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Night is Darkest…? - High Quality Credit Spreads

FICC Podcasts July 06, 2022
FICC Podcasts July 06, 2022

 

Dan Krieter and Dan Belton discuss to drivers of the recent weakness in credit including their medium-term targets for index spreads and what might drive the next move in credit spreads. Other topics include the challenging technical backdrop facing the market and second half supply outlook.


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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 for the week of July 6th. The night is darkest. I'm your host, Dan Krieter, here with Dan Belton, as we discussed the drivers behind the most recent widening in credit spreads, including the very challenging technical backdrop facing the investigative market right now. We also discussed the factor shaping our view on credit, looking ahead, and when might be a good time to start looking to get long credit spreads.

Dan Krieter:
Each week we offer our view on credit spreads, ranging from the highest quality sectors such as agencies and SASs to investment-grade corporates. We also focus on US Dollar swap spreads and all the factors that entail, 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.

Dan Krieter:
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@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, its affiliates, or subsidiaries.

Dan Krieter:
Before we begin, I just want to make a brief announcement that the institutional investor poll is now open and runs through the end of July. If you find this podcast helpful, or any of our written work, we would greatly appreciate your support in this poll that is very meaningful for us. If you have any questions including on how to support, please feel free to reach out to us directly, or to your BMO sales coverage for more information. Now, with that said, let's jump right in.

Dan Krieter:
Dan, another week of widening last week, another 10 basis points, the fourth consecutive week of widening here, bringing us to new year to date highs in credit and to levels not seen since early 2016, excluding the pandemic. Of course, the driver of this has been building recessionary fears, which falls right in line with the view we've been putting forth for basically the majority of the year here as we've been underweight credit for the majority of 2022 and anticipation of the economic data rolling over.

Dan Krieter:
And indeed that's happened. In fact, the US is now very likely facing two quarters of negative GDP growth to start the year in 2022, meeting the definition for many of a technical recession. However, it's worth noting Dan, that we're now within shouting distance of our 175 to 180 basis point target on the broad IG index by some metrics we're less than 10 basis points from those levels. And so I think we have to begin asking ourselves whether spreads are going to reach an inflection point in the weeks or months ahead here. And whether that point will represent the 2022 peak in credit spreads. So Dan, that's the question I want to start this podcast by trying to answer and I'll kick it to you. Are we approaching the point where the night is darkest just before the dawn, or is the time we begin to adjust that target higher? And what are the things you're thinking about as you try to answer that question?

Dan Belton:
Yeah, so I think there are two separate questions to me, at least. First, whether 175 basis points remains a point at which I start to find some value in credit. And then a separate question is whether or not I view that as the peaks for this year. So I do think at 175 basis points, you could make an argument where it starts to make sense to start adding some positions in credit, even if spreads are likely to have further room to go after touching that target. So if you look back at the three recessions on record, since index spreads began publishing on a daily basis, each of these episodes saw spreads topping out over a hundred basis points wider than current levels. Of course, the pandemic and the financial crisis, both coincided with periods of acute market stress, which saw spreads in the 400 to 600 basis point range at the index level.

Dan Belton:
So I think the 2002 dot.com bubble recession is probably the best barometer of where spreads could sustainably trade. I think in a bad-case scenario, maybe not the worst-case scenario, but in a negative outlook for credit spreads, that's another a hundred basis points to go. So I certainly wouldn't call this anywhere near the top of where we're expecting spreads to go. But given that we're in a very different environment structurally right now, where we have talked a lot in recent podcasts about why spreads are just structurally more narrow than they were 20 years ago.

Dan Belton:
And also the fact that the market is starting to price and rate cuts as early as about nine months from now. I think you could make an argument for at 175 to 200 basis points. That could be a level that makes sense for some investors. Also, when you talk about those levels and we think about them from an all-in yield perspective, corporate bond yields are now at about 4.6% or so. That is more attractive than they've been at any point in the last decade. So it could very well be the case that a year from now, we're looking at these levels and saying that was pretty attractive for many investors.

Dan Krieter:
Okay. So let me just go back really quick and make sure I'm understanding what you're saying correctly here. The peak in spreads you think will likely be above 175 to 180, but that will not likely be a long-lived peak. Is that what you're saying? The 100 basis points higher that we traded in the 2002 dot.com era that would be a short-lived, move higher to that level, and that 175 to 200 basis point range, as you put it, will likely end up looking attractive in the long-term chart.

