Deutsche Bank: "Last Week Is A Dress Rehearsal For The Credit Problems Ahead"

In recent months we have covered extensively the threat to the credit market that is the downgrade of over a $1 trillion in BBB-rated investment grade bonds - most extensively in "The Next Bond Crisis: Over $1 Trillion In Bonds Risk Cut To Junk Once Cycle Turns" - with recent sharp moves wider by GE, PG&E and Ford bonds confirming that the credit market is starting to crack, and prompting a deluge of media coverage on this topic which we first discussed would be a major threat to the financial system last November.

Overnight, Deutsche Bank's credit strategist Jim Reid shared a good summary of his thoughts on the ongoing repricing in both investment grade and high yield, putting the recent moves in a broader context.

Below we excerpt his key thoughts from his latest Morning Reid publication.

From Deutsche Bank's Jim Reid:

There was lots in the press this weekend about Brexit but interestingly for me as a credit strategist by day, there was also a fair bit of negative press about credit with some of the more sensational articles suggesting that credit could soon blow up financial markets due to (amongst other things) the weight of US BBBs about to swamp the HY market, record levels of Cov-lite issuance  and due to record high US corporate leverage. For us there needs to some perspective.

We have been on the underweight side of credit all year, more weighted to a US underweight of late but that’s been more of a valuation play than over too much concerns about immediate credit quality. The US economy remains strong and credit deterioration is likely to remain idiosyncratic until it rolls over.

At that point we will have big problems though and last week’s activity made us more confident liquidity will be bad when the cycle turns as we moved a fairly large amount on nervousness as much as anything else.

GE, PG&E, plunging oil and the factors discussed above provided a jolt but we don’t think this is enough for now to impact the economy so credit will probably stabilise. However once there is actual broad economic weakness, this last week will be a dress rehearsal for the problems ahead and there will be little two-way activity with spreads gapping wider.

However that’s for further down the cycle. For now credit’s main problem has been it hadn’t responded enough to the pick up in vol.  The good news is that this is starting to catch-up and correct. Last week, EU non-fin. IG spread widened by 13bps and HY by 45bps while those on US IG by 14bps and HY by 49bps.

Big moves relative to a small down week in equities.