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Are We There Yet? - High Quality Credit Spreads

FICC Podcasts February 23, 2022
FICC Podcasts February 23, 2022

 

Dan Krieter and Dan Belton discuss the recent widening in credit spreads including when, and at what level, spreads are likely to find stability. Other topics include recent trends in supply and the outlook for primary markets.



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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. Welcome to Macro Horizon's high quality spreads for the week of February 23rd. Are we there yet? I'm your host, Dan Krieter here with Dan Belton, as we discussed the widening and credit spreads in the last week plus, and try to forecast when credit spreads we'll finally find some stability.

Dan Krieter:
Each week we offer our UN credit spreads ranging from the highest quality sectors such as agencies and SAS's 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 at 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, Dan, certainly a lot has changed in the week since our last podcast recording really hard to believe it's only been a week. Why don't we start as we often do, just giving us a high level overview of what we've seen in credit in the past week.

Dan Belton:
So the risk off tone that we've seen characterized markets for most of to 2022 has really intensified over the past couple weeks. Our regular listeners and readers will know that we spent a lot of January talking about how credit spreads had been resilient in the face of elevated volatility. We had declines in equity markets and rises in Treasury yields that saw credit spreads really hang in relative to the under performance in other assets. That narrative has really reversed over the past couple weeks. So the S&P 500 is down 6.2% in the last two weeks. Normally the linear relationship between stock market returns and credit market returns would imply about a six or seven basis point widening and spreads over that period.

Dan Belton:
We've seen more than double that amount of spread widening of 14 basis points in just the past two weeks. And spreads are really gaping wider here. Leaving a lot of investors, just wondering where and when credit spreads will find stability, we've seen that weakness permeate into the primary markets. And right now I think the focus for most investors and issuers and the focus for this episode will be on when and where credit spreads finds their new range.

Dan Krieter:
Yeah, I think it's really the only topic we can really consider for today's podcast. And so to try to begin answering that question, I think it's worth going back and looking at the outlook we had on the market coming into the year. We'd certainly say that things have happened quicker than we expected, but the move isn't entirely unexpected. I mean, we thought we would see a fundamental repricing and credit just given the move in Treasury rates and where inflation numbers are coming in, coming off, the likely stimulus driven and excess liquidity driven, very narrow spreads of 2021. We didn't think those could be sustained. And we did think we'd see a significant winding and credit spreads at some point in time in the first half of the year, obviously that happened quicker than we thought.

Dan Krieter:
Usually we see pretty supportive technicals around this time of the year that we thought would at least counteract the fundamentals and keep spreads well anchored while not really expected to see much narrowing instead, the move has happened quickly. And before the end of February, we are now off 40 plus basis points since the load of September. So from the fundamental perspective, let's start here, Dan. We were expecting a move to a new trading plateau that better reflected the fair value of credit. And I think that we are either at or approaching those levels. So let's start the conversation by just laying out some of the ways that we think about fair value in credit spreads and where we are now.

Dan Belton:
So we updated our credit spread model, which shows a fair value of 138 basis points as of last Friday. And that's about 15 basis points wider than current levels. As we've updated this model, basically every week, this year, just in the spirit of trying to find the new appropriate target level for credit spreads. We've noticed that this model has widened almost in lockstep with actual credit spreads. And most recently that widening has been driven by tightening and financial conditions as well as a moderation in corporate fundamental. So the tightening and financial conditions, I think we can attribute largely to the Russia Ukraine situation, at least over the past couple of weeks, but financial conditions have been moving tighter for most of this year. And a lot of that's due to the inflation concerns.

Dan Krieter:
And another metric that I think we like to lean on a lot, just looks at the ratio of corporate spread enhancement compared to Treasury yields. And we look at a long term average there of about 62 to 65% of Treasury yield as a fair value. That is the long term range and the index. That's also the average that we saw post-financial crisis pre COVID. So that very comparable low rate environment between 2010 and 2020, you get a pretty consistent 62 to 65% of Treasury yields. And given the backup that we've just had coming in today, we're about 62%. So model implied or percentage of Treasury basis levels, we are get two levels that we consider maybe on the narrow end of fair value, but no longer out outrageously narrow. We're getting to maybe levels that you might consider neutral. Now, those indicators reaching neutral by no means means that we're going to suddenly see spreads dig in here and start to hold the line.

