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Q2 Spread Outlook - High Quality Credit Spreads

FICC Podcasts April 15, 2021
FICC Podcasts April 15, 2021

 

Dan Krieter and Dan Belton discuss the various factors set to drive the path of credit spreads in Q2, including their outlook for market technicals and fundamentals.


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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 April 15th Q2 spread outlook. I'm your host Dan Krieter here with Dan Belton. As we discuss how the fundamental and technical pictures likely to evolve during the second quarter and what it will mean for both credit and swap spreads.

Dan Krieter:

Each week, we offer a 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 [lighboard to sulfur 00:00:35]. 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, 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 we're here today to deliver our second quarter market outlook. Unfortunately it is already April 15th, so we've lost the first half of the first month here, but we were off last week with a monthly macro round table, so I guess this will be our outlook for the rest of the second quarter. And as we sit here today, credit spreads are either at, or very, very near cyclical lows of 87, 88 basis points, depending on which index you're looking at. So let's just say we're at cyclical lows, but whether or not we're at all time lows, I'm not sure that that's the actual story, I think actually the more predominant theme is that spreads have really not been moving very much in the month of April so far.

Dan Belton:

Yeah, so far there's been very little volatility. Since the calendar turned to April, spreads have been pretty directionless. They've grown slightly narrower, but that's really happened on light volumes, light supply. We've seen modestly better performance by higher beta sectors, but nothing very extreme it's about what you would expect. And there's been little disparity across different sectors. The broad index hasn't moved by more than one basis point in absolute terms on any day in April so far, but the index is two basis points narrower on the month. And that's been kind of consistent with our view that we laid out in our last episode when we made the case for wider versus narrower spreads, which was that absent a strong widening impulse in credit, spreads were likely to just grind narrower without much conviction and I think that's exactly what we've seen.

Dan Krieter:

And I think you made a key point there. On pretty light flows, last week, Friday, we saw the lowest volume change hands in the secondary market so far in 2021 of any day. And they've come off those lows, but volume remains on the light end of the year to date range. And I think that's a pretty important indicator, just a lack of conviction out there. I mean, certainly anecdotally in our conversations with clients, you're starting to see more and more bocket the outright spread level and really wondering how much upside is there really in credit spreads. And we're certainly sympathetic to that view. Our listeners know that despite our expectation for more of a steady grind narrower in the near term, that we're neutral on credit spreads here because it's really hard to make a case for credit spreads smooth significantly narrower in the near term, where there is a scenario where if this reflation trade is reignited, obviously that's not happening today, we have a pretty significant treasury rally going on today, which is helpful for spreads.

Dan Krieter:

But if that were to change, you could envision a scenario where spreads sort of move wider in a quick fashion. So I think you summed that up. Well, I mean, low conviction, low trading volumes in this grind narrower, it seems to be the environment we're in now, but now let's maybe broaden things out a little bit and look where we expect spreads to go over the remainder of the quarter. Obviously Dan, in the last six months, we've seen a significant improvement in the fundamental view, not just from an economic perspective with vaccines in the life, but also in just credit specifically, we've seen a much more ratings upgrades and things of that nature. Giving a boost to credit on the fundamental side, how do you see fundamentals shaping up for the rest of the second quarter?

Dan Belton:

Yeah, so there's been a lot of optimism priced in this year and we don't see that changing very much in the second quarter. I think there'll be short-lived bouts of concerns over inflation and maybe some data misses to the downside, but it's likely that the data is going to continue to come in in a positive manner. And it's unlikely that we're going to see a serious threat to this pricing and have a strong recovery. You talked about rating upgrades and that's something we've seen fairly consistently over the past six months or so. And I think as a more positive business environment is priced into corporate debt. Credit concerns are going to remain very low and obviously that's going to be positive for spreads. But the question to me is how much of this has already priced in, how much more can fundamentals really drag credit spreads narrower?

Dan Krieter:

That's certainly the key issue in my view as well. And I just don't think we're going to get that kind of clarity over the rest of the second quarter. I mean, even looking just domestically, the expectation here is that the majority of adults will have at least one vaccine shot by May. But if that leads to, there's a two week waiting period after each shot, so if that means that things quote unquote, go back to normal maybe in June at the earliest, we're not going to get any data to measure the strengths of the economic reopening before July at the earliest. And then even at that point, we're still going to be trying to gauge the impact that stimulus has had. At some point, stimulus is going to fade. Ostensibly, the $1.9 trillion package passed by president Biden at the beginning of the year is like the last SIM this program, unless an infrastructure program goes through.

