Suspension of disbelief has been a big theme of 2023 financial markets, and pretty much provided the impetus for this column when I started writing it back in May. Since then investors have got through the main challenges (as they were popularly identified), and if anything the overriding mindset in September is less the “willingly duped” to one of near imperviousness to harm.

Even those with a lousy aim may imagine they have a set of magic bullets to hunt down any opportunities they feel like in the coming months. No wonder there are high hopes for the primary bond and loan pipeline.

The problem with this mindset: no matter how many times the illusion seemingly lets you confirm your bias, there are lots of ways to shoot the wrong thing. 

Credit spreads are back at a point where the downside is vertiginous, the lustre on AI-boosted tech stocks looks to be rubbing off, sovereign GDP is under pressure, commodity supply is down as producers strain to keep prices high amid falling global demand, consumers are becoming more delinquent, big cracks are appearing in commercial and residential real estate, and US jobs numbers are finally starting to soften.

And then you have China (the world’s second largest economy, let’s not forget), which just posted another set of grim import / export numbers — imports being perhaps the most worrying, as it sends a forward signal on exports and GDP.

I’m not here to rain on anyone’s primary parade. For an objective analysis of some of those opportunities coming up, read our latest US and European levfin wraps here and here. And a rigorous Workout in the riskier realms of credit here.

But for this week’s Macro Prophet I’m riffing off William Burroughs’ The Black Rider: The Casting of the Magic Bullets, put to music by Tom Waits and based off an old German folktale, Freischutz. The protagonist of this fable, Wilhelm, makes good with a set of magic bullets he obtains at a crossroads from the devil (Pegleg). All of these bullets fire true at Wilhelm’s chosen targets — fostering his growing dependency on them — except one that remains the property of the devil, a lingering flaw in the pact. 

I first saw The Black Rider in production almost 20 years ago, with Marianne Faithfull playing Pegleg. Strange how the lesson of it comes back to me now as financial markets sit at a treacherous and beguiling crossroads.

Of course, market participants are able to look at all of the above macroeconomic concerns and still read them as an overall positive, because it means central bank policy is likely to be more accommodating. As long as that proves the case at this week’s and next week’s meetings, the confirmation bias remains intact. The ECB will be up on Thursday to test market assumptions of a 3.75% terminal policy rate.

Arguably, at the performing end of the market the downside for credit is less vertiginous than for stocks, simply because a growth outlook dent is much more realistic than default. Taking an extreme from the tech world, Apple’s share price has slumped almost 5% in the last five days, while its five-year CDS — already one of the safest in existence — continues to grind tighter.

But broader market confidence rides on headline events from this super-boosted sector — Apple’s unveiling of the iPhone 15 this week being one case in point, but also the hotly anticipated Arm IPO (valuing the company around $50-54.5bn) and those that might follow from Instarcart and Klaviyo. Nvidia’s share price retreat following earnings shows how twitchy investors are at today’s levels.

Even setting that aside though, mismatches within credit itself deserve attention. On IG, investors are saying CDS looks tight to bonds, and that CDX IG contains more cyclical triple-B credits than the US dollar IG cash bond index. But, ever the contrarian, I’m bullish on this part in the very short term, and reckon bonds have room to catch up with CDS. Unless stocks really take a dive — ie on a bigger story than current growth outlook debate — it’s easy to see IG corporate credit staying sturdy and consolidating the cash/synthetic divide in a positive direction.

The high yield basis goes the other way though, and I’m not sure bond levels are justified. Defaults subsided as a talked-about concern but there are plenty of US and European candidates out there ready to tip, as I alluded to in last week’s column. This isn’t helped by the number of CLOs exiting reinvestment that may be unable to participate in A&Es, and certainly won’t be if the longer end of the US Treasury yield curve gains further ground on the short end.

Those are perhaps more medium term concerns, but primary markets kicking back into gear is a likely catalyst to send secondary bonds levels back on convergence with CDS. We only need one over-eager borrower to misfire (push too hard on pricing, upsize and over-allocate irresponsibly, or just pick the wrong day), and Pegleg may get Pegleg’s due.

Another uncomfortable acknowledgement is that, historically, September has not been a great month for cash credit market performance, especially in Europe. Reopening primary is correlated if not entirely causal to this.

The spectre of a proper default cycle was fully reawakened for me last week by Casino Guichard-Perrachon finally triggering a failure-to-pay credit event on CDS contracts. That company has felt more like an anti-magic bullets situation, where no matter how many times activist investors took aim at it they missed, or were blocked by the magic shield of the French conciliation process. Truth was though, the EMEA Credit Derivatives Determinations Committee was just waiting for the right set of conditions, an appropriate array of substantiating sources, and an actual failure to pay on Casino’s notes.

This is the first credit event to hit an on-the-run iTraxx Crossover index series since Europcar in January 2021 — even though that particular auction didn’t result in a hit at all, as it turned out (a technicality of the process and over-opportunistic shorters causing contracts to pay out zero in the final reckoning).

