Investment grade credit spreads were only marginally wider in September as a benign interest rate hike outlook from the Fed, coupled with the Bank of Japan’s pledge to keep 10 year Japanese Government Bond yields at 0%, kept the theme of yield repression-driven credit risk taking intact. There were plenty of negative headlines to cause investors consternation, and concerns over the European banking sector were front and center - specifically, concerns over Deutsche Bank’s capital levels in the face of a potential $14 bln fine by the U.S. Department of Justice. Yankee bank spreads underperformed the broader market with subordinated parts of the capital structure hardest hit. The AT1/Coco (Additional T1 Capital securities) market was especially weak, as those deeply subordinated securities are subject to coupon deferrals and in an extreme scenario, principal write-down and/or equity conversion.
While European bank spreads did underperform, we did not see much spillover into the broader credit markets. In fact, the markets have been quite resilient in the face of re-emerging signs of stress in the European banking system, weak earnings and deteriorating credit metrics. Global central bank QE continues to be the driving force behind the quest for yield in the face of a growing global pool of negative-yielding debt. These forces are supplanting deteriorating fundamentals and tight valuations.
VIX and Credit Spreads: Credit Spreads Were Unmoved By the Increase in Equity Volatility
Source: Barclays Live
Strong Foreign Demand for U.S. Spread Product
Source: Federal Reserve, Barclays Research
Foreign Purchases of U.S. Corporate Bonds
Source: BofA Merrill Lynch Global Research
European Bank Senior CDs
Source: HSBC Calculations, Bloomberg as of 26 Set 16
Credit Index Performance: Despite record September supply
and negative European banking headlines, investment grade
credit widened only 2 basis points in September, ending
the month at an OAS of +131. The excess return of the
index was marginally negative (-.07%) as was the total return
(-.28%) as spread widening and a modest rate backup was
not offset by carry. Of the major sector categories, financials
and sovereigns underperformed, widening 6 and 7 basis
points respectively. Within financials, performance was
bifurcated with three names meaningfully underperforming
the rest of the sector: DB (-2.54% excess return), RBS (-1.37%
excess return), and WFC (-1.18% excess return). DB and RBS
underperformed, in part, over concerns about capital levels
in the face of unsettled fines related to pre-crisis mortgage
underwriting. For WFC, negative headlines regarding the
bank’s opening of unauthorized consumer accounts (and
the Senate hearings that followed), resulted in about 17 basis
points of widening in WFC 10yr senior holding company
spreads. WFC capital levels are strong, which should help
mitigate some of the pressures arising from large fines
and lawsuits that are likely to ensue. The other sector to
underperform was sovereigns, led by Turkey which fell out of
the IG index at month end. With $47 bln in index-eligible debt,
Turkey is the largest fallen angel ever. It spent almost 3.5 years
in the IG index, after becoming a rising star in May, 2013.
Best performing sector in September was independent
energy, tightening 10 basis points to an OAS of +227.
Energy rallied with oil prices (WTI +$3.5) on the heels of the
OPEC proposal to cut production by 796k barrels per day
(2.4% of production). More clarity is expected at the 11/30
OPEC meeting but the devil is in the details including which
countries will cut and by how much, as well as how it will be
implemented and enforced.
Credit Curves: There was notable credit curve flattening in
September. The 10-30s non fin credit curve flattened 5 bps
for BBB securities and 2 bps for A-rated securities. While a 61
basis point 10-30s curve is still steep by historical standards
(40 basis point mean), the flattening of the curve is likely a
result of foreign buyers extending out the curve in search
for yield. Another notable development is the flattening of
the front end of the credit curve ahead of the October 14
implementation date for money market reform. The new
rules for money market funds include a floating NAV, liquidity
fees and redemption gates in times of market stress. The 1-2
year credit curve is now inverted by 9 basis points as money
market outflows have caused dislocations in the front end.
September Credit Index Returns
*Including Turkey index widened 7 bps to an OAS of 176
Credit Curves Flattened in September
Source: BofA Merrill Lynch Global Research
1-2 Year Credit Curve is Inverted on the Heels of Money
Market Fund Outflows Ahead of 10/14 Rule Changes
Source: BofA Merrill Lynch Global Research
FRA-OIS Spread Has Widened as Short Term Funding Rates Have Been Under Pressure
Note: Spread contribution taken by subtracting OIS from each component.
Source: BofA Merrill Lynch Global Research, Boomberg
IG Supply: $144 bln in investment grade new issues priced this
month, another record for the month of September. Demand
was strong and new issue concessions were de minimis,
averaging 1 basis point in September. Industrial supply
dominated at $98 bln with a mix of M&A related issuance and
issuance earmarked for share buybacks. On the M&A front,
Shire issued $12.1 bln worth of debt to fund its acquisition of
Baxalta (multi-tranched deal, 5yrs priced at +120, 10yrs priced at
+150). Other large issuers included Gild ($5 bln multi-tranched
deal, 10yrs at +125, 30yrs at +172), CSCO ($6.25 bln multitranched
deal, 5yrs at +62.5, 10yrs at +80), and SIEGR ($6 bln
across five maturities, 5yr priced at +60, 10yrs at +85).
September Supply Record
Source: BofA Merrill Lynch Global Research
IG Monthly Supply
Source: BofA Merrill Lynch Global Research
New Issue Concessions
Source: BofA Merrill Lynch Global Research
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