to say, we're for sure out of the woods yet. And let's talk about what supplies come since then. At the end of last week, we had a Pepsi deal that was very well received from the market. And this week it's been almost entirely American banks now out of earnings blackouts, coming to market as they do every quarter, which is highly anticipated. Investors are ready for it with money to put to work and so we've seen those deals go well.

Dan Krieter:
But one Pepsi deal and then this week's swath of financial supply, maybe not indicative of the entire market. And today we have IBM in the market. Another very highly rated, very stable corporation. I'm sure that deal will go well, but we haven't really yet seen marginal triple B borrower hit the screens or a borrower in a more recession exposed sector or something like that. So it's certainly been an encouraging step for primary markets in the last week. I'm just not yet ready to wave the all clear flag.

Dan Belton:
Yeah. I mean, you said it. The largest US banks, the JP Morgan, Bank of America. Those guys, they're really liquid borrowers. They don't really ever have issues tapping the market and those deals typically go very well. At least in the context of prevailing market conditions. Low things, new issue concessions for those borrowers, not surprising in the current environment. I think it'll be very telling to see how much more supply we get into the end of the month than into August. And how many of these marginal borrowers as you call them, are willing to step out there and test the waters and see how those deals really go.

Dan Krieter:
Yeah, it would seem like now is the time. And so if issuance doesn't pick up meaningfully here, I think that does send a signal that perhaps the amount of supply that we perceive to be out there that's been waiting for calmer markets, isn't really there. We already lowered our projections for IG supply this year from 1.5 down to 1.3 trillion. Even that could prove optimistic if we don't see borrowers start coming to market in a much more meaningful way going forward. But to go back to a second to talk about the under the hood theme of this episode. It hasn't just been in primary markets where you can caveat the recent performance and credit spreads. Also looking at secondary market metrics, the strength of the rally and secondary spreads, hasn't been supported by demonstrable end user demand. And to demonstrate that, we lean on trace data which has shown maybe more net selling than you'd expect in a rally of the degree we've had.

Dan Belton:
Yeah. The second quarter actually had the most net selling as a percentage of total client activity of any quarter since this data has been published since the end of 2015. In July, that net selling figure has gotten a little bit better, but still towards the lower end of historical ranges. But obviously, a bearish indicator there where we're seeing end user activity focused on selling to dealers and corporates. Not what you typically, you see in a rally.

Dan Krieter:
Even this week, which has been generally risk on, we saw a big equity rally yesterday. I think the biggest equity rally in three weeks. We've seen net selling in the two days of this week of 58% and 57% by end users. So we haven't seen a big increase in end user demand. Rather, this week's rally has been primarily dealer driven. Now I want to talk a bit about that because the most recent print we got from the FED's data series on net positioning is that, corporate inventory at dealers touched their lows since the data series began publication in 2013. The lowest on record. So typically when we see low dealer inventories, that's associated with end user demand and is generally a bullish signal for credit spreads. And to that point, if you look at 2015 until 2021, which we use that time period for a few reasons. First, 2015 is when we can say bachelor regulations were now in full effect.

Dan Krieter:
And so the regime change impact that had on dealer inventories should be pretty constant from 2015 on. And if you look at just 2015 to 2021, credit spreads in dealer inventories are correlated at about 40%. So that goes to show you that we see lower dealer inventories, we see tighter spreads as an indication of end user demand. This year has been the exact opposite. We've seen inventories falling at dealers for the majority of the year.

Dan Krieter:
Well, spreads have widened obviously most of the year and we see a negative correlation of negative 55%. So it's been a departure from the historical experience this year, ultimately leading with the lowest print we've seen in dealer and inventory. So now what does that mean for this week? Dealer and inventory seem to be going up. That's been supporting credit spreads here. Where do we go from here, Dan? Do you think that these underlying metrics are going to come to the surface now and weakness from end users is going to return to another leg wider in credit spreads or is there potential for the dealers to lead this value that becomes self reinforcing and we start to see real end user demand increase going forward?

