Fixed income market dislocations Benoît Hubaud Global Head of Fixed Income Research
Dislocation: one word, two definitions An extreme movement which can be absolute or relative EuroStoxx 5 up +15% Five indicators are enough to explain most market movements Global market (equities, credit, volatility) Interest rates (short-term rates, curves) Commodities (oil & gas, agricultural prices) Liquidity (credit financial spreads, swap vs treasury spreads, OIS spreads) Inflation (inflation swaps, yield curves, commodities) Detailed contributions Global market move +1% due to global market rise +5% due to EuroStoxx-specific performance Asset price movement Interest rate move Commodities move Liquidity move Beta contributions Market dislocation (beta) Alpha dislocation Inflation move Asset relative move
Market indicators 4 5 4 G lo b a l m a rk e ts Global markets have recovered half way since Lehman s collapse 3 5 3 2 5 2 6 / 9 / 8 2 2 7 /1 / 8 1 5 M a y - 7 S e p - 7 Ja n - 8 M a y - 8 S e p - 8 Ja n - 9 M a y - 9! Interest rates have fallen steadily with monetary easing policies Commodities: a difficult rally - 3 S h o r t-te r m r a te s - 8 1 6 /1 / 8-1 3-1 8-2 3 4 / 6 / 9-2 8 M a y - 7 S e p - 7 Ja n - 8 M a y - 8 S e p - 8 Ja n - 9 M a y - 9 1 2 1 C o m m o d i ti e s 8 1 /1 / 8 6 4 2 1 /1 2 / 8-2 M a y - 7 S e p - 7 J a n - 8 M a y - 8 S e p - 8 J a n - 9 M a y - 9
Market indicators Liquidity risk has improved since the Bear Stearns bailout, but has remained under stress since Jan 9 14 13 18/3/8 12 11 9 8 7 16/1/7 6 5 Liquidity May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9! Inflation risk has exploded since the beginning of 29 7 6 5 4 3 2 1-1 -2 Inflation 5/6/9 9/12/8 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9
Alpha dislocations at top-down level 25 2 15-5 Credit spreads (especially financials) overreacted after Lehman. This dislocation corrected in May-June 29. itraxx Main Long-termmodel Jun-7 Oct-7 Feb-8 Jun-8 Oct-8 Feb-9 Jun-9 3 25 2 15 - Yield curves flattened due to Quantitative Easing (QE) at the end of 28. This dislocation has since partly corrected. 5 USD 2-1Y QE Long-term model Jun-7 Oct-7 Feb-8 Jun-8 Oct-8 Feb-9 Jun-9 35 3 25 2 15 5-5 -
Credit dislocations Credit sectorial indices have suffered massive dislocations Cheap financials signals concerns about the banking system Cheap cyclicals signals concerns about the economy Cyclicals (most impacted by economic cycles) vs others Alpha (bp) 15 5-5 Financials vs corporates Financials cheap vs Non-fin - Financials expensive -15 vs Non-fin Jun-7 Sep-7 Dec-7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Jun-9 Alpha (bp) 8 6 4 2-2 -4-6 -8 - Cyclicals cheap vs non-cyclicals Jun-7 Sep-7 Dec-7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Cyclicals expensive vs Non-cyclicals Crisis has transferred from the financial world to the real economy and back again what s next?
Credit dislocations Cash credit spreads exploded vs CDS spreads (swaps) after Lehman s collapse because of funding costs counterparty risk liquidity issues This dislocation has started to correct but remains strong 3 CDS spreads Cash spreads 25 2 15 5 Jun-7 Oct-7 Feb-8 Jun-8 Oct-8 Feb-9 Jun-9 The most senior investments have been extremely volatile Super senior CDOs were used as a proxy for systemic risk This dislocation has corrected but still has some potential CDX IG 5y 8 7 6 5 4 3 2 1 CDX super senior CDX IG index 32 27 22 17 12 7 CDX IG 3-% 2 Jun-7 Nov-7 Apr-8 Sep-8 Feb-9 Systemic fears reach a climax following BS bailout Dislocation has mostly corrected
Inflexion or turning point? Q1 stock market recovery may herald a turning point - need for clarity on success of monetary/fiscal/qe measures and on the exit In credit markets, there is still a dislocation between high grade non-fin. corporates and everything else, but financials are beginning to recover Primary market supply set to break records Subordinated financials push cash index wider but aid the recovery 2 5 4 2 9 8 34 in billions 1 5 1 5 Spread to Benchmarks 7 6 5 4 3 2 28 22 16 J a n M a r M a y J u ly S e p N o v 2 1 2 3 2 5 2 8 2 9 4 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 iboxx Corp. LT2 Senior Banks T1 (rhs)
Long spread history confirms overreaction The omens do not presage risk asset performance into a weakening economic environment GDP swung from -13% to +13% between 193 and 1936 expect nothing like that now, but a severe spread reaction 6 5 Spreads and GDP growth 6% 5% US Investment Grade Credit Spreads 4 3 2 24 29 34 39 44 49 54 59 64 69 74 79 84 89 94 99 4 9 4% 3% 2% 1% % Real GDP Growth, Y/Y - -1% -2 Source: Various, SG Credit Research -2%