Dan Krieter:
I think momentum is decidedly on the other side. And Belton alluded to earlier, the primary market metrics seems like that's going to continue to be a headwind for credit here in the near term, but we had 125 basis points on the broad IG index as a target coming into the year that we expected to see in the first half of the year. And we are now approaching that level. It does seem to me that we're going to go past that level for sure, but I think there's an argument to be made that we might now be establishing that range, the new range for credit that we thought we'd reprice to a new fair value. And we'll probably establish some high point in the next couple weeks that maybe that becomes the new range. If we get up to say 135 or a 140 basis points, maybe we can look at 120 to whatever that high point is as a new trading range for credit. But the question of where that level lies, is it a couple basis points from here, or is it 30 basis points more to 150?

Dan Krieter:
That's going to be a very important question to answer. So maybe we can talk a bit about some of the more technical aspects of it now that we've reached a more quote unquote neutral fundamental range, and try to come up with an appropriate upper bound target for the range that we're going into here. And so, and we've gotten how many minutes into the podcast without having to talk about the Ukraine situation. I think we can no longer continue that we have to at least talk about it now. I mean, as we sit down to record here this morning, headlines coming in US has informed the Ukraine to prepare for a full scale invasion, not just of the separatist regions that Russia acknowledged as standalone from Ukraine earlier in the week. Now we're talking about a full scale invasion headed for Kiev and it appears we are headed for all out war. And I think the first question we have to try at a tackle, it's not an easy one.

Dan Krieter:
Is that what the market was projecting? Because we've certainly seen some of the positive momentum early in the morning in the equity markets and in risk assets come off, but we're still mostly on change from yesterday's levels. So is this a reflection that this was mostly priced or is there going to be another shoe that drops here?

Dan Belton:
I think it was largely priced some of it, like you said, some of it was priced in more this morning. We saw equities drop from up about 0.8% to about flat as of when we're recording this. And I think the market is now starting to price it more as impacting inflation and energy prices. And so obviously there are a lot of different ways that this can progress, but I think this headline was probably largely priced just given that the market reaction was pretty mild.

Dan Krieter:
Yeah, I agree. And at the risk of being proven wrong in the near term, I think you can make an argument that while this situation is terrible, it's really hard to see how it's going to worsen meaningfully from here, I mean, I don't want to dwell on the topic here, but it does seem like we're going to have a war and Ukraine is going to fight back. And this will last a long time months, likely, potentially years who knows, but it's hard to see how it's going to get worse unless there's more aggression from Russia against other countries maybe, or something like that, or the use of some type of weapon or something of that nature, something truly at the tail that it'd be impossible to predict here. Maybe the drag on credit and risk assets arising from the Ukraine situation. Maybe that starts to abate a little bit here.

Dan Krieter:
And certainly, it's not going to be a massive relief rally or something like that, but we're not going to see as much upward pressure on credit from the geopolitical sphere, arguably going forward. Now that we sort of have realized the worst case scenario with full out war and Ukraine becoming a reality. And so if we're going to get a bit more stability on the geopolitical front, potentially in the weeks ahead, then it's going to come down to really refocusing on inflation. And you talked about the Ukraine situation. Is it currently being traded as inflationary, which was surprising when the headlines this morning hit the knee jerk and 10 year yields was not flight to quality lower. It was higher just in recognition of the inflationary impact that the head and level of high oil prices coming from the Ukraine showdown. But we should take a moment to talk about energy prices because certainly high energy prices are something that are going to be felt on the corporate bottom lines and could lead to further weakness and credit.