Dan Belton:
Yeah. So I think that the combination of net selling from clients to dealers and the decline in dealer inventories over the second quarter was really made possible by light issuance. The ICE B of a corporate index only increased by about 35 billion in the second quarter, but that's the lowest of any quarter since the pandemic. And so I think that this reduction in dealer inventories is on its own a bullish indicator for the market, but I'm not expecting it to lead to a more sustained rally. So this 15 basis point rally that we've had since the beginning of July is the third bear market rally in credit spreads that we've had this year. We had one in the second half of March where credit spreads narrowed about 35 basis points. And then the second half of May, credit spreads narrowed about 15 to 20 basis points.

Dan Belton:
But really we are seeing just these small bounces in credit as parts of a longer term trudge wider in spreads. And that's how I expect this one to ultimately be resolved. I do expect that while technicals have gotten a little bit better, we talked about primary markets firming, primary dealer balances falling, and secondary activity probably starting to normalize here. I think I on a whole, technicals are still a negative for the market and fundamentals are not pointing to necessarily supportive conditions either. So I don't expect this to be sustained. I'm looking for another leg wider in credit spreads before I start to get outright constructive on the asset class.

Dan Krieter:
I think, generally I'm in agreement with you. But just to provide a counterpoint here, I do think that liquidity has been a major factor so far this year, specifically the lack thereof. So if we're going to see dealers now starting to increase balance sheet of risk tolerance the dealers are starting to increase, we see more capacity to intermediate those selling flows. I do think an improvement in liquidity could spark a more meaningful, sustainable rally in credit spreads if you will. But that's only going to hinge on whether or not fundamentals justify it. So for me, obviously the most important thing in the next couple weeks is going to be what we see from the fundamental side. And on that topic, earnings have gotten off to a bit of a rocky start with the big banks at the end of last week and early this week. And we started to see some deterioration in corporate fundamentals which we were expecting to lead another leg wider in credit spreads here in the near term.

Dan Belton:
Yeah. So we look at the four week moving average of the interplay between rating upgrades and downgrades for the group of corporates that we track. And for the first time during any four week stretch since March 2021, downgrades have actually outpaced upgrades. So we've seen this general deterioration and fundamentals from their all time constructive levels around the middle of 2021. That's been a long running trend we've been following over the past year. And now fundamentals are really representing probably a neutral at best or maybe even pointing towards a headwind for the corporate market. So that's something that's going to be extremely important to watch as these earnings unfold. And yet, like you said so far, we haven't had money earnings yet outside of the big banks. The big banks, I would call a mixed bag. We had four of the six largest banks miss earnings.

Dan Belton:
There were some positives to be taken away. A board of commentary around the strength of the consumer, the strength of corporates. And then there was optimism around any recession likely to be mild saying that the consumer is in a better spot right now than they were even before the 2020 recession, much less the 2008 financial crisis. And then on the negative side, we had an increase in loan loss provisions among a lot of the big banks. Real consensus tone that the economy is going to start facing some real headwinds here. I mean, nothing groundbreaking there that seems to be the general consensus around the market anyways. So kind of a mixed bag. I don't see it in that negative or positive at this point yet, but over the next few weeks, we're going to start to see these earnings roll in. I think it's going to be very important to see where the fundamentals point.

Dan Krieter:
Yeah. We'll certainly keep an eye on that, but I want to go back to what you talked about with the fundamentals. Because that's certainly a very important factor in our model for credit spreads. And you talked about how fundamentals downgrades, upgrades have become less supportive, even potentially a headwind now. How has that impacted what the model's saying for credit spreads?

Dan Belton:
Yeah. So our model had seen credit spreads really catch up to fair value over the second half of June as spreads were really gaping wider. And then for a couple weeks, their credit spreads were trading in line with model fair value. And then just over the past two weeks, when these grading downgrades started to take hold and downgrades started to outpace upgrades over the four week moving average we look at, we've seen model implied spreads trade about 10 basis points wider than current spreads. So the model calling for about 10 basis points of widening.

Dan Krieter:
Yeah. And one interpretation there just being that the model is capturing something that we've said from a macro level, which is that there's likely more pessimism to come. I do think that there's still a pretty significant chance of a soft landing being priced in to the financial markets here and the hope that the FED is going to guide this ship to maybe a recession, but not a bad one. Even some people question whether or not this will even meet the qualifications of a recession. So I don't personally subscribe to that belief. I think it's going to be very difficult to achieve a soft landing here. And I think there's going to be increasing odds of recession pricing in here that will ultimately push credit spreads wider here in the next couple months.