Dan Belton:
Yeah, I think I'm about neutral on credit spreads at 175, and then sure there is a lot more room to go. We could see a scenario where something in the system "breaks" and spreads jump significantly higher than that. But I do think in the long run, 175 to 200 is probably a decent level, especially given where yields are right now.

Dan Krieter:
Yeah, I think broadly, I agree with you. I'll go into a little more detail here in a little bit on the way I'm approaching the market. But first I want to talk a bit about some of the drivers of the macro-environment that the path of credit threads will certainly depend upon. And the first is the economic data because that's really what has been getting a lot of press coverage recently is that the economic data is rolling over. It seems a little surprising to me that's getting so much publicity now because it seems apparent to me the data has been rolling over for quite a while now. I mean, anyone who listens to our podcast with regularity will know that we've been talking about the leading economic indicators looking quite troublesome really since March. I mean, it's been months, we've been talking about this and now it's starting to show up in more concurrent indicators and next it will show up in employment numbers, which are lagging indicators.

Dan Krieter:
The economic data is rolling through the leading to lagging indicators in the expected fashion. So now looking at the leading indicators, certainly, we're not seeing strength there by any stretch of the imagination, but we're starting to see some stability. The pace of the decline is slowing potentially starting to form a bottom there in some of the leading economic indicators, which to me says from a purely economic standpoint, maybe we are approaching that point where the night is the darkest, and we'll start to see some rays of light start to emanate in the months ahead. But if we look at it from a corporate fundamental standpoint, I'm not sure we're at that "night is darkest" point in corporate fundamentals yet.

Dan Belton:
Yeah, I think when we start to see corporate earnings be released as early as next Thursday with some of the big US banks, there's a potential there that leads the next leg, wider and credit spreads and next leg lower in other risk assets. We saw this in the release of Q1 data when a few high profile companies, I'm thinking of Target and a few others, had releases that shed some really serious doubt on economic growth prospects and profit margins and other things like that, really sent risk assets significantly lower. I don't think it's out of the question that we get some comments from CEOs of big banks or other big companies that really add to the recessionary fears that are currently permeating the market and really send risk assets lower. And so I think at that point it would maybe make some sense to start to add positions and credit.

Dan Krieter:
I'm sympathetic to the view that we haven't yet priced in full recessionary fears into corporate spreads yet. That the outlook for corporations will likely continue to worsen. And I think that's also because the consumer will likely continue get weaker here. I mean, like I said earlier, unemployment is going to go up invariably and we're going to get a look at the employment picture on Friday, but I'm talking more in the months ahead. Unemployment is going to go up, which should hurt consumption.

Dan Krieter:
And it's worth noting that student loan payments, which haven't had to be paid since March 2020, are scheduled in August. Those payments have to start coming back. And I think that's potentially a pretty important development for a pretty considerable slice of the demographics in the US, prime earners at the younger ages that still have student loan payments. We could see that consumption continue to weaken here if student loan payments are ultimately reinstated. So I don't think we've reached the point yet where the consumer is at "the bottoms", if you will.

Dan Krieter:
And the same goes for corporate fundamentals. So I think the near-term view on credit, for me, and I'll go back now to what we were trying to answer at the beginning is the night the darkest. I don't think it's there yet from a corporate fundamental standpoint, but if I was going to sum up our view over the past nine to 12 months, we've been pretty much bearish on credit since September, I would say of 2021. Now we've had pockets where we were neutral, even overweight credit, where we expected to see some stability or potentially some narrowing in near-term windows, but long-term, we really never wavered in the view that credit would need to widen.

Dan Krieter:
And I think maybe we're approaching an inflection point where the medium to long-term view on credit, at least for me, starts to become more bullish. Going back to your point on the 175 basis points being a potentially attractive level in the long-term. I think that's right. I don't think it's going to be the peak and spreads. I think we could very easily get to 200 in the next three months, but if we view that 175 to 180 basis points levels, where we start to turn more neutral and start to look at opportunistically adding to positions, I think that does pay off in the long-term.

Dan Krieter:
So really the question then becomes, do we get a spike? Like we saw on oh eight in 2020. It goes without saying, that's kind of impossible to forecast. I mean, sure. Right now it doesn't look like that, but it didn't look like that in 2007 and it didn't look like that in 2019. These things come out of nowhere and there is a pretty compelling argument, at least for me that the excess of the fiscal monetary stimulus of the past couple of years, maybe papers over some underlying weakness that can come to the surface potentially causing some type of credit event.

