April 2021 | Issue 233
Opinion Credit derivatives
Watch the IG credit curve — we may see steepening of IG 5s10s and flattening of 10s30s
Kelley Baum
Head of credit derivatives III Capital Management/AVM
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Stimulus measures are supporting short tenors, and pension demand for 30-year paper is strong, so 10-year IG credit may have few buyers
2021 has started out as a year of regime changes. Rising rates and the potential for inflation are leading to broad shifts across asset markets, while a new US political leadership has got to work, bringing stimulus packages and the potential for significant tax code changes.
The coronavirus still lurks in the background, but the continued rollout of vaccines will change how we interact, gather and travel. To top it off, my personal life has undergone a regime change — I’ve just returned to work after having a baby boy!
On the surface, it seems these changes should broadly benefit credit markets (the amount of baby gear that has arrived at my house alone could boost aggregate demand and inflation). Many market participants are talking about a rotation from equities to fixed income because of higher all-in yields. The large stimulus in the US could also prove to be a boon for the credit markets, as corporates benefit from stronger demand and GDP growth.
But while these factors may continue to support credit spreads generally, the picture is more nuanced across the credit curve, and across the ratings spectrum. Higher rates could lead to more demand for certain parts of fixed income, but if interest rate volatility remains high, investors may demand higher spreads for longer-dated credit. Additionally, fundamentals have been deteriorating as leverage is at historically high levels — US IG gross leverage is roughly 2.8x, compared to 2.2-2.4x at the peaks of 2003 and 2009.
Long-dated triple B volumes are escalating
There has been an increase in issuance, especially in long-maturity paper from triple B-rated corporates, which could weigh on the space — though issuance is abating as we enter Q2.
Triple B 10-year issuance increased from $177 billion to $275 billion from 2019 to 2020. In 2021 it is expected to be around $179 billion. Triple B 30-year issuance increased from $138 billion to $258 billion from 2019 to 2020, and is on track to reach $225 billion in 2021. And though the stimulus should help growth in the medium-term, higher corporate tax rates may weigh on long-term prospects, especially for lower-rated investment grade corporates.
So what does this mean for investing? Watch the credit curve — we may see steepening of IG 5s10s and flattening of 10s30s cash curves as the long-end (20 years-plus) is supported by pension demand and near-term stimulus supports the front-end, while 10-year paper is left with fewer natural buyers. If fundamentals deteriorate from here, we could see a wave of fallen angels given the high leverage levels combined with high triple B issuance.
High yield markets could be impacted by this even more than investment grade — there are fewer buyers of HY credit overall, and these limited buyers may rotate from current HY to the relatively higher-quality recent fallen angels.
Threat of higher dispersion
In the derivative space, these themes have led to compression and lower dispersion. In tranches, lower dispersion has contributed to outperformance of junior tranches and underperformance of senior tranches. So it’s important to keep an eye on dispersion as this could tick higher, which would mean risk could shift again out of senior tranches and into junior.
In the US, CDX HY equity tranches have compressed such that at current pricing it takes about one-and-a half-defaults per year (or seven defaults to maturity) to break even on a short HY35 0-15% versus delta position, on a hold-to-maturity basis with static current delta. Even though default outlooks have ameliorated a lot in the past few months, projections are still for HY defaults to be 2-3% per year — which are well through the number needed for a short HY 0-15% versus delta position to profit.
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Global credit funds & CLO's
April 2021
| Issue 233
Published in London & New York.
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