09 Juillet 2014

Towards diverging ECB and Fed policies?

We ended last month with our eyes on the ECB and the ECB did not disappoint credit markets. That being said, a lot of what was announced by the ECB in its June press conference was already priced in and the resulting price action in credit market was more one of relief than of rally. Overall, we believe that this new ECB “package” – rate cut, extended forward guidance, TLTRO and other non-conventional measures – is another indication of the central bank’s willingness to support European financial institutions and credit markets further. In that respect, it lays a supportive backdrop for fundamental credit investors like us, for which the main concern is often a sudden macro-driven market dislocation. To some extent, the “ECB put option” is now more valid and less out of the money than ever. Importantly, this new ECB “package” also emphasized the potential decoupling between the US and European central bank policies, which could materialize in the coming months. We have been arguing for months in this letter that the credit cycles of the two regions are at different stages and we feel comforted in that view.

The phenomenal growth of the European HY market and its impact on the CDS market

We have also previously discussed in several instances the huge growth of the European HY and financials bond markets, as well as the significant increase in HY new issues from first-time bond issuers, or “debut borrowers”. So far this year, there have been 132 new HY bonds issued by European borrowers, which compares with a total of 204 issues for the whole of 2013. Volume-wise, more than €78bn of new bonds have been absorbed by the market vs. €91bn for the whole of 2013. Last, 44 debut borrowers have come to the primary market so far in 2014 vs. 86 for 2013, creating some serious challenges and opportunities for credit investors.

The latest development reflecting this trend came last month from Markit, the financial information and services company that administers and issues all series of iTraxx CDS indexes. Markit announced the expansion of the iTraxx Xover index (European HY issuers) from 60 to 75 names in September 2014, just six months after the index went up from 50 to 60 names. At the same time, the iTraxx Financials Subordinated and Senior indexes may expand from 25 to 30 names.

To the same point, we found amusing a recent remark a trader at one of our major counterparties. He argued that they now trade 200 bonds, up 50% from a year ago, coming up with “ridiculous” tickers (HYDHLD for “Eden Springs”, BLTEBG for VivaCom, CLAYAX for Amec Spie, GALAