June Credit Update

Monthly Commentary

July 05, 2016

The Brexit vote brought a new element of instability to the markets. The immediate aftermath saw risk assets decline substantially. Global stocks posted big losses, credit spreads widened 11 basis points in the two days following the vote, the VIX (CBOE Volatility Index) spiked to levels last touched in February and European financial stocks were down as much as 30%. The carnage ended up being rather short-lived as risk assets recovered – if not all the way, then most of the way, for most asset classes. The insatiable appetite for yield, coupled with faith in the central banks’ ability to mitigate any Brexit fallout (whatever it takes mantra), has been a driving force behind the resiliency in credit spreads/risk assets. The positive technicals caused by this grab for yield have supplanted worsening credit fundamentals – driven by the ability of corporations to lever up using cheap borrowed money. We are already hearing chatter of the European Central Bank (ECB) “easing” the rules for their bond purchase program. One way to do this would be to relax the capital key, which dictates the proportion of bond purchases for each country based on population and GDP. As European sovereign bond yields have declined further, the universe of eligible bonds that can be purchased by the ECB has declined (must yield more than the deposit rate of -40 bps). Relaxing the capital key by moving to a more bond market value weighting would help the periphery (see chart). Other CB’s are also signaling that more easing is on the way, including the Bank of England (BOE), which may cut interest rates and has expressed a willingness to ease bank capital requirements. The prospect of more CB intervention caused global bond yields to decline further with 10-year Treasury yields ending the month near record lows. This resulted in strong total returns for the credit index, despite marginal spread widening.

Brexit vote - now what? It is unclear if, or when, Article 50 will be triggered. There is chatter of another referendum or a Norway-type model (Brexit-lite). Assuming the British government allows the vote to play out, a newly appointed prime minister would trigger Article 50 of the Lisbon Treaty, thereby starting the two-year exit process during which issues of trade, labor movement, etc., would be negotiated. The final outcome is uncertain and will take time to play out. Looking at the bigger picture, this brings into question the sanctity of the European Union. Will there be a domino effect as other countries with disaffected populations look to exit the union (Nexit, Auxit, Frexit)? The global economic backdrop is already precarious and this political instability adds another element of risk to the marketplace. Couple that with an already deteriorating credit fundamental backdrop, and a cautious approach to credit is warranted.

Credit Index OAS vs. S&P 500

Source: Barclays

Global Benchmark Yields

Source: Barclays

31% of Global Government Yields are in Negative Territory

Source: JP Morgan

$5.9 Trillion U.S. IG Credit Market Accounts for 12% of the Global IG Market Value ($49 Trillion) But 31.5% of its Yield

Source: BofA Merrill Lynch Global Research

Capital Key vs. Share of Eurozone Sovereign Debt

Source: BofA Merrill Lynch Global Research, ECB

Credit Index Performance: Credit spreads widened 6 basis points (bps), ending the month at an OAS of +147 bps over Treasuries. Volatility picked up as the intra-month spread range was 11 bps (+140 to +151), with all of the widening occurring post the June 23 Brexit vote. Returns have been strong as Treasury yields have dropped to near record low levels (10-yr at 1.47%). The total return on the credit index was 2.28% in June while the year-to-date return is 7.54%. Year-to-date excess returns are more modest at 1.19%, which means most of the outperformance vs. Treasuries is coming from carry. Best performers in June were those tied to commodities, i.e., the sovereign (EM sovereigns), metals, and energy sectors, as commodity prices have rebounded off the lows of the year. Gold spot prices ended the month well north of $1,300 ounce (2-yr highs), West Texas Intermediate (WTI) hovered at ~ $49 for most of the month, and natural gas prices rebounded to ~ $3.00 (thanks to above normal weather in U.S.). Financials underperformed as banks and insurance companies continue to be pressured by a low interest rate environment that hurts profitability. While balance sheets remain the strongest they’ve been in decades (in terms of capital ratios and liquidity), earnings have been pressured by persistently low interest rates. Bank profitability gets hurt via net interest margin (NIM) compression and insurance companies earn lower returns on reinvested premiums. Within financials, European banks (and the U.K. in particular) underperformed post Brexit, given increased systemic risks from the political uncertainty. Additionally, European banks have not de-levered as much as the U.S. banks (Tangible Common Equity/Asset ratios much lower for European banks vs. U.S.), making them inherently more risky.

Stress tests: The Fed’s stress test results were released in June with all but two of the 33 U.S. banks passing. The stressed minimum common equity tier 1 ratio average for the money center banks was above 7%. The U.S. money centers’ capital plans were approved and most instituted modest dividend increases and share buyback plans. The stress tests are meant to stress banks’ balance sheets in a severe economic slowdown. Some of the adverse scenario assumptions include: Severe GDP declines, equity price drops of 50% through 2016, housing price declines of 25% through 3Q18 and unemployment going to 10% by mid-2017.

June Credit Index Returns

June IG Supply: At $86 billion, supply was more modest in June as Brexit volatility brought supply to a standstill for almost a week. Industrial issuance comprised 62% of total supply volumes and about half of industrial supply was to fund M&A. The largest deal in June was a $14 billion drive by from Oracle, issuing bonds across several maturities (with Use of Proceeds (UOP) to fund share buybacks). 10-yrs priced at +120, 30-yrs at +170.

The largest M&A issuer was Aetna, pricing a $13 billion multi-tranched deal to fund Humana acquisition. 10-yrs priced at +145, 30-yrs at +180. Year-to-date supply is $706 billion, which is just below 2015 volumes through June 30. New issue concessions averaged 8 bps in June, a nice change versus the de minimis concessions we saw the previous two months.

IG Monthly Supply Volumes

Source: BofA Merrill Lynch Global Research

M&A Related Supply

Source: BofA Merrill Lynch Global Research

New Issue Concessions

Source: BofA Merrill Lynch Global Research

M&A Funding Backlog

Source: JP Morgan

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW