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Dan Alderson

“In the light of the moon a little egg lay on a leaf…”

As any structured credit trader will tell you, last week was all all about BWICs. But what should be on investors' minds this week, and much more than it appears to be, is BRICS — the big recently invigorated caterpillar situation.

BRICS 2023 kicks off in South Africa today (Tuesday) with the tagline “partnership for mutually accelerated growth, sustainable development and inclusive multilateralism”. There’s been very little commentary on this in credit research, and plenty of skepticism about its significance in the broader press, but the summit has scope to bring announcements with far-reaching impact on the global economy both immediately and over time.

As we all grapple with central bank messaging, rising government bond yields, and the latest round of tech earnings, there’s the risk of being blindsided by BRICS. I will outline some of the concerns this raises, but the central one is this: a lot of countries are very hungry for change. The big caterpillar could be about to get a whole lot bigger, and it definitely wants to become a butterfly.

CLO investors and managers are also very hungry for business, as last week’s deluge of BWICs illustrated, although traders did start to complain of indigestion by Friday. There’s also hope for change, mainly in the form of tighter triple-A spreads that could unlock a wave of CLO resets to help avert the problem of so many deals leaving their reinvestment periods. That feels quite optimistic right now, but let’s explore the dynamics.

Skip ahead to the CLO part below if you like, but while I have your attention… here’s what Brazil, Russia, India, China and South Africa have been cooking up.

“The Very Hungry Caterpillar is about hope,” said author Eric Carle about his well-known illustrated children’s book. “You, like the little caterpillar, will grow up, unfold your wings and fly off into the future.”

BRICS skepticism is natural. Conceptually the BRIC acronym has been in use for over 20 years, since Goldman Sachs coined it in a 2001 report. It began gaining momentum after an informal meeting between the countries on the sidelines of the G8 Outreach Summit in 2006. South Africa was invited to join in 2010.

Detractors would argue the BRICS have very little show for their work since, despite around 150 annual meetings across their three pillars of cooperation: political and security, financial and economic, cultural and people-to-people. Since joining, South Africa’s only concrete gain has been a step-up in Chinese trade, they argue.

But the BRICS themselves can point to 30 agreements and memoranda of understanding. One might wonder if, by moving quietly, a lot of BRICS foundational work has gone under the radar.

This year’s summit could easily be a disappointment, and you can say I got all worked up about nothing. After all, China goes into it with problems of deflation, falling exports and imports, a crumbling property market, and soaring credit spreads — see my colleague Chris Haffenden’s Friday Workout column for deeper analysis, but here’s what the iTraxx Asia Ex-Japan index looks like:

Russia’s President Vladimir Putin can’t even attend the summit for fear of international prosecution, while his country languishes with a collapsed ruble and dwindling income from its once powerful industries.

Arguably though, there are several fronts on which BRICS 2023 could send some tremors through market that will find their way into credit.

Firstly, some 23 other countries have formally applied to join BRICS, and South Africa claims more than 40 want to join. With China and India as part of the group, it already encompasses a huge part of the world’s population, but bringing African countries like Nigeria into the fold would harness accelerating population growth over the coming years.

Of more immediate impact would be adding Saudi Arabia and Iran. Under China’s watchful eye, the two countries have made a “wave of reconciliation” ahead of the summit. They also happen to command two of the world’s biggest oil reserves.

Brazil has been in disagreement with Russia and China about the merits of expanding the group. But should this go ahead, it would challenge the long-standing dominance of western economies and threaten to tip the balance of political power. At the very least, it would give all of the new joiners much more leverage in dealing with the US and Europe. Diplomatic strategies, trade agreements, and even security arrangements could suddenly be back on the table. Some of the possible joiners haver substantial foreign exchange reserves and sovereign wealth funds, which might influence investment trends, asset classes, and even the valuation of major currencies.

South Africa has issued an invitation to all African leaders to attend the summit, and President Cyril Ramaphosa is well known for giving rousing speeches about this being Africa’s century.

South African President Cyril Ramaphosa, source: BRICS 2023

Another huge rumour though is that the BRICS have been working towards establishing a unified currency, based on gold. That could be could be a game-changer in the global currency landscape, challenging the US dollar's role as the world's primary reserve currency and its leverage in sanctions. Attempts by investors and central banks to front-run the currency’s introduction by buying up gold would only play into its hands and diminish the value of the dollar.

This doesn’t appear to have been a dynamic in play up to now. The dollar has been strengthening and gold prices retracing below key technical analysis levels, having been made much less attractive by rising central bank treasury yields. But unveiling a new BRICS currency would be sure to spark some volatility in that dynamic.

Being the scenes, the BRICS’ work on forming a Development Bank and Contingent Reserve Arrangement presents obvious alternative sources of liquidity and investment to traditional western institutions. Expanding those with new member states could add billions to approved projects that would spur economic growth and trade within the coalition. On the flip-side, this would also heighten concerns about the sustainability of some of the joining countries' existing debt burdens, echoing debates with other large-scale initiatives.

Amid a climate of intensifying trade standoffs on technology (with China at the centre), adding emerging economies to BRICS could bring increasing focus on innovation and technological advancement. Failing to recognise this competition might hinder western markets from adequately responding to shifts in global innovation trends.

Even a perceived step up in threat to the G7 could spur the US and Europe to re-galvanise their own diplomatic strategies and trade agreements to manage interests. The UK’s invitation for Saudi Crown Prince Mohamed bin Salman to visit this autumn feels somewhat pre-emptive.

These are big ifs, but any immediate impact they make on commodities, precious metals and currency markets would have multi-faceted implications for global credit. Increased economic growth and trade would surely create a more favourable environment for debt issued by companies based in BRICS and new member states. 

Higher demand and lower borrowing costs would come at a time when western corporate borrowers are hard-pressed to find willing pockets to refinance ahead of approaching maturity walls. The shift might especially benefit corporations involved in infrastructure and sustainable development, but present an array of knots for investors to untangle in the form of sanctions regimes, country risk, and hedging problems in countries with less advanced (or investor favourable) bankruptcy frameworks.

All of which takes us nicely back to indigestion in the credit markets we all know and love.

Friday brought welcome relief for CLO traders, with many having been worked off their feet and expressing amazement at the level of BWIC supply last week. Some bank desks said Thursday was their busiest day of the year for trading, while several traders complained of BWIC fatigue.

CLOs have held up strikingly well across the capital stack, considering the softening tone in other markets. There was an acceleration last week in the sell off of high yield bonds and equities, while leveraged loans managed to keep trading higher, which prompted some confusion among CLO investors.

Morningstar LSTA US Leveraged Loan 100 Index, source: S&P

One explanation is that markets are reversing some of the technical dynamics that were prevalent in the May to June rally across financial markets. Rates driven volatility is the central underlying issue, given there have been five successive weekly declines in government bonds. That supports extended flows into floating rate assets (ie loans and CLOs), while equities and pressured bond sectors are those that took the market higher in the earlier rally while CLOs and loans struggled to obtain lift off.

Certainly a lack of primary bond and loan supply might also lend buoyancy to secondary supply.

But the primary CLO pipeline has continued to avail new deals throughout August, largely due to the resulting overhang from previous months. There have even been a couple of US resets (see here and here), prompting talk that the theme might pick up if CLO spreads — particularly at the triple-A level — manage to grind still tighter.

To my mind this is optimistic when you consider the underlying market dynamics. But it’s understandable when one of the biggest concerns in the market is the sheer number of CLOs set to leave their reinvestment period by the end of 2023, and the impact that will have on highly indebted borrowers’ A&E prospects.

"The market has probably rallied enough for 2023,” opined one credit trader to me recently, speaking about spreads in general but in relation to the prospects for CLO improvement. “The returns in loans have been close to 10% YTD and Crossover 15%, so I don’t think investors are going to stretch to make more for the year."

Nevertheless, Barclays for one has taken time to assess what tighter CLO spreads could mean for the return of resets.

“As AAA spreads tighten, reset expectations rise,” Barclays strategists wrote last week in a note focused on the European outlook. “We see €2.4bn reset potential if spreads tighten to 160bp in the next three months, which rises to €5bn in the next six months.”

Triple-A spreads remain wide to historical levels before Russia invaded Ukraine. But there were periods during 2022 when CLOs printed at wider levels, and some of those deals are coming out of their non-call periods. Barclays noted Apollo is readying what would be Europe’s first CLO reset in more than a year, for Redding Ridge Europe 14.

“With the recent primary AAA print at 175bp, we are within attractive reset levels for some CLOs coming out of their non-call periods within the next six months,” said the strategists. “If spreads stay flat for the next six months, we could see €4.2bn of reset activity.”

Not many deals coming out of non-calls have triple-A spreads between 130bps and 160bps. So even a return to those levels might only unlock €5bn of resets.

“However, should spreads tighten to 120bp in the next six months, we could see resets increase to €8.2bn,” said Barclays. “As more deals issued in 2022 and 2023 come out of their non-call periods, reset activity could also rise. For example, if spreads stay flat for the next 12 months, we could see reset activity of up to €9bn.”

All very lovely to think about. But with US Federal Reserve Jerome Powell likely to strike a hawkish tone at this week’s Jackson Hole meeting, with flash PMI figures likely to tell a bruising tale, and with China — as mentioned — in the midst of a proper crisis, there’s little to inspire confidence in that narrative. Let’s hope Nvidia’s results tomorrow(Wednesday) to kick off another round of AI-boosted furore.

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