Dan Belton:
Yeah, that's right. And I want to go back to something that you said earlier, which is that the worst case scenario is already he realized, and I think that's possible. I think what has transpired up to this point certainly represents the worst case outcome that we foresaw as of just a few weeks ago or a month ago. There's a lot of ways that this could unfold and progress from here that could potentially lead to further flight to quality bids and widening and credit spreads. But I agree with you at this point, at least in the near term, we've probably priced to the worst of these headlines.

Dan Krieter:
I just want to clarify that. I realize that there are certainly ways that this Ukrainian situation gets worse from here. I just, I want to be cognizant of the fact that when risk sentiment turns, it can turn quickly. And so by saying, this is the worst case scenario and saying, it's difficult to see things worsening meaningfully. I'm not saying it can't happen, but if we see this sort of just turn into a long drawn out war, the market will begin to tune it out at some point and will refocus on other variables. And to me, that can be constructive for credit. And so then the conversation becomes what will be those other variables that are going to determine the next leg in credit, if for settling into this range that we expected to be more fundamentally fair value level for credit spreads. If we're not settling into that range, what are going to be the drivers of the next move?

Dan Krieter:
And for me, then we have to set aside the Russia situation because obviously if it gets worse from here in any way, that's an obvious credit spread widener. And I think what I was trying to go for earlier was saying that the probability of that appears to be low currently, but obviously we can't have a ton of conviction there and there will have to be some risk that it gets worse priced into markets. But I think we do start to refocus now on other narratives. And that's what we argue. We saw in today's market reaction to the hell ads coming in. So what are those variables going to be? And I think all roads are going to lead back to inflation. And that's what informs the expectation for credit spread to find some civil here. At some point, we won't try to say exactly what level that's going to be, but we'll see some stability and credit here in the weeks ahead as the market just waits for more inflation data, because we go back to the high level macro view.

Dan Krieter:
Is the Fed behind the curve with inflation. Is it inflation truly runaway because if it is, we are going to see another wider and credit spreads and likely a large one because we have corporate earnings that are going to be affected by high inflation. We're going to have a hawkish Fed that will continue to be hawkish regardless of the impact of their policy on financial conditions. So if inflation come July, August, September is still very high credit spread are for sure going to widen significantly from here, but we're going to need data coming in before we start to price that. So I think we're going to just have some stability in credit while we await incoming economic data to see the way it's going to go.

Dan Krieter:
And so ultimately, what is the top end of this range we're alluding to for the most of this podcast? I think it's going to come from primary markets. It's going to be a question of where do primary markets settle down. And so for me, the thing that I'm watching most right now is new issue executions every day to see at what point they begin to improve.

Dan Belton:
And to that point, I think today we'll be an interesting data point on that front. We have 11 deals in the market. Risk assets are down slightly, not terribly, but down about half a percentage point as of this recording. We have 11 borrowers in the market. Most of them non financials, as we've discussed in this podcast before there's been a lot of fatigue with respect to heavy financial supply. So I think we'll see again where primary market executions come in, I'm not expecting particularly strong. I think the days of one basis point average new issue concessions are largely behind us, at least in the near term. But if we see some improvement over where new deal executions have been in the past couple weeks, I think that could go a long way towards suring up some investor sentiment.

Dan Krieter:
And if the risk of stating the obvious, reserves remain extremely the abundant in the financial system like demand is going to materialize from investors at some point here, once the momentum stops being such a headwind spreads are much wider now than they were at the end of last year, even the beginning of this year. And you can start to frame an argument. I'm not saying I'm doing this, but you can start to frame an argument that maybe the path the Fed liftoffs is too aggressive. Maybe the Russia situation slows the Fed down a little bit, just and reflection of the geopolitical concerns. Just saying that the narrative of the year thus far has been Russian inflation, and maybe that narrative starts to change a little bit and suddenly spreads are much wider than they were. So I think you could see some demand materialized here in the weeks ahead.

