I’ve been patiently waiting on a decent hook to highlight some brief color and visuals on high grade corporate bond liquidity and also on the BBB “apocalypse” story.
Happily, the market afforded me just such an opportunity in the form of Friday being the best day for IG in years and BBBs being a standout performer in 2019.
On the former point, IG spreads tightened the most since 2016 headed into the long weekend.
That’s welcome news for high grade investors who have looked on as junk staged an enormous rally to start 2019 thanks to a combination of surging crude, rampant risk-on sentiment and an extremely bullish technical (i.e., a complete dearth of high yield supply).
That rally served to erase December’s HY/IG decompression as quickly as it showed up.
Lurking in the background here, is the never-ending BBB debate. In a testament to – I don’t know, something – BBBs have actually outperformed in 2019, coming off a quarter during which everyone was ready to hold hands and jump off a bridge on the apparent assumption that the entire bucket was on the verge of getting downgraded to junk. Oh what a difference a flip of the calendar makes:
As far as that story is concerned, the narrative now seems to be that intra-IG downgrades are more likely than a fallen angel apocalypse. That’s a view Goldman has been pushing since at least September and Barclays is out with a sweeping new note on the subject.
Although the bank takes a generally benign view of things, it’s possible that the relative optimism stems from the fact that positing a worst case scenario is akin to predicting a disaster. There are so many quotables from Barclays’ note that it would be impossible to do it justice in a single post, but here are two excepts that convey the gravity of this (potential) problem:
The drastic increase (in BBB debt outstanding) has raised concerns about potential downgrades of large BBB capital structures to high yield, which would not only result in significant losses for investment grade investors, but could also overwhelm the high yield market. Indeed, the growth of the BBB segment has been coincident with a decline in the size of the High Yield Index – the BBB universe (including 144A issuance), as seen in Figure 2, is now larger than the combined leveraged finance market (high yield and loans).
A downgrade to high yield for some of the large capital structures could have drastically negative implications. Not only would funding costs increase significantly, but funding a large capital structure – each of the top 10 BBB would be more than 2% of the High Yield Index if downgrade – in the high yield market might be downright impossible. In addition to funding issues, some companies could face operational challenges as high yield credits.
In other words, it would be a catastrophe, which is presumably why it can’t be allowed to happen. Again, Barclays thinks it’s more likely that we see downgrades within IG as opposed to a wave of fallen angels. That would itself cause problems, but not of the same magnitude.
The bank throws out a number of statistics which, while not surprising to anyone who has followed this story, are still disconcerting. For instance, the bank notes that the market value of BBBs with higher leverage than the median BB is now $540 billion, larger than the size of the BB index. If you’re wondering how common an occurrence that is, the answer is, quote, “this is the only period in recent memory.”
So, generally speaking, this is why it’s good news when IG rallies and specifically why it’s nice to see BBBs outperforming in the new year.
On liquidity – a topic that regular readers know is near and dear to our hearts – BofAML has an update on their “kitchen sink” series in high grade.
“In the secondary market, bid/ask spreads have increased, but less than expected given how much spreads have widened since October”, the bank observes, before noting that outright bond trading volumes expanded in line with the market size last year.” That’s nice, but as you might expect, ETFs and CDX IG are shouldering a larger and larger share of the “burden” (if you will), a reflection of folks going where the liquidity is.
“Investors have significantly increased the use of high grade ETFs and the CDX IG index”, BofAML goes on to say, on the way to breaking things down. Trading volumes in CDX IG rose 58% last year and trading in high grade ETFs soared to record levels relative to bond trading volumes. Here are the visuals on all of that:
This is one of those times where I fall into the “critics say” category and where the “conceptually speaking” caveat applies, but at the end of the day, I continue to think the liquidity issue will manifest itself in a highly destabilizing manner at some point. Those trends (shown in the charts) are just people looking for liquidity and the less concentrated the action is in the cash market for the underlying, the less liquid that market will become, encouraging still more trading in ETFs and synthetics, in a self-fulfilling prophecy.
That’s obviously exacerbated by the post-crisis regulatory regime wherein the street is hamstrung in its capacity to buffer turmoil.
In any event, that’s all I’ve got for you right now. What you just read is the result of an ad hoc non-process where I started out aiming to craft something short and coherent and ended up with an IG potpourri. And I hate potpourri.