Well might Casino be the only such casualty for CDS indices between now and the 20 September index roll (or 27 September if you’re looking at US high index CDX HY). But I would be surprised if the incoming series of Crossover and HY trade for very long before defaults start to stack up. As I pointed out before, there are 43 credits between the two baskets that administrator IHS Markit quotes in points up front, rather than spread.

Eight changes are finalised in iTraxx Crossover for the September roll — confirming previously discussed dynamicsregarding the introduction of new names. This adds a fresh feel to the incoming series 40 but also introduces an unknown element given the new names are thus far untested in CDS trading. Importantly, none of Crossover series 39’s other biggest default candidates are exiting the portfolio.

We won’t find out till Friday what the full set of changes are for CDX HY series 41, which rolls a week later than Crossover. But we do know that Apache, Netflix, and Occidental are to be promoted from HY to CDX IG on rising star performance — something unseen in European indices this time around. It will be interesting to see if HY undergoes a similar shake up to Crossover and whether it results in a marked difference in credit quality and dispersion versus the outgoing series.

This is particularly important for Crossover 40 and HY 41 because they will bring with them a new set of index tranches, which are renewed every two index rolls. Bets on greater idiosyncratic risk have not worked out too well on Crossover 38 and HY 39 tranches, but again this could be more fruitful ground if defaults start to rack up, or if there are big enough structural differences between the performance of on-the-run and off-the-run tranches for relative value traders to exploit.

A bearish shift in the market by year-end — which is firmly my prediction — should play into that.

The start of the default cycle is somewhat obscured by what investors may see at an index and portfolio level, which is not much. Away from CDS, defaults in the Morningstar European Leveraged Loan index (ELLI) have trailed off lately, for the first time in five months. And as Deutsche Bank pointed out in a research note on Friday, defaults in European CLO portfolios appear contained — although Casino has done its bit to add to that.

“On our count,” wrote Deutsche strategists, “19 obligors have defaulted across European CLO portfolios since the start of the year, with year-to-date default volumes reaching ¢2.1bn.”

This means the 1.8% trailing 12-month default rate in CLOs has moved up above ELLI, which fell back from 1.5% at its July local peak to 1.27%. Deutsche explains this disconnect by noting that CLO defaults include debt exchanges, which are specifically excluded by the index, as well as high yield bonds and those from US obligors.

CLO defaults are also quite concentrated.

“The largest three defaults, Genesis Care (€547m), Casino (€537m) and Wittur Group (€299m), for instance, together account for 64% of total default volumes,” wrote the strategists. “The top eight defaults account for 93%, while the bottom 10 defaulted obligors account for just €110m of total default volumes, or 5%. Concentration is also very much apparent at a manager level. For example, six defaults are held by just one manager and a further four by just two managers — the Black Diamond platform features prominently in this respect.”

The crossroads idea holds true for CLOs as well, because something still needs to give between primary and secondary spread levels. Recent deals have tightened the benchmark for triple-As, but these still have some way to catch up on secondary paper. Or it could be the other way around.

Meanwhile European CLO triple-As look tight versus US counterparts, given historical differences. But which needs to move to bring things back into line?

“Two longer-duration deals priced in Europe over the past two weeks, with AAA spreads ranging from 160bps to 168bps,” wrote Barclays. “As a result, the generic AAA index hovers near 168bps marking tightening of about 10bps. European CLO AAAs in primary now provide additional yield of about 0.6% versus BSL CLO AAAs after hedge costs. However, this is relatively tight compared with the median of 1.3% since January 2022.”

At least this all looks better than the direction CMBS is going.

For now, the overall slant in CLO land is a positive one, with greater emphasis on improving spreads and issuance volume. But even in that scenario there is scope for a rejig in valuation throughout the capital structure as new deals come to market. Much is riding on liabilities tightening, as that would improve reset prospects and help rebalance distributions to equity.

But such an outlook has to sit with the underlying loan and bond market making further improvement, and at the moment key CLO tranches (triple-As, triple-Bs) look rich versus the corresponding corporate IG / Leveraged Loan index, as Barclays notes in latest CLO research published today (Tuesday).

On the other hand, perhaps it’s healthier to consider how much loans need to cheapen to become attractive again to a non-CLO buyer base? Or perhaps it’s time for direct lending to step up and fill the gap? These are exactly the questions JP Morgan asked in a research note last week. 

As JPM strategists pointed out, CLOs account for an estimated 65% of the market size ($1.01tr out of $1.5tr), a peak in the 23-year history. Most demand comes from new originations, but there is a record percentage of CLOs exiting their reinvestment period, which the strategists characterise as a ‘ticking clock’. Already at a post-GFC high of 33%, that could rise to 40% by year-end and 50% by the end of 2024.

And then the loan maturity wall will hit $210bn in 2025 and $218bn in 2026. CLOs hold about $126bn of those 2025 maturing loans, 52% of which are in CLO portfolios already out, or exiting reinvestment in 2023. In 2026 that rises to $140bn, 45% of which are in CLOs out of / exiting reinvestment. And 27% of these ‘25/’26 loan maturities in CLOs exiting reinvestment in 2023 are for borrowers rated B3 or lower. 

Seems like a problem we can safely file for later! After all, the CLO market has proven time and time again it has an infinite supply of magic bullets.