Dan Krieter:

So there's going to be some transition over away from stimulus into the regular economy, I guess just cut to the chase, what I'm saying here is that we're really not going to be able to know how strong the economic recovery is here during the second quarter in either direction. So it's difficult for me to see how you're going to have a lot more optimism price in which would be higher rates and likely higher spreads. But at the same time, I don't see how that optimism is going to fade, which would maybe be more supportive of spreads as we descend back into the yield grab type environment. In fact, if treasury rates do move significantly lower from here, it would likely be because quote unquote, something happened, we've seen some bad news on the vaccine, obviously around the world, the vaccine rollout has been very low, COVID cases have been very, very high in recent weeks.

Dan Krieter:

So if there is this flight to quality and rates move significantly lower, I'm talking back down to the 120 or below territory, tough to division credit spreads like performing in that environment. That's not a yield grab type environment, that's flight to quality where spreads with typically underperformed. So it's just hard to see a significant move either way, which leads to this neutraly that we've been maintaining for a month now. I think that's really from a fundamental perspective, that's the view that's going to remain mostly in place for the second quarter as we just sort of remained in this wait and see mode. And if that's the case, if fundamentals are neutral, then I think technical is going to take on a lot higher of importance. And that's what we've been harping on for the past couple of weeks.

Dan Krieter:

And now we said at the beginning, the podcast we're down to the cyclical low in credit spreads or maybe at it. And I think a big portion of that has been an improvement in technicals. Obviously the sell off in treasury rates has slowed down and actually gone the other way. We've rallied all the way from about 175 intraday now down to 155 today and also invest rate corporate supply has slowed significantly after the record pace of Q1. And on the demand side, we've seen consistent inflows into fixed income funds, investment grade funds, more specifically just this morning, we had BlackRock out with a $60 billion inflow in fixed income funds, $44 billion of which was in passive funds to have seen a pretty significant net improvement in technicals here in just the last month. And therefore it's not really a surprise to see spreads at the narrow end of the trading range.

Dan Krieter:

My question now is let's look at technicals from a high level over the rest of the second quarter, and let's look at IG and high yield and even the SSA market because we've had divergent technicals in all three of those markets that could really have an impact on the performance of each asset class. So why don't we start with the biggest IGs and Dan, why don't you give us an overview on what you're expecting in terms of IG supply for the rest of the second quarter and what's happened so far actually?

Dan Belton:

Yeah. So after a near record first quarter, it was the third heaviest quarter on record, only behind the second and third quarters of last year, supply in the IG market has really slowed in April. So through two weeks, we've had just about $32 billion in issuance and that's likely going to fall pretty well short of the forecast $100 billion for the month of April. We're expecting supply to come back later on in the month and the quarter, and we're still expecting about $350 billion in gross issuance in the second quarter. We are maintaining our call for $1.2 trillion in issuance over the course of 2021.

Dan Belton:

And given the strong supply that we saw in the first quarter, we could see moderate issuance at times this year and still reach that target of a pretty heavy $1.2 trillion in supply. And we think that's what's going to happen. Now, moving out into the high yield market, it's kind of an interesting juxtaposition here where high yield supply is still at around record pace in April. I think as of this morning, high yield supply for the month of April is right around in line with IG supply, and you don't see that very often just given the different sizes of those two markets.

Dan Krieter:

That's an interesting point you make on how heavy high yield issuance has been compared to IG. My question for you though is how have spreads performed given the divergent technicals in these two markets over the past couple of weeks?

Dan Belton:

We've seen modest narrowing in both markets. I wouldn't say either one has outperformed the other. High yield spreads have rallied a little bit harder than IG, but that's probably to be expected given the continued improvement in fundamentals we've seen.

Dan Krieter:

So the argument there is that given the economic backdrop, we maybe would have expected see high yield spreads are performing a little bit more where it not for the divergent technicals, I think I can buy that story. So I guess the interesting question becomes now that we have such heavy issuance in high yield while IG supplies slowing down, how has this disparity going to be corrected? Are we going to see high yield supply start to slow down or is IG supply going to pick up? Or can the divergence sort of be sustained for a while here? What are your thoughts there?

Dan Belton:

Yeah, so that's the big question, I think, as it relates to the IG market and you could make the argument that IG supply's going to remain quiet here for the foreseeable future, even if we don't necessarily buy that. But just for the sake of discussion, high yield supply has been lagging IG basically since the onset of the pandemic, it's been a couple of months behind the IG market, just as it took a while for issuance markets to really reopen in high yield after the FED stepped in as a backstop to the investment grade market. So you could see as IG issuers have borrowed a lot of cash, you could see those cash needs being met in the high yield market just a little bit later than IG. I think that's a possibility.

