Select Language

Search

Insights

No match found

Services

No match found

Industries

No match found

People

No match found

Insights

No match found

Services

No match found

People

No match found

Industries

No match found

Q3 Outlook - High Quality Credit Spreads

FICC Podcasts June 30, 2021
FICC Podcasts June 30, 2021

 

Dan Krieter and Dan Belton discuss the likely path of credit spreads in Q3 including the supply and demand factors that will drive credit markets including deleveraging, financial issuance, and seasonality.


Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


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.

Podcast Disclaimer

Read more

Dan Krieter:                                           Hello, and welcome to Macro Horizons: High Quality Spreads for the week of June 30th, Q3 outlook. I'm your host Dan Krieter here with Dan Belton as we discuss our expectations for the path of credit spreads in the quarter ahead, looking at things from both the supply and the demand side.
                                                       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 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@bmo.com. We value and greatly appreciate your input.

Speaker 3:                                             The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries.

Dan Krieter:                                           Well, Dan, been a bit of a ho-hum week since our last podcast recording last Wednesday. I think looking at credit spreads in the broad IG index, we have moved less than one basis point in an entire week. And I don't think there's anything from a news perspective that really had much of an impact that we have to talk about. So the timing is really perfect here with today, the last day of the quarter for us to provide a bit of an outlook for the third quarter and what to expect going forward. And obviously, to begin that quarter, we're entering Q3 with spreads currently sitting at post financial crisis highs. And as we talked about last week, if we make adjustments to the credit spread index for credit and duration changes, arguably the lowest credit spreads on record. So Dan, with that in mind, I'd like to start the conversation and maybe we should start initially by focusing on the supply side of our Q3 outlook, what are some of the key trends from the supply side to keep an eye on in the third quarter?

Dan Belton:                                            Yeah, Dan, it's interesting because as you've mentioned, we're sitting here at near historical lows and credit spreads. We've gotten here amidst some pretty heavy supply. So supply in the first half of the year, excluding the historic 2020 issuance was the heaviest first half of the year on record. And just for a high-level overview on our outlook on supply for the second half, we think it's going to turn a little bit more neutral, but remain more or less heavy into the second half of the year. So the first thing that we talked about in our written piece, which was the supply outlook for the second half of the year, and specifically Q3 that despite this heavy issuance you've seen in the first half of the year, there's actually some de-leveraging efforts underway with respect to investment grade corporate borrowers.
                                                       So when you break down the total debt outstanding on corporate balance sheets, that's actually moderate and it's not up too much from a year ago, but the IG index in corporate bond supply has remained heavy. So what we've seen is sort of an opportunistic move away from traditional funding in the form of bank loans and into more corporate debt outstanding, just given the favorability of rates.

Dan Krieter:                                           That's a really interesting observation, Dan, and I think there's a few things we can take away from it. I think first, we talk about the impact of technicals and you make the point that we've gotten to arguably all time low spreads given such heavy supply, but maybe that makes sense if we've seen some de-leveraging, so corporate balance sheets are arguably getting healthier, that wouldn't maybe be the knee jerk reaction when you hear things like, "This is a record year in corporate issuance outside of 2020," but really if it's more of a change in the debt mix rather than increase in leverage on a gross basis, well, then you have corporate balance sheets getting more healthy, which should ultimately [inaudible 00:03:39] our spread. So I think that's played out and I think that's been something a little more difficult to see just from looking at headline issuance numbers so far this year. But then trying to project with this trend means for the rest of the year is a little more difficult because I think there's really two main ways you can interpret this.
                                                       First you could look at it and say, "Well, there's been very heavy supply this year, but it's mostly been just refinancing of bank loans and other types of corporate debt into bonds." Basically just refinancing more expensive debt into cheaper debt and capital markets. And once that's over, we should expect to see the de-leveraging trend continuing, we should see corporate issuance fall. The other way to interpret it, of course, is rates are still very, very low, particularly now at the long end if we just had a big flattening of the curve two weeks ago. It's likely that corporate bonds are still significantly less expensive than corporate loans and other forms of corporate debt. So we should see this trend continue where other forms of debt continue to be refinanced and demands and corporate debt supply continues to be strong. So it's probably not mutually exclusive. Obviously it's going to be a very individual decision, which one of those two interpretations is correct. But if we look at things from a high level at the index as a whole, Dan, what are your thoughts as to which interpretation would likely win out?

Dan Belton:                                            So as you might expect, it's going to be a lot of both. Like you mentioned, it's going to become a very individual decision and then there will continue to be some refinancing of bank loans, but then there will be more de-leveraging going on in the second half than maybe there was in the first half. And I want to go back to what you said about corporate balance sheets, because I think that's ultimately what a lot of it's going to come down to. And I think corporate balance sheets are just in a significantly different place today than they were a year ago. On one hand, yes, you do have a lot more debt outstanding, but the rates that they're borrowing at are significantly lower and now the profits that they're generating.
                                                       So if you think about most leverage ratios, which have some form of profit in the denominator that makes the leverage ratio look optically more attractive, given that profit streams have been revitalized here. So it's just going to come down to how these different companies are looking at their debt outstanding and looking at their balance sheet health. But ultimately it will see a little bit of both. We'll see some continued move away from traditional forms of financing into the bonds market. And then we'll ultimately see some companies continue to reduce leverage as the expansionary phase of the business cycle sort of takes hold here.

Dan Krieter:                                           It's a difficult thing to estimate, and there's really not much you can do to try and figure out how much more powder there is in the loan and to bond refinancing trade. But really the only thing we can do is look at the share of corporate balance sheets in loans and in bonds going back historically, and we can rely on [inaudible 00:06:17] one day to get at least a general idea of it. And if you look at a chart of just percentage of corporate debt that is made up of loans and the percentages of the same thing made up by bonds, you'll see that bonds are not at all time highs right now. And that would suggest at least that there is room for them to continue to move higher and for the share of loans to continue to drop. Now, there have been a few regime changes there specifically in 2018, with the passage of Donald Trump's corporate tax reform.
                                                       We see a pretty significant drop in corporate debt portfolios, and that makes sense. We had corporate debt portfolios financing overseas investment portfolios that were maintained in other jurisdictions in order to avoid repatriation taxes. Once President Trump pushed through his tax reform, those overseas investment dollars are no longer necessary, they were repatriated and corporate debt falls. So there's a bit of a regime shift there, but even optically adjusting for that, it does appear that there's still room for the share of bonds as a percentage of corporate debt to move higher, even just to being in line with some of the higher observations over the past decade, let alone going to new highs.
                                                       So I guess to your point, Dan, it's a very difficult thing to measure and it's going to be a little of both, but at least from where I sit there does appear to be at least a little more in this trade of refinancing from loans into bonds. So I think we could see technical start to improve, like you said, but it's not going to be a massive improvement. Supply's likely still going to be pretty heavy at least from a high level.

Dan Belton:                                            Yeah, exactly. So that's sort of the bottom line we arrived at in the outlook we published on Friday for Q3 supply. And one reason to think that there's more room for corporations to continue to move their financing into the bond market is just the favor ability of primary market conditions and that's another trend we talked about in this piece. But primary market conditions right now are about as favorable as they've ever been on record. So all in corporate borrowing costs are at or near all time lows and then primary market demand is seemingly insatiable. Even after these past six quarters of record supply, demand just continues to outpace it. We've had negative new issue concessions on average in 9 of the last 11 months, which is the strongest demand that we see in our database going back to 2016. It just seems like as long as issuers continue to come to market, there will be the demands to meet that assuming that there's not a significant shift in risk appetite.

Dan Krieter:                                           Yeah. And primary market conditions are obviously extremely important factor, especially when we're looking at how much money can you really save refinancing loans into bonds. So that's one big trend worth watching. I want to move on now to the second big trend on the supply side worth keeping a very close high on, and that is issuance from financials. We know it's been one of the major storylines this year, we know that financial entities are issuing a ton more than they did even last year. I think issuance is up 11%, that's 11 percentage points as a share of total IG supply. I think the numbers are 31% of total 2020 IG supply was from financials and in 2021 year-to-date 42% of total IG supplies coming from financial. So it's been a big increase this year and it's one of the main reasons why we're on this record pace.
                                                       Will financial supply continue to remain heavy? So we know that there have been a couple of key drivers this year, the first one being potential of the SLR, we've talked about it many times, another one being a restriction on banks and paying dividends and buying back shares, basically distributing capital to shareholders. And both of these factors are likely to be lifted in the near term. I guess, starting with the Fed's restrictions on bank dividends and share buybacks. We know that's ending on June 30th, we know from news here yesterday morning, that Morgan Stanley, as well as the other big banks are planning to reinitiate stock buybacks in pretty heavy volume in July.
                                                       And regarding [inaudible 00:09:59] resolution's a little more uncertain, we still don't have any idea from the Fed when it's going to come. But both the SLR and the restriction on share buybacks can result in the same thing, which is really, really heavy cash positions or increased debt issuance temporarily while banks through their funding reserves as Treasury portfolios that will soon be exempted under SLR or heavy liquid asset positions that are going to be used to buy back stocks or distribute to shareholders once the restriction's lifted.
                                                       So regardless of which factor has been more responsible for the increase in corporate debt this year, both work the same way that they should potentially influence corporate supply lower here in the third quarter.

