07 Août 2016

Unstressed markets. How much longer?

What a difference a month makes in today’s markets. After we ended up last June trying to gauge how credit assets would behave in the aftermath of the Brexit vote, we are now close again to new highs in several credit market segments. While we acknowledge that Brexit will not have an impact of systemic nature on the credit outlook for the UK or Europe, we remain convinced that it will be not be a non-event. The UK economy is probably on the road to recession by the end of this year, domestic financial conditions will likely tighten and risk aversion towards risk assets in the country should rise sooner or later. In this context, we believe that risks are clearly skewed to the downside as far as UK HY and financial credits are concerned, with the most levered and domestic names being quite vulnerable. The impact on non-UK European credit is much more limited, in our opinion. However, we are carefully watching any sign of potential financial or political contagion, which could break the “goldilocks” equilibrium currently benefiting European credit markets.

Beyond Brexit-related risks, the renewed selloff in energy and commodities markets could also trigger a new round of market dislocation and credit pressure on some names. Interestingly, credit markets have remained surprisingly relaxed about such recent volatility in commodities, in particular when compared with what happened at the beginning of this year. While oil prices have been falling by 20%-25% since their June peak, US HY energy credit – the best proxy for energy-related credits – has barely nudged despite the phenomenal rally it has experienced since mid-February. In contrast, a similar drop in oil price between YE 2015 and mid-February drove a spread widening close to 600bps for US HY energy names over the same period of time. Even considering that the price action was excessive in the early weeks of 2016, we think that the current episode should be a useful reminder that the energy credit crisis is far from over and will continue to reverberate for many more quarters. After so many episodes of high market volatility and risk aversion since the onset of the GFC, we will not complain about the current unstressed state of credit markets. However, such analysis supports our cautious stance and portfolio position. It is also driving our trimming of several lower-yielding long positions and our increase in some portfolio hedges.

Stressing banks to remove investor stress. That works in credit.

The highlight of July in terms of credit event was the release of the EBA stress tests on 51 of the largest European banking institutions. Overall, the tests showed a European banking sector with decently strong capital and leverage positions under the EBA adverse scenario. On a fully loaded basis, CET1 ratios would decrease by 340bps on average to a respectable 9.2% for the tested universe. Beyond such gross numbers lie significant disparities with worst-ranked Italy-based MPS – a complete basket case of all the past European banking sins, in our view – at -2.4% (yes, minus 2.4%) vs. best-ranked Sweden-based Swedbank at 23.1%. That being said, only 11 institutions ended up with a stressed CET1 ratio below 8%, including 5 of them already on the path to boosting their capital base significantly via organic capital generation, asset disposals, rights issues, RWA reductions, etc. As imperfect as they might be, the EBA stress tests confirm our long-held view that European banks continue to be managed in the interest of their creditors. Although such tests also highlight the long-lasting profitability concerns weighting on the sector, they are showing the picture of resilient institutions with a better capital and leverage position than they have ever experienced. Hence, the diverging price actions between falling European bank stocks and stable European bank subordinated instruments, in our opinion.

Very importantly, the whole test exercise and analysis will be used to determine each institution’s SREP and Pillar 2 (Requirement and Guidance) regulatory capital levels, which in turn will be used to assess the buffer available for coupon payments on AT1 instruments – a vital indicator for any credit investor in that asset class. As a result, the broadly favorable outcome of those tests and the additional transparency it will force on hybrid capital issuers – especially with regards to the various idiosyncratic buffers for coupon payments and principal write-downs on such instruments – are positive developments for investors. In this context, we have marginally increased our long exposure to the sector while rotating some positions into certain names which are in the process of transforming their capital structure in a radical manner.