Dan Krieter:
It will show up first in primary markets when you're getting 10 plus basis points in concession every day. There's not much utility in buying secondary spreads. It's going to show up in primary markets first, but when we see that stability in primary markets that I think we'll see in the weeks ahead, I think that'll be the indication that spreads are going to settle into this new wider range. And we'll see some cash get put to work around these levels here pretty soon, with that in mind, I think maybe we should for the rest of the podcast, just maybe focus more a bit on the supply are specifically and what we've seen so far this year in terms of IG supply and what we might be looking for in the weeks and months ahead.

Dan Belton:
So coming into the year, we're expecting IG supply to be pretty heavy. We forecast about 1.6 trillion in gross issuance. Obviously the wobbles and risk sentiment have cast some downside risk to that estimate. To date, we've seen about 225 billion in supply, and that includes 72 billion in February, January supply actually this year was the heaviest we've seen since 2017 and then supply has slowed since then. So a couple supply trends that I think are worth mentioning on the high grade side, we've seen continued heavy financial issuance. It's constituted 59% of all high grade supply this year. And that's really outsized from any year on record, at least through this point. So something to watch there. And as I mentioned earlier, we've seen some investor fatigue with that heavy financial supply. We've also seen a lot of front end issuance, particularly with FRNs. FRNs currently are the highest proportion of issuance in February that we've seen any month since the onset of the pandemic.

Dan Belton:
That makes sense as a Fed is embarking on a rate hiking cycle, but something to keep in mind there, especially as it relates to SOFR floaters, which some investors are only recently becoming familiar with. And then the weaker execution levels remain. I think the most important story in high grade issuance, new issue concessions in February have averaged 9.4 basis points. And maybe even more importantly, it's been worse for lower rated products. So for Triple-Bs we've seen new issue concessions of about 12 and a half basis points. And for Triple-B minuses, that's about 18 basis points of new issue concessions on average. For context in 2021, average concessions were just 1.3 basis points. And for that Triple-B minus subgroup, we saw actually negative concessions on average last year. And so the reversal of this dynamic, I think is reflective of two things. First, there's the risk off tone that we've seen with the Ukraine Russia situation, as well as a potential for the Fed to start to pull away some of its accommodation more quickly than anyone was expecting as inflation remains high.

Dan Belton:
It also probably reflects some moderation and fundamentals as this appetite for Triple-B debt that we saw for most of 2020 and 2021 really subsides. So in March, we are looking at about 75 billion in redemptions. A couple of the things we're going to focus on in our supply piece that we're publishing on Friday are the financial supply picturing And where we expect that to go, we expect financial issuance to moderate, somewhat as the Fed reduces the size of its balance sheet. As the Fed runs down its assets, bank balance sheets tends to decline as reserves fall as well. And we should see financial supplies start to normalize later on this year, even if it won't fall significant below where we've seen it recently.

Dan Belton:
And then lastly, at risk of stating the obvious near term supply trends are really going to take their cue from demand and from risk sentiment broadly. And we're going to have to see where new issue concessions come in over the next several sessions of heavy supply. If they start to shore up, I think March supply could come in on the heavier side, but in the near term supply has been beholden to investor demand. And that's the main reason that February supply looks to be on track to fall short of expectations.

Dan Krieter:
Dan, you hit on a point that I think is extremely important. So I want to circle back to it. You talked about how the worsening of financial conditions has been a headwind for supply in February. And obviously that is true, but do you think that will continue to be sustained if we continue to be in a bit of a risk off mentality, will issuers continue to avoid the market or will we actually see the opposite where borrowers will say better just to pay some concession now and get my debt place versus waiting for potentially hiring rates and spreads in a couple weeks or months?

Dan Belton:
Yeah, it's a great question. And we saw that dynamic, the latter that you mentioned play out in much of 2020, where investors once primary markets were really open as the Fed began to engage in extremely accommodated policies that led to record issuance, but there was a period in 2020 where we saw weeks on end with absolutely no supply as there was just investor trepidation and a lot of uncertainty. So I think it really depends on the flavor of this financial condition tightening, but I don't expect primary markets to be closed for a very extended period of time, even during these bouts of risk offs sentiment.