Dan Belton:                                            So I think the evolution of financial supply and to Q3 represents one of the most likely reasons for supply to moderate a little bit. So you mentioned the SLR uncertainty, which really began in the second quarter of the year. So the big six US financials, which are most impacted by SLR and stands to gain the most if there is some permanent tweak to that rule, they accounted for 74 billion or 20% of all IG supply in the second quarter. So that's a pretty significant portion that we could attribute largely to the SLR uncertainty. So if that segment of supply in the market goes away in the third quarter, it's likely we see a much more normalized supply in Q3, but still even non-financial supply was above trend in the first and second quarters of the year. So even if this financial supply, which has been a driver of heavy issuance early on this year, even if that dissipates there's reason to think that we could still see moderately heavy supply going forward.

Dan Krieter:                                           And goes back to your theme about opportunistic funding. Given how cheap debt is right now, banks can continue to fund share buybacks with bank debt going forward. It's not like it's going to this one time thing because it was pent up. And now that the Fed is no longer restricting, if they're going to pay that off and they're just going to shrink, it could still be a significant portion of debt fueled share buybacks given how opportunistic the funding is, in which case you wouldn't see as dramatic a drop-off in bank funding as perhaps you might initially think. So looking at financial supply, just in a vacuum, the trend sort of mirrors what we talked about with IG supply from a high level. It should slow, but I don't think it's going to fall off a cliff. It's going to stay pretty heavy while slowing at least a little bit.
                                                       And then finally, I want to talk about the third trend in 2020 supply that could change a little bit going forward and that's been a renewed focus on funding at the short end of the curve this year. There's been a lot more funding accomplished in the five-year sector and in this year as compared to last year, and we could see that begin to change. And this is just simply highlighting the big flattening, the Treasury curve following the FOMC meeting two weeks ago. Obviously earlier in the year, we saw a large steepening in the Treasury curve, which likely is the main reason why corporate supply has been focused more at the short end. Now with that sort of reversed and a big flattening, I think the biggest flattening in 10 years, we talked about last week, we could see issue in start to shift further out the curve again, which maybe provides a little bit of support for short end secondary market corporate spread.
                                                       So I just wanted to highlight that very briefly as a straightforward thing. And now Dan, before moving on to the demand side of the equation for the Q3 spread out, look, I do want to spend just a quick minute here talking about SSA funding given our franchise focus on the SSA market. And it's really a very similar picture to what we talked about in the IG market. When you look at SSA funding at this point in the year, compared to years past from a percentage of funding progress done so far with SSAs, looking at 2021 compared to 2020 and 2019, we're actually at a higher percentage funding accomplished this year than it was in either 2020 or 2019. Now that said, borrowing programs are naturally a lot larger this year given the pandemic last year. So even with a better funding progress, larger borrowing programs, combining those two, we have a pretty similar dollar amount in total that the SSAs have left to fund in the second half of the year.
                                                       It's actually the highest this year of the past three years, not by a lot, but it is the highest. So technicals in the SSA market, pretty neutral now. We've had obviously extremely heavy issuance through the first half of the year. I think that will start to slow a little bit, but it's not going to be similar to IG, it's not going to be a drop off the cliff. It's going to be a modest reduction, I don't think is going to result in any real material change in the outlook for credit spreads from the supply side. Is that how you're interpreting things as well, Dan?

Dan Belton:                                            Yeah, exactly.
                                                       It's going to be a lot more of the same and I think both markets are going to kind of follow the same path and just to put a bow on things for our outlook for supply in July and the third quarter, so in high-grade corporates we're expecting $90 billion in gross issuance in July with $340 billion in the third quarter. And that's down marginally from the second quarter which looks on pace to end up at about $360-$370 billion. And then in the SSA market, we're looking at gross issuance of about $27 billion in July and $73 billion in the third quarter.

Dan Krieter:                                           Yeah, I think that sums things up quite well, actually. So with that, let's transition the conversation now away from the supply side and start focusing a bit on the demand side for our Q3 outlook. And here's really where our view on credit that we've laid out in the past few podcasts really starts to factor in here because we've had a neutral view on credit really since early March, just given how narrow credit spreads have gotten, a ton of optimism and enthusiasm priced into the market based on expectations for a strong economic reopening, but still some uncertainty there that [inaudible 00:15:37] still obviously ways that that economic reopening could fall off the rails and that we really wouldn't have much narrowing potential until we started to see more demonstrable evidence of that economic reopening and that's more or less what's played out. Right, Dan?

Dan Belton:                                            Yeah, Dan. We've seen pretty directionless trading in IG corporate spreads. We've been confined to about a 20 basis point range since we initiated that neutral stance on credit in the beginning of March and absent much fundamental or even technical direction, the market is just kind of ground narrow and we sit at the narrow end of current spread ranges, but further out performance has really required a higher bar as we've anecdotally heard of a lot of investors kind of balking at current spread levels. And we got a lot of feedback about our piece in podcast last week in which we talked about the adjusted index spread, which actually shows credit spreads well within all-time tights.
                                                       And I think that just goes to investor sentiment broadly where credit spreads are very rich right now, especially given the risks that we're looking at on the horizon. I think that the most important of these risks is that in the middle of the third quarter, we're probably going to start getting a lot more economic clarity about this recovery. And we've talked a lot about the two-sided risks to that clarity, but that's going to start to become tangible later on in the third quarter and we could see some spread weakness following that.

Dan Krieter:                                           With economic clarity comes increased risks that the Goldilocks scenario is going to price out. We've talked about this a lot, so I'm not going to belabour the point, but you're right that that will likely start to come in the middle of Q3 economic data that is more market moving. And that's going to come at a time that is from a demand side, seasonally, not great for credit spreads. And to demonstrate why in our written work, we went back and looked at seasonal spread moves in all the different months of the year over various time horizons because obviously your selection of time horizon here is going to have an extremely important impact on what your seasonality metrics show and the analysis is sort of inherently always going to be exposed to the risk of outliers.
                                                       So to try and adjust for outliers, we looked at seasonal spread moves or a bunch of different time horizons since the financial crisis, just the past five years, since 2000 by itself, then just pre-crisis and looking at a bunch of different time regimes in order to try and smooth out as best we could the impact of outliers.
                                                       And what kept consistently coming up was that spreads seemingly consistently underperformed during August. Almost every time horizon we used, August was one of the weakest performing once a year, but more importantly, looking at the number of times a single month showed underperformance, August, November were the only two months where we saw consistent under performance across different time horizons in all of our studies. So there may not be a perfect way to do seasonality. You hear about seasonality all the time, I don't know if there's a perfect way to measure it, but this analysis we did, we tried as best we could to eliminate the impact of outliers and still consistent underperformance in August continued to show up.
                                                       So if you have this intersection of poor seasonality as well as increased risk to the Goldilocks scenario, the Fed likely starting to talk about tapering, it just seems to be a perfect combination for spread market weakness. And it's also important to highlight here that, well, we found that August was typically a pretty poor month in terms of credit performance, July happened to be one of the best seasonals. So what does that tell you, Dan?

Dan Belton:                                            I think that seasonality really adds to the bias that we've had for a couple of months now, which is that the continued [inaudible 00:19:04] in the near term is the most likely outcome. But then especially given that seasonality you talked about, and then economic clarity in August, any further strength we'll probably want to use as an opportunity to reduce positions in corporates and then look for better buying opportunities down the road once any weakness is realized in August.

Dan Krieter:                                           Yeah, I agree Dan. So just high level, our conversation today focused on the outlook for Q3 from both the supply side and the demand side. And I think to sum it all up, on the supply side for credit spreads, I think the outlook is pretty neutral from the second quarter to the third, but on the demand side, I think you could see technical start to turn less supportive. So on that neutral and negative, we do have a slight negative outlook for Q3, at least for the first half of it. And any spread weakness that does result from that, again, we'll stress, we view that as a buying opportunity that's likely to become less frequent and less substantial as we settle into the sort of post-crisis ample reserve regime that we saw following the financial crisis that was typified by very low spreads and low volatility.
                                                       I think we're headed there again. So any buying opportunity is when we need to be taken advantage of here. And just on a quick program note, we'll be back next week and I hope everyone enjoys their long Fourth of July weekend.

Dan Belton:                                            Thanks for listening.

Dan Krieter:                                           Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including a FICC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:                                             This podcast has been prepared with the assistance that 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. Notwithstanding 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 suggestion that any investment or strategy referenced herein maybe suitable for you.
                                                       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 undertaken to act as a swap advisor to you or in your best interest. In you to the extent applicable, we'll rely solely on advice from your qualified, independent representative in making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.
                                                       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 containing 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 affects transactions or make markets in insecurities mentioned herein, or provide 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 bmocm.com/macrohorizons/legal.

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

You might also be interested in