The shud­der in US credit

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

As oil prices tum­ble and the first US in­ter­est rate hike for eight years comes into view, bond in­vestors in the high-yield seg­ment are tak­ing flight. The mar­ket was given a fore­taste of what a dis­or­derly un­wind­ing of an over-bought US cor­po­rate bond mar­ket may look like late last week, when two high-yield bond funds sus­pended redemp­tions.

The worry is that th­ese tremors be­come an earth­quake, making it more costly for all com­pa­nies to re­fi­nance them­selves. Such a cy­cle of con­ta­gion could tip both the US econ­omy and eq­uity mar­ket into a proper down­turn. To our mind, this risk is prob­a­bly overblown.

First, it should be recog­nised that there has been no “melt­down” in the credit space. To be sure, spreads and yields have gen­er­ally risen since April, but out­side of the high-yield com­mod­ity sec­tor, the moves have so far con­formed to “nor­mal” pat­terns given the point in the eco­nomic cy­cle.

While yields on sub-in­vest­ment grade en­ergy bonds have risen by an­other 700bp since May (when the cur­rent move in bond mar­kets really got started), the rest of the high-yield bond in­dex has seen yields rise a sig­nif­i­cantly lower 200bp, and the over­all cost of bor­row­ing for US com­pa­nies of all shades is up by 75-100bp. The mar­ket is still dis­tin­guish­ing be­tween vary­ing risks and not yet in a gen­er­alised panic.

A strong ar­gu­ment can also be made that con­ta­gion risk has less­ened com­pared to past pan­ics. Bank­ing sec­tor re­forms that fol­lowed the 2008-09 crises mean that banks are less in­volved in mar­ket-making ac­tiv­ity (the share of cor­po­rate bonds held by banks has halved since 2008; this means less lever­age). And with bank bal­ance sheets not so ex­posed, bond mar­ket tremors are less likely to spark riska­verse re­sponses by those in­sti­tu­tions and with it a con­trac­tion of the US money sup­ply.

This does not mean con­ta­gion risk has gone to zero. A new risk has emerged with a pos­si­ble wave of redemp­tions from bond funds re­sult­ing in price gap­ping.

Open-ended mu­tual funds lack the lever­age of banks, but they share some sim­i­lar­i­ties in that they have an in­her­ent ma­tu­rity mis­match — such funds typ­i­cally prom­ise daily liq­uid­ity, while own­ing less-liq­uid long-term as­sets. A run on th­ese funds would cre­ate a wave of forced sell­ing, es­pe­cially as the hold­ing of liq­uid as­sets (cash, US trea­suries…) amounts to just 5% of as­sets.

And since in­vest­ment banks play a greatly di­min­ished mar­ket-making role, th­ese sell­ers may strug­gle to find buy­ers in any or­derly fash­ion. In such a sce­nario, fund man­agers will off­load what they can, not what they “should”—the re­sult would be an in­dis­crim­i­nate rise in credit spreads and in­ter­est rates.

This risk is real, and worth mon­i­tor­ing. In fact, if the US is to face a re­ces­sion in 2016, this is the most likely trans­mis­sion mech­a­nism. Yet in our view it re­mains a tail risk. We es­ti­mate that cor­po­rate bor­row­ing costs would need to rise by about 200bp from here to usher in re­ces­sion (twice the in­crease seen since May, see chart). This would elim­i­nate the pos­i­tive spread be­tween the cost of cap­i­tal and its cur­rent rate of re­turn.

With less lever­age in the sys­tem, and with yields on longterm cor­po­rate bonds so far above the re­turn of­fered on money mar­ket funds, we think such big moves in yields are un­likely.

To be sure, it would not sur­prise us to see bond yields rise by a fur­ther 100bp in the next few weeks or months (whether on the back of ris­ing gov­ern­ment yields or wider credit spreads). But we would ex­pect this to at­tract do­mes­tic and in­ter­na­tional buy­ers, cap­ping the rise be­fore it trig­gered a re­ces­sion. Tail risks notwith­stand­ing, the US is most likely march­ing to­ward a re­ces­sion some­time in 2017 or there­after, not jump­ing into one af­ter the Fed­eral Re­serve’s first rate hike.

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