Dan Krieter:
All right, thanks Dan. Before we wrap up today, I did want to spend at least a moment talking about SSA technicals because we've really seen remarkable our performance from particularly tier one SSAs throughout this entire credit spread widening event. Obviously we talked about how we've seen credit spreads 40 plus wide since September. Tier one SSAs spreads have really almost not moved maybe a basis point or two, but they're still very, very narrow. And even tier two spreads have widened 10 plus basis points, but tier one spreads haven't moved at all. That doesn't come as a huge shock. Given the flights of quality episode we've seen with the Russia Ukraine situation, you would expect to see more flows moving into SSAs at the expense of higher beta asset classes. But I also want to highlight that a big reason for why SSAs spreads have held in so well is because technicals have been extremely supportive.

Dan Krieter:
US dollar SSAs supply in February was just 3 billion. That is the lightest month of SSAs supply. Excluding Decembers we have in our data and further net supply was negative, almost 30 billion, given a pretty heavy maturity schedule in February, which we have as the least net supply in the SSA market for a month on record. It's just been extremely, extremely strong technicals. And what's behind that. We have seen a bit more supply in other currencies. The basis has worked for not just euros, but also some of the other currencies, Canadian dollars supply has been high this year. We saw some Ozzie supply at the beginning of the year, but that's notable because in just the past couple weeks now, the ARBs has moved again in favor of US dollars pretty significantly. And so even though we've seen a very slow start to the year in terms of dollar SSA supply, SSA borrowers, aren't drastically behind like their funding programs.

Dan Krieter:
It's a little lighter than years past, but certainly nothing that would make us think that supply is to start flooding the market. But we're certainly not ahead either. There's going to have to be supply in March, always a heavy issue in two months, we're going to get supply in March and in a lot of it's going to be in dollars. We had almost no issuance in dollars in February, and now the ARBs are all working for dollars again. So a long winded way of saying that we haven't seen supply really test the SSA market, not really in dollars since the risk off attitude began. And I think as that supply comes back, we could see supply leading SSA spreads, particularly tier one SSA spreads wider in the coming weeks. And again, not expecting any meaningful outsized widening in SSAs, but I think we do need to see some catch widening in SSAs because their RV is way off compared to really any other comparable asset class like double A rated Corp, A rated Corp spread SSA is very wide.

Dan Krieter:
I mean, even agencies at the short end of the curve are now a pick two SSAs, which is departure from the experience of really the previous decade for most periods of time. So I think tier one SSAs is we could see some spread widening here in the weeks ahead. So maybe now wouldn't be a bad time to and you can go with it either way. If you're nervous about the Russia situation, you think spreads are can continue widening significantly. You can go into an agency at a positive picked SSAs, likely be a bit more insulated from spread widening. Or if you subscribe more to the view that we laid out, that we're expecting credit spreads to find some traction here and the risk off, start to stabilize at least a little bit moving out of SSAs back into high rated corporates where you now get a much healthier pick than you were getting for certainly all of 2021. And even in the beginning of this year.

Dan Krieter:
So if we're looking to do any trades now at a very uncertain time for the market, but I think SSAs are a good cell candidate here, particularly tier one SSAs. And you can look at depending on what your view is, you can look to readjust your portfolio there and we'll just alongside everyone else. Wait and see where spreads finally do gain some traction. Anything else from you Dan, before we sign off?

Dan Belton:
No, I think that covers it. Thanks for listening. Thanks for listening to Macro Horizon's, 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, 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 in BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:
This podcast has been prepared with the assistance of employee bank of Montreal, BMO Nesbitt Burn 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 here in may be suitable for you.

Speaker 2:
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Speaker 2:
You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative if applicable. BMO assumes no responsibility for verification of the information in this podcast, no representation or warranty is made as to the accuracy or completeness of such information. And BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter, and information may be available to BMO and, or its affiliates that is not reflected here in. BMO and its affiliates may have position long or shorts and affect transactions or make markets in securities mentioned here in or provide advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned here in. Moreover, BMO trading desks may have acted on the basis of the information in this podcast. For further information, please go to BMOcm.com/macrohorizons/legal.

Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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