September Credit Update

Monthly Commentary

October 06, 2016

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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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