Dan Krieter:
Certainly, the risk of that is higher now than at more "normal" times, but that's not something we can really build into our outlook here. So I think, long-term, I'm anticipating getting more bullish on credit spreads in the next three months, but near-term, like I said, I do think things will get worse. We haven't truly bottomed yet. And now I think we can talk about the focus of today's podcast, which is the technical side of things, which we've talked about for a few weeks now is being potentially the worst in the history of the IG market for at least the history that we can quantify. And that certainly remains the same. And I think technicals are going to continue in influencing spreads upward for a considerable period of time here.

Dan Belton:
Yeah. I mean, just to put some numbers on it. Over the past three weeks, index spreads are 21 basis points wider while CDX has moved out just four basis points. So we're really seeing out-sized moves in the cash IG index relative to where derivatives would suggest spreads are setting. And you can see this through the primary markets. Issuance has all but dried up since the beginning of May. And it's gotten progressively worse here into the end of June and early July. And most of that is due to the weak, new deal reception that we've seen.

Dan Belton:
So since the beginning of February, just about every month on record has seen double-digit new issue concessions on average. And it's been even worse for triple Bs and triple B minuses, which have seen an average of 15 basis points and 17 basis points of new issue concessions on average. So we're seeing really, really tepid demand from investors for new debt. And that's just reflective of the weaker tone that we're seeing broadly, that we alluded to at the top with bond fund outflows of 14 consecutive weeks, the longest stretch on record. And reduced attractiveness for foreign investors who are seeing higher hedging costs alongside increased policy rates.

Dan Krieter:
Yeah, certainly at this point, higher concessions have become embedded into the psyche of investors. And that's something that's going to probably take a significant amount of time to reverse course. And it's going to start with supply having to come back. I mean, we're at the point where supply is just sidelined out of the prospect of higher concessions, but those concessions are going to have to be paid at some point.

Dan Krieter:
You know, it's not like you're going to await a market here that's going to suddenly turn around and you're back to paying zero to five beeps in concession. I'll say that's extremely unlikely. So we're going to have to see supply return. And I think at this point, I think a lot of hesitancy also comes from the looming jumbos that have still yet to hit the market that maybe some other borrowers are looking to get those out of the way first, before coming to market. And if that's the case, history tells us that jumbo M and A-related transactions will likely come even weaker than the already weak statistics we've seen recently.

Dan Belton:
Yeah. So between the two jumbos that we're waiting on, the Oracle and Celonis, the market's expecting about 25 to 30 billion in supply. And when we look back at M and A jumbos with 10 billion or more in issuance, we tend to see elevated concessions relative to the prevailing levels in the market. And so if we compare concessions on jumbos to the monthly average of concessions. During that month that the jumbo comes, we see about three to four basis points of additional concession.

Dan Belton:
So like I mentioned earlier, triple Bs and triple B minuses are seeing 15 to 17 basis points of concession on average in recent months. That implies just given those two facts we could see about 20 basis points of average concessions for these jumbo deals. Now, it's going to come down to a lot more factors than that. It's going to come down to tone and what different investors think of these individual credits, but new issue concessions could get worse from here, at least in the near-term.

Dan Krieter:
And like you said, earnings season is right around the corner and right after earnings season, what should we expect coming? But the large American banks coming back with jumbos again. So it's going to be supplied back in the market here relatively quickly and large financials, some M and A ones that we wouldn't necessarily expect to be the ones that would erase the concession. So it's going to take time and spreads going to continue to be influenced wider in the near-term while the technical headwinds start to abate.

Dan Krieter:
And I think another question that arises here, Dan, sort of away from the impact on spreads is given the dearth of supply we've had in the past couple of months, is it time to start adjusting, lower our expectations for total 2022 supply? I think heading into May, we were basically right on top of the 2021 pace give or take a couple of percent, depending on how you actually count it. But now at the beginning of July, we are as much as 10% behind 2021's pace, and it's looking less and less likely that we're going to catch up.

Dan Belton:
Yeah. Going into the year, we expected supply to be generally front-loaded this year, where the favorable funding conditions that persisted for all of 2021 and really the second half of 2020 would continue for the first six months or so of 2022 before maybe fading into late Q3, early Q4. And that's generally been what happened except it played out much more quickly than we expected. Obviously, Russia's invasion of Ukraine tightened financial market conditions beginning in February, then continued more hawkish than expected.

