US Credit – Financial Conditions Starting to Bite
Highlights from U.S. credit markets:
- Investment grade improving but Treasury bounce fading
- Volatility keeping corporate buyers on the sidelines
- Financial conditions starting to bite
- Falling oil prices dent high yield energy
- Trading desk comments
- Limited new issuance
- Bank spreads underperforming
Investment grade improving but Treasury bounce fading
Treasuries yields ended lower on the week, but the rally early in the week faded quickly. Investment grade corporates followed Treasuries higher, but both industrials and financials underperformed. Volatility and uncertainty about whether Treasuries yields can stay lower kept buyers on the sidelines.
The second solid week in a row for safer assets has turned the rolling 1-month performance around. Treasuries were the best performer in May, with the Bloomberg Barclays Treasury total return index rising 0.7%. Riskier credits lagged with U.S. high yield corporates rising only 0.2%.
Volatility keeping corporate buyers on the sidelines
The next chart shows year to date changes in the total return indices for U.S. Treasuries, investment grade, and high yield corporates. High yield has essentially traded sideways since mid-April. Investment grade corporates underperformed since the second half of April and have not been able to close the gap. Rising Treasury volatility and persistent belief that higher interest rates are coming have discouraged buyers.
Financial conditions starting to bite
We see evidence that tighter financial conditions are becoming a more significant headwind for investment grade corporates. The charts below show Bloomberg Barclays total return indices for U.S. investment grade and U.S. high yield along with our fair value estimates. These are generated using Google search trends for consumers and businesses, changes in economic data and surprise indices, fund flows and implied volatility across major asset classes.
We’ve been highlighting the shrinking upside for investment grade credits. Our fair value estimate has now fallen below actual for investment grade. High yield bonds continue to track fair value.
The next chart illustrates some of the influences that have us expecting investment grade to underperform. Financial and non-financial leverage continue to fall, a symptom of the Fed’s continued tightening past our estimate of the reversal rate. Consumer search interest in borrowing related to home and auto purchases has falling, along with interest in home furnishings and improvements. Uncertainty about trade policy is also a growing headwind for investment grade total returns.
Falling oil prices dent high yield energy
The narrative in energy markets is moving past geopolitical risks to supply and increasingly focused on oversupply issues in U.S. shale territory. Falling oil prices have knocked high yield energy lower, but oil above $60 per barrel is still a tailwind for many risky borrowers in the energy space. The chart below shows changes in the Bloomberg Barclay’s U.S. high yield and high yield energy total return indices since January 2017. High yield energy has outperformed by about 1% since April.
Trading desk comments
Our corporate desk had the following remarks on Friday:
It proved to be a volatile week for the credit markets. Government unrest in Italy and Spain caused spreads in Yankee banks to back up significantly during Tuesday and Wednesday’s sessions. However, as the waters calmed spreads were able to recover somewhat. The domestic fared much better, closing +1-5 basis points generically.
The primary calendar was largely shut down this week due to peripheral Europe concerns. May saw only $135 billion of issuance, -27% v. May 2017. YTD investment grade issuance stands at $711
billion, -7% v. 2017. DB bonds continued to get hammered. S&P downgraded the senior unsecured debt to BBB-, which will raise funding costs. US regulators added DB to a list of troubled lenders they are monitoring. Numerous analysts downgraded the stock. DB 4.875 12/32 backed up +70 basis points to +400/390. That is roughly 95 basis points wider this month.
Benchmark Italian and Spanish bank bonds were hit hard for the second week in a row, but did recover from the wides of Tuesday and Wednesday. ISPIM 5.25 1/24 closed +250/240 +(25).
UCGIM 4.625 4/27 went out +245/235 (+35). SANTAN 3.848 4/23 closed +155/145 (+10). Domestic banks held their ground rather well, going out unchanged to +3 basis points.
Limited new issuance
New issuance was quite limited with the volatility and concerns about Europe. The largest deal was $1.8 billion from L3. BB&T brought the only financial paper as the sector was under heavy pressure early in the week.
Bank spreads underperforming
Bank spreads have been under fire. The chart shows average 1-month changes to benchmark Treasuries for issues in the Bloomberg Barclays Financials index by 2-year duration buckets. Spread performance worsened as you move out the curve. Banks, the largest industry group within the index, saw spreads widen about 5 bps on average in the 2-4 year duration space. Spreads for issues with durations up to 10 years saw spreads widen about 10 bps on average.