Spreads extremely high compared with default rate In Europe and in the US 35 25% 7 14.% ASW Spread 3 25 2 15 5 2% 15% 1% 5% Default Rates Spread to Treasuries 6 5 4 3 2 12.% 1.% 8.% 6.% 4.% 2.% 1 2 3 4 5 6 7 8 9 % 85 87 89 91 93 95 97 99 1 3 5 7 9.% Euro Default Rate (RHS) iboxx Corporates iboxx Non-Financials USDefault Rate(RHS) USCorporates Source: Moody s
but defaults set to increase Speculative default rate lags the economic cycle by 4-7 months History of default rates 18% 16% Peak of speculative grade defaults Default probability 14% 12% 1% 8% 6% 4% 2% Peak of investment grade defaults % 192 1928 1936 1944 1952 196 1968 1976 1984 1992 2 28 I-Grade Spec Grade Total Source: SG Credit Research, Moody s
Corporate sector heads into downturn in better shape Excess liquidity conditions in 23-27 and productivity gains boost balance sheet deleveraging Corporate sector balance sheets in much better shape Debt/equity lower Net position much more supportive.7x.8x.65x.75x.7x Previous downturn Deleveraging cycle.6x.65x.55x.6x.55x.5x 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 Debt/Equity.5x 2 21 22 23 24 25 26 27 28* Net debt / Common Shareholders equity Source: SG Credit Research, FTSE 5
Market financing replacing bank lending Deleveraging by banks is ongoing; the impact on the economy is still limited as public financing is supporting the recovery The disintermediation trend will continue, as regulator pressure on capital will be long-lasting - though governments are still asking banks to finance the whole economy Net issues 21-29 18 bn 14 6 2-2 21 22 23 24 25 26 27 28 29f Redemptions Supply Net Source: SG Credit Research Le nding by m one ta ry a nd fina ncia l Institutions 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 16 17 18 19 2 21 16 Loans to non-financial corporations % y/y C ons um er C redit % y/y 14 Loans for hous e purchas e % y/y 12 1 8 6 4 2 Jan 99 Jan 1 Jan 3 Jan 5 Sourc e: ECB, Datastream, SG Economic Res earc h Jan 7 Jan 9
Usual marginal buyer is absent, which will limit recovery potential Hedge funds were the predominant marginal buyer of risk in 23. Replaced by structured credit bid in 24-27, today by private banking? Depressed issuance of structured products in 29 is leading to contained spread recovery ABS issuance drops and marginal buyer fades Demise of CDO removes the other marginal buyer 5 6 45 5 4 4 3 in $bn in billions 35 25 2 15 3 2 5 22 23 24 25 26 27 28 1995 1997 Total Source: SG Credit Research, Creditflux 1999 21 23 25 27
Credit begins to recover in March 29 Financial crisis engulfs credit and banks/insurers take the pain: corporates hold firm Subordinated debt recovery in March sees tightening at the same rate as non-financial corporates iboxx index recovery well entrenched iboxx cash financials vs non-financials 2.6x 5 2.4x 2.2x Financials / NonFinancials Spread to Benchmark 45 4 35 3 2.x 1.8x 1.6x 1.4x 1.2x 1.x.8x 25.6x.4x 2 Sep-8 Nov-8 Jan-9 Mar-9 May-9 May-3 May-4 May-5 May-6 May-7 May-8 iboxx Corporates Source: SG Credit Research May-9
Secondaries tighten faster The relative lack of new issue product forces a move into the illiquid secondary market Supply and demand economics push spreads to tighten by the biggest margin this year in April Primary supply versus non-financial secondary spreads 38bp 5bn Spread changes on a monthly basis 8bp 36bp 34bp 4bn 32bp 4bp bp 3bp 3bn 28bp -4bp 26bp 2bn 24bp 22bp 1bn -8bp -12bp 2bp bn 18bp Jan-9 Feb-9 Issuance Mar-9 Apr-9 May-9 Jun-9 iboxx NonFi -16bp Jan-9 Feb-9 iboxx Corps Mar-9 Financials Apr-9 Non-financials May-9
Credit: all that glisters is gold? 12% 45 1% 4 35 8% 3 6% 25 4% 2 2% 15 % Jan-99 Jan- Jan-1 Jan-2 Eur Dividend Yield iboxx Financial yield Jan-3 Jan-4 Jan-5 Jan-6 iboxx Corps yield DJ Stoxx 6 (rhs) Jan-7 Jan-8 DJ Stoxx 6 Asset reallocation rather than IG asset deterioration is the biggest risk for sustained spread weakness HG investment grade credit remains the asset class of choice Yield Jan-9 iboxx non Financials yield Source: Various, SG Credit Research
Highest total returns YTD 29 Equities hit multi-year lows, but recovered from April onwards High yield boasts the biggest positive return of any asset class 3% 2 8.1 5 % 25% 2% 15% 1% 7.3 5 % 5. 6 % 5% 1.8 6 % 1.7 6 %.1 7 %.2 7 % D J E u ro S to x x 5 S o v e r e ig n s % C o r p o r a te s F in a n c ia ls NonF in a n c ia ls E u r H ig h Y ie ld S&P 5 Source: SG Credit Research