Dan Belton:
Fed has been another reason for this, but the first quarter brought 470 billion in IG supply. That's the second heaviest Q1 on record behind only 2020. And then Q2 was one of the lightest second quarters on record. It was actually the lightest second quarter since 2013. So really a tale of two halves within the first half of this year. And it seems likely that slowed momentum is going to persist even despite some of these jumbos that are likely to come in July. So if we see relatively average issuance in the second half of this year, I'm looking at about 1.3 to 1.4 trillion in gross high-grade supply for 2022. And that's a downward revision from our initial estimate of 1.6 trillion.

Dan Krieter:
Yeah. I'm with you. I think there's just not enough time anymore at this point. And given our view on the economy going forward, maybe we reach a point where corporations are more willing to just pay up, to get more precautionary money if the economic data continues to sour from here. But it does seem like we're going to come in lower than expected. And maybe that's another long-term reason to start, in the long term, getting more bullish on credit if second half supply isn't maybe as high as we thought it was going to be. That just goes back to the reason we talked about at top of the podcast, or why maybe the long-term view here can start to change for the first time in nine to 12 months, which spreads might be lower six months from now than they are right now. And I think that'd be the first time we've said that on this podcast, probably since September. And also it's worth saying, we're at a point now, just very anecdotally that it seems that everybody just hates credit.

Dan Krieter:
It's been a one way marching credit spreads. Liquidity is very difficult to come by, but that can reverse very, very quickly. We've seen it already this year after nine consecutive weeks of sell-off between January and March of this year. Suddenly spreads snapped 30 basis points narrower on basically nothing. I guess Russia started to price out a little bit as the financial sector withstood, but essentially on nothing. And so at times like this, going back to the night is darkest theme, when everyone seems to hate credit that maybe it's time to start adding to positions in small size, in good names, just as long-term buy and hold plays that are at levels that six months from now, nine months from now look pretty good. And then Dan, before wrapping up, I wanted to just touch on technicals in the SSA segment. Certainly, we have a large SSA buyer base that listens to us and it's been a bit of an opposite story in SSAs actually.

Dan Krieter:
Q2 2022 was actually the largest net issuance quarter in SSA since Q1 of 2021. And that relatively heavy supply, I don't want to say heavy supply because it was just net zero, but this was the first time we haven't had net negative supply in a quarter since the first quarter of 2021. And that relatively heavy supply has weighed on SSA spreads increasingly here. In the first three, four months of the year, all we talked about was how remarkable the out performance in SSA was compared to other credit spread products and our SSAs are trading more like governments and participating in flights, the quality and things like that. And all of that is true to a certain extent, but I think it was maybe more of a technical story. The Q1 SSA supply was the second lightest quarter on record during what's usually a very heavy quarter.

Dan Krieter:
And now suddenly Q2 supply is the heaviest it's been in five quarters and we see under performance in SSA spreads widening a bit faster on an adjusted basis compared to corporates than what we're seeing. So technicals is really a story there and SSA have not been supportive and it exposed the vulnerability of SSA spreads have to new supply. Now we're in the summer doldrums now, July and August two of the lightest months in the year.

Dan Krieter:
And so supply probably not going to be a big threat in SSAs here yet for the time being, but looking ahead to September when we think issuance will return in full force, spreads even at these somewhat elevated levels of SSAs don't look overly attractive here either from a technical standpoint. So again, reason to think maybe long-term, we look to start getting maybe long SSA spreads, August, September taking advantage of any technical weakness that we see with the longer term view being that these spreads will ultimately prove attractive. Dan, anything else before we sign off here?

Dan Belton:
No, just to reiterate what you said at the top, we would greatly appreciate any support in the institutional investor survey. The poll is now open. So please reach out to us or sales coverage if you're interested in participating and have any questions, but thanks for listening.

Dan Belton:
Thanks for listening to Macro Horizons. Please visit us at BMOCM.com/Macro Horizons. 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 the 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 employees of Bank of Montreal, Vemo, NBE firms, incorporated, and Vemo 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, notwithstanding or 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.

Speaker 2:
It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment legal accounting or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances or otherwise it constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures, contracts, and commodity options, or any other activity, which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you or in your best interests in you to the extent applicable you'll rely solely on advice from your qualified independent representative in making hedging or trading decisions. This podcast does not be relied upon in substitution for the exercise of independent judgment.

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 herein. BMO and its affiliates may have positions long or short and affect transactions or make markets in securities mentioned herein or provided advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to BMO cm.com/MacroHorizons/legal.

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

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