CBOE Vix

How though to navigate this if your mandate is high yield bonds and leveraged loans? The answer from most people we speak with is to continue to use a longer lens on where valuations are going — at least that appears to be what is keeping credit investors sanguine at a time when other asset classes will likely be much more sensitive to daily events.

There’s also a reversal in the weighting of investor focus. Rates outlook arguably remains the biggest driver across asset classes, as my colleague Chris Haffenden explored in his Friday Workout, but last week there was much more lean into credit dynamics than feels the case today (Tuesday). In some respects at least, it was the synthetic credit market that led the way last week.

iTraxx Crossover retreated from the wides last week — source: IHS Markit / S&P

“From a pure RV standpoint, the main move of the week has been the outperformance of iTraxx and CDX indices versus most of the other markets but notably versus equities, Equity Implied Volatility as well as cash, whether bonds or loans,” wrote BNP Paribas relative value strategists in a note on Friday.

As such, the cash bond / CDS basis cheapened in both the US and Europe, in both investment grade and high yield. One Restaurant Brands Iberia pulled loan aside, my London levfin colleagues also saw loans in more buoyant mood than high yield bonds last week. US loans likewise had a busy time of it.

As a follow up to some of the concerns in credit I explored in Macro Prophet last week, one buysider in London told me they don’t see loans as too rich at today’s levels given the technical support they receive from CLO demand and a lack of supply. Certainly high yield bonds look more expensive, they opined.

However, this may be more of a European-centric perspective or reflect where they are positioned within the credit spectrum. According to latest Bank of America US CLO research, “the back up in rates over the past few weeks has caused the price differential in HY and loans to increase” although the yield differential has fallen.

“We expect rotation into HY bonds away from riskier loans to continue to increase,” wrote the strategists. “To wit, the BB HY index is trading $89 vs B- loans being bid at $96 and CCC+ loans at $82. For a non-MTM vehicle, managers have more flexibility to take duration risk over credit risk for specific names.”

According to the buysider, investors should be swapping out of longer dated paper into shorter duration, ie one to three years, and going up in credit quality — rather than the reach-for-yield theme that has lately been at work in some sectors of the loan market. This chimes very much with what other investors told me ahead of writing last week’s Macro Prophet.

All well and good as a graceful but not complacent response to the global economy’s litany of mishaps. Earning short-duration carry makes a lot of sense. But the approach requires more fundamental credit work than many in the beta mindset will be used to doing, since shorter duration puts your portfolio right in the cross-hairs of the bond and loan maturity walls coming up in 2025 and 2026.

Source: Bondvigilantes.com

Similarly within CLO tranches, the top end of the stack is a more compelling opportunity for the buysider than double-Bs, especially where the end of reinvestment periods brings amortisation of the triple-As. This may be a growing consensus among CLO investors, given the findings of BofA on a shift in the perceived relative value of different rating bands.

“CLO AAA basis versus lower parts of the capital stack has been close to fair value over the past few months,” wrote BofA’s CLO strategists in the same research. “However, the basis between AAA and BBs and AAA vs BBBs has increased more recently suggesting investors pricing in more tail risk events going forward. We expect this basis to continue to increase as downgrades are expected to pick up post Q3 2023 earnings. As we highlighted last week, thats the first full year when companies report trailing 12-months of interest expense that references a higher base rate of 4%.”

What is not in dispute is that the narrative of dispersion and defaults picking up within credit (which I’ve been Chicken Littling all year) is finally happening. Aside from the much discussed bearish dis-inversion of Treasury yield curves, another dynamic to consider is that corporate defence mechanisms against rates are starting to falter against the siege of ‘higher-for-longer’ central bank policy. In short, according to the buysider, around this time in 2022 a lot of high yield corporate CFOs thought they’d tackled the problem of rising rates by placing one-year hedges. But these are running off now.

Two corporate CDS trigger events do not make a high yield winter, or indeed a trend. But in the US, drugstore chain Rite Aid looks set to be the next CDS index constituent to require settlement after French supermarket retailer Casino Guichard-Perrachon defaulted in late August. A request to Credit Derivatives Determinations Committee on Rite Aid (see our report here) was also the first such occurrence within US markets for more than six months — after the company filed for Chapter 11 protection over the weekend.

Rite Aid, like Casino, was so well telegraphed as a potential credit event that I doubt its final denouement will do much to stir CDX HY index equity 0-10% tranches — a tradable measure of dispersion in the US high yield universe (participants can make lucrative returns for taking that first-loss slice of risk, although any defaults in the index over the lifespan of the trade hit into that, meaning you want index constituents to be highly correlated and happy).

CDX HY series 41 equity 0-10% tranche price — via IHS Markit

But these news headline-generating triggers should make the prospect of idiosyncratic default risk at the wide end of portfolios feel a bit more real. Alongside this, investors are starting to be confronted with frequent outlook analysis on what default rates could look like in the coming year under different scenarios. The ones I’ve seen generally point to an uptick, but I feel most err on the conservative side.

All of which brings us back to where we sit today, waiting for whatever the Next Big Thing is to ramp up some volatility. The iTraxx Crossover index is widening as I write (“Stop writing then!” you cry) but is still some distance within the 462bps print it hit last Monday. Today’s 2bps move in the index to 447.5bps is merely a partial reversal of the 5bps rally it underwent yesterday, which itself felt more a reflective response to improving stock indices.

S&P 500

The S&P 500 gained 1% on Monday — at the expense of a sell off in US Treasuries — seemingly on the back of Israel not yet starting its offensive in Gaza. That does not at all feel like a constructive balancing act to play in the two markets, given such awful daily events and the possibility of a spiralling crisis in the Middle East region. But it does suggest either treasuries or equities are about to give in a big way. Investors taking a short-term view are thus caught in the uncomfortable position of having to decide which has the biggest upside and downside from where they sit.

US Treasury yield curve

Lest I ever worry that I’m getting too carried away with making dour prognoses on the future path of markets, I can now hold in mind the latest claims by Bloomberg Economics — that Iran intervening in the Israel/Gaza conflict will send crude oil to $150 a barrel (from its current $90 region), cut global growth to just 1.7%, tip many countries into recession, and wipe $1tr off global economic output. To be fair to the report’s contributors, they do assign a ‘low probability’ to direct war between Israel and Iran, but that hasn’t stopped other media commentators running with it.

This may prove a very bad case of famous last words, but while I do see this adding to recession prospects I don’t see how the price impact for oil happens on anything like the scale caused by the Russian invasion of Ukraine — unless the whole Gulf of Arabia becomes closed, and Iran is also effectively at war with Saudi Arabia. Iran is a big oil producer but, at around 3,800 barrels a day on average last year, it supplies less than a quarter of US and a third of Saudi volume. Iran is also already heavily impacted by US sanctions so has largely been supplying places like China rather than the west. Compare and contrast to Russia, which produced almost as much oil as Saudi in 2022 and was previously a big supplier of fuel to western countries.

Maybe I need to give this more thought. Winter is approaching and a spike to those price levels — if at all within the realms of possibility — is something much worse to consider on a human level than anything it entails for financial markets. With markets not doing too much today, maybe the human level is where all our thoughts should be.