Dan Krieter:

So to me, that comes off as sort of the optimistic case that you just had stress conditions in the high yield market for longer than IG so they were just behind the curve. IGs have now raised the money they needed to raise and high yield will do so in the weeks and months ahead and then issuance in high yield will start to fall. Another way of looking at sort of the same phenomenon is also that because the capital markets reopened to IGs earlier than high yield, IGs were able to build up a much larger war chest of liquidity to weather the economic storm that was coming from the pandemic.

Dan Krieter:

And as the months have gone on and cash continues to burn, if revenue streams don't come back in quite the way that they were expecting or not as robustly as maybe they were expecting, they may have to come back to the market. And in which case we'd expect to see IG supply come back up with high yield staying heavy as well. And I think again, it comes back to the robustness of the economic recovery. And that scenario strikes me is just maybe a bit more realistic than high yield issuance falling significantly in the near term. Of course, that said there is also an argument to be made that maybe this disparity is more fundamental in nature given the way the market has evolved since the pandemic.

Dan Belton:

Yeah Dan, I think that's a good point. And I think it's probably more likely that this slowdown in IG supply is probably more of just a blip in the radar. We might be making a little bit much out of just two to three weeks of slower issuance. Remember IG supply in March was over $200 billion, which is the second heaviest on record behind last year. But moving back to your last point about fundamentals, it's possible that balance sheet management is playing a role here. There's still a fairly steep cost to fallen angel status, which keeps triple Bs probably somewhat wary of issuing a lot more debt.

Dan Belton:

And that's one reason to think that this divergence could persist for this foreseeable future. The IG market is now mostly populated with triple Bs. We've seen a fair number of downgrades from A to triple B in the past couple of months. And that's likely due to some extent, to the tight spreads between triple Bs and single A issuers. But when you move further down the credit spectrum from triple B to double B, well, that's where it starts to become a little bit more costly. And so that could be partially to blame for this slower issuance and then moving further out the credit spectrum, most of the issuance in high yields has come from the double Bs And that's one reason to expect that this divergence could persist over time.

Dan Krieter:

You raised really interesting points about what the market is telling borrowers and what isn't valid from a balance sheet prudent standpoint. And I think you might be onto something there. So we'll see, if this disparity continues for a while here there's a couple takeaways. I think first it goes to show the dynamic that you just laid out, but also that we should expect to see IGs start to outperform high yield. Even if we haven't seen that so far, you know, IG supply has really just started to slow down so it might take a little while for the disparity to really start showing up in spreads, especially given how much higher high yield debt trades over IGs in the first place. And just to also hammer home the point on the importance of technicals with spreads at such low absolute levels.

Dan Krieter:

I think it's worthwhile to spend a minute just talking about the SSA sector here, which is really a tale of two halves. In the first quarter, we saw record pace of supply in January and February. And during those months as that supply was digested, we saw spreads start to leak wider. But then in March, suddenly unseasonably, very light issuance. We had just $12 billion worth of issuance coming all of March. And at the same time, March 2021 was actually the largest month of redemptions in the SSA market that we have on record. And combining those two factors, we had the most net negative issuance of any month in the history of the SSA market in our data obviously extremely supportive for credit spreads. And then it's perhaps not surprising that we saw SSA spreads really outperform during March, both treasuries and swaps, but also compared to other credit alternatives, even IGs peak the trough SSA outperformed by 10 basis points at the short end, which is a pretty significant move for the asset class.

Dan Krieter:

So clearly tech terminals are playing a significant role there. And I want to highlight that really quickly because SSA supply has been extremely, extremely heavy so far in April through the first two weeks. We're on pace for a record April. In fact, the pace is almost 50% ahead of April of 2020, which is a record we're 50% ahead of that pace. So issuance could slow down, but it looks like we're well on our way to a record April here in the SSA market. And we've seen the return of at least a modicum of concession. I wouldn't say the concession is there in every deal. It's not, but when we went from the beginning of the year when concessions were zero or negative and in basically every deal, that's not the case anymore. There still is plenty of zero and negative deals coming to market, but there are a few where you're still getting two, three basis points in concession for the large jumbo $5 billion benchmark, what have you.

Dan Krieter:

And that could start to spill over into credit spreads as well. So looking over the entirety of the second quarter, I think obviously SSA supply is going to slow from the record pace of the first two weeks, but will remain relatively elevated at least compared to historicals. So when you're looking across different asset classes for where you see the most supportive technicals right now, I think that's in the IG space. So we've been favoring this credit barbell strategy with SSA is at the top of the credit curve and then looking on the triple Bs, I think that the attractiveness in the SSA sector has gone down a little bit in the last couple of weeks, both because of how much outperformance it's enjoyed, but also the fact that issuance is starting to come back.

Dan Krieter:

So maybe looking to take some of the profits in SSA positions implemented during Q1 and looking further out the curve towards triple Bs where we think for the reasons that Belton just laid out, we may need to exercise a little bit more balance sheet prudence. Falling out of the investment grade still does have a punitive impact on borrowing costs that supply might stay pretty low there in the triple B segment, and you still have at least, not a lot, but you still have some upward potential coming from economic reopening and optimism surrounding vaccines and things of that nature. So that's where we favor focusing investment for the rest of Q2 based off of a very range-bound technical trading environment.

Dan Belton:

Dan, one more thing I like about triple Bs here is we've talked a lot about how we're not going to get much clarity on the fundamental side of things this quarter. Well, in a continued sort of directionless trading environment, I think we could very likely see a yield grab take place here, and that would benefit some of the higher spread products. We would likely continue to see inflows into investment grade funds as we've seen for the past pretty much 52 weeks at this point. That would likely just lead to more spread compression.

Dan Krieter:

Yeah, well today's treasury move I'm looking at Bloomberg now, it just continues unabated. That would certainly lend credence to the notion that we could have a bit of a reach for yield in the second quarter. I'm not convinced yet, but this treasury rally has surprised me from the get go. So maybe we will settle into a bit of a lower rate environment than I was personally expecting. Okay Dan, so quickly before wrapping up, I think we should at least take a moment to mention swap spreads.

Dan Krieter:

We've had quite the move narrower here in the last, what, just week and a half. Spreads are two to six basis points narrower across the curve led by the long end [inaudible 00:18:14] by five or six. And in terms of drivers, it's sort of hard to find one. I don't see much that's changed in the fundamental perspective that would indicate spreads should be narrowing this significantly. I mean, I've heard the argument that it could be convexity hedging related. At least up until today, I wasn't buying that. Today obviously makes you think twice about it, but still, I don't think the move narrower has been sufficient to really unleash a lot of convexity hedging. So to me it seems like the move is more technical in nature.

Dan Belton:

Yeah, I agree. It seems like maybe it was the case that given the severity of that selloff and treasury yields, the widening in swap spreads might've been a little bit overdone in this room we see narrower could have been something of a reversal of that widening. I think that's probably a factor, but might not explain all of the narrowing we've seen.

Dan Krieter:

Well, to that point, I want to highlight we talked about earlier in the podcast, I have the SSA supply whose been an SSA supply in particular can have a pretty important impact on swap spreads, given that all SSA supply is swapped and it comes in the ten-year sector or shorter. So certainly supply has been more heavy than expected and dealers might still be working off some of that exposure and now look at where we are on the earning cycle, the big US banks will be coming out of blackouts here, actually starting today we see JP Morgan in the market with the jumbo deal this morning and other domestics locally to follow. So it's just likely to me that there's this technical buildup with issuance related receiving that has likely pushed swatches lower. And also in the process probably rinse out a couple of speculative longs and also it's worth mentioning that bank HQLA holding periods are typically about three months.

Dan Krieter:

So three months ago was January when swap spreads are much narrower. And so we might be starting to see some profit taking in some of those bank trades enacted in January that would likely be significantly in the money, especially given where swap spreads were toward the upper end of the range and starting to come in. There may have been some profit-taking there for fear of missing the boat. So it's been somewhat of a self fulfilling prophecy started by issuance, and then some of those other factors also playing a role in the narrowing.

Dan Krieter:

But I think the important point is from a high level last Tuesday in our written work, we actually recommended looking to sell swap spreads. And our long-term view has been we preferred Widener's, but early last week when spreads hit the upper end of the year to date range, it was like, okay, maybe it's time to take some profit here on that position, because no matter what the outlook for swaps reds is likely to be range-bound with short rates still anchored by the FED at very, very low and unlikely to move significantly from there.

Dan Krieter:

So you just have to, play the range and buy at the lows and sell the highs. If that logic applied last week, when we were at the top of the range, I think we can apply the same logic in reverse this time. Spreads have now reached the low end of the year to day trading range this morning on the back of what we think is a pretty technical move. So looking to set longs and swap spreads here would likely prove to be a profitable trade at current levels here, just given the sharpness of the move we've seen in the past week and a half.

Dan Krieter:

That said the wild card out there remains SLR, we know the FED is working on a permanent rule addressing the SLR. We don't know what that is, and it could either influence swap spreads upwards or downwards, depending on what is ultimately exempted from SLR calculations. But what's going to be exempted. And the timeline for that rule remains extremely uncertain. So that could definitely change the range, but setting that aside for now, I think range-bound trading and looking to add at current levels after the technical move is a good idea.

Dan Krieter:

Dan, anything else you think we should mention before wrapping this episode up?

Dan Belton:

No, I think that covers it.

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 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 FIC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:

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



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