Just one month ago, we showed a chart according to which the corporate bond spreads as tracked by the BofA/ML Corporate Master Index had tumbled to a level not seen since July 2007...
... while European high yield bonds have sunk below 2%, a head-scratching plunge in European "high" yields. As we have observed previously, the catalyst for the dramatic collapse in yields has been an obvious one: central banks, which have not only crushed asset volatility, but through the ECB's explicit guarantee to be the buyer of last resort for corporate bonds, pushed yields to unprecednted low levels.
How unprecedented? Commenting on recent market moves, BofA's credit strategist Barnaby Martin writes that even when accounting for Draghi's pledge to buy "sizable" amounts of corporate bonds next year, the bullish spread reaction over the last few weeks "has caught us by surprise."
As the charts below show, the credit market is posting eye-catching - and now somewhat perverse - valuations in places. Valuations that start to challenge the "natural order" of relative value…
HY vs. USTs
For example, high-yield bond yields in Europe are now yielding just 1.9%, a 50bp drop since the start of October. And Euro high-yield yields are lower than those on ICE BofAML's US Treasury Master Index.
AT1s vs dividend yields
Moreover, as Chart 3 shows, the aggressive move of late has been in the AT1 space, where yields have declined over 70bp since the start of October. This has left CoCo yields very close to the dividend yield on European bank stocks. And what if AT1 yields dip below this threshold? We think this would create a fairly unique - and perhaps troubling - pricing point for the credit market, given that fixed-income securities with less upside than (but with all the downside of) equity are yielding less for investors.
However, in the subsequent weeks - especially on this side of the Atlantic - there has been a sharp repricing of corporate debt, especially junk bonds, which as we showed earlier today have dropped sharply in the past month...
... leading also to a sharp divergence in equity vs credit risk.
So is the recent move wider the end of what Martin "happy days" in credit? There are two main catalysts that could pop the credit euphoria observed in markets:
The first is a surprise in the form of higher-than-expected inflation: this would be the big negative for credit markets down the line. The irony, of course, being that as Martin observes this is exactly what central banks would love to see materialize, as it would safeguard the health of the European periphery, in particular. Signs of success with inflation could easily provoke central banks to rethink their patient and dovish monetary stance…with higher rate volatility stunting the big "reach for yield" underway in corporate bonds.
Then again, considering that central banks have been desperate to boost inflation - at least the "flawed" inflation as captured by erroneous CPI measures - for nearly a decade while injecting $15 trillion in liquidity, this is probably not an immediate worry.
What else may cause central banks to exit sooner than expected? Here, we once again go back to central banks, because the other major risk listed by Martin is that financial stability concerns and fears over misallocation of capital prompt central banks to curtail stimulus sooner than expected.
We sense some central banks are already becoming more cognizant of the financial stability implications of low for long rates. And given how much monetary support has already been doled out (Chart 6), reducing stimulus would at least build some ammunition for any slowdown in the future. Likewise, we think surprise rate hikes from central banks - on financial stability grounds - would be very problematic for credit markets.
To this end, Martin admits that even Bank of America is worried that a bubble in credit is forming:
We think the last few weeks of impressive tightening have shown that credit bubbles are a legitimate risk in Europe down the line, and we think central banks should pay attention to this. After all, it was extremely tight credit markets in '05 and '06 that provoked higher levels of risk taking by investors, and the advent of riskier products.
Meanwhile, many of the other pre-crisis hallmarks of investor exuberance have returned today. Martin also notes in the charts below that LBO leverage levels have climbed again over the last year. In the US in particular, LBO leverage levels are close to their 2007 highs (although US tax reform may slow this). Europe is a bit further behind, though, however the creep higher in LBO leverage over the last year is still visible.
Fast forwarding to BofA's conclusion, just as it all started with central banks, so it will eventually end with them: with little vol, investors are incentivized to keep crowding into high-beta parts of the bond market. But if central banks begin to contemplate curbing stimulus on the grounds of financial stability, then we think the end of "predictable" monetary policy would be a game changer for credit."