Dan Krieter:
So, backing up and just looking at things high level, I don't think our view has changed too much in the two weeks since our last podcast. I think we still believe that spreads have widened such a magnitude this year, that we're at a point that current spread levels will likely look attractive on the long term chart as we look back, say three, five years from now. But I don't think we're at the peak yet. So with the expectation of some near term widening, maybe using the term neutral is almost the best way to describe our positioning in high quality spreads here and maybe looking to be opportunistic. And before we go here, I do want to just highlight potentially an RV opportunity on that IG corporate curve, which is in the belly of the curve. Specifically, the seven to 10 year point which has underperformed pretty significantly all year. And you can look at that both with short end to belly spreads and with belly to long end spreads.

Dan Krieter:
We've seen say between threes and tens, that's trading at a steepness of about a hundred basis points heading into the week. Which is just six, seven basis points off all time highs in terms of curve steepness there. And then looking at tens thirties from the belly to the long end. That's inverted now which, it's not at extreme levels but it's at levels visited only a few times in the past decade or so. So the under performance has been specifically in the belly of the curve and it's looking very attractive here, but let's talk about what's driving this because we have a few potential explanations for why that is. The first one would obviously be supply.

Dan Belton:
Yeah, but supply hasn't really been concentrated in the belly this year. Actually seven year, 10 year issuance has been well below normal ranges. So that's not really what's driving this. Another potential explanation that we looked at was maybe investors shortening their whams. And we pulled over a thousand IG funds representing over $3.3 trillion. And while the volume weighted wham of these funds had declined over the course of the year, it hadn't actually declined as much as the IG index duration had declined. So that's probably not driving it either.

Dan Krieter:
No. So, where we landed was the best explanation we could come up with. Was just the investor mix of who has been active this year. And to look at that, we had to lean on Z1 data from the FED, which admittedly comes with a significant lag. But the most recent data as of Q1 showed that the biggest net investors in corporate bonds in Q1 were foreigners, life insurance companies and surprisingly banks. And the biggest net sellers were hedge funds and mutual funds which doesn't come as a big surprise because we've all seen the outflows this year. And those outflows actually accelerated during Q2. So while we don't have Q2 data yet, it's highly likely that hedge funds and mutual funds were likely net sellers. Once again, keeping this story intact. And if you look at the type of demand you're likely to get in that type of environment, we know insurance company and pension demand is going to be further out to curve given their duration needs.

Dan Krieter:
We know that bank demand for corporate paper is likely to be at the short end of the curve, say five years and in. It's hedge funds and mutual funds that are likely to be more opportunistic along the curve, looking at relative value that would be looking at the attractiveness in the ability of the curve. And they have been the net sellers this year. So it's likely been that technical that's led to the cheapness here. And well, it's difficult to say that hedge funds and mutual funds are going to become net buyers soon. I think we are at a point where the relative value is compelling enough to potentially look at over weighting that part of the curve. Particularly with a view that if recession does start to become more meaningfully priced in here, we know that alongside recessions or economic slowdowns, spread curves tend to flatten as credit risk in the near term increases substantially.

Dan Krieter:
So we could start to see flattening of the spread curve between the short end in the belly where belly spreads will add a bit of out performance stereo [inaudible 00:17:22] portfolio.

Dan Krieter:
So high level neutral here and with the preference for belly spreads in the year term, as we wait to see what the FED has to say next week and how the economic data unfolds. Anything else Dan, before we sign off?

Dan Belton:
Just a quick programming note. We'll be back next week with our reactions to the FOMC episode. And just as a reminder, the institutional investor poll is now open. So if you find our work valuable, we would greatly appreciate your support. Please take a look at any of our written work for a link to voting in that poll. Thanks for listening.

Dan Belton:
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 @daniel.belton B-E-L-T-O-N @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 and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:
This podcast has been repaired with the assistance of employees of Bank of Montreal. BMO Nesbitt Burns Incorporated and BMO Capital Markets Corporation. Together, BMO who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services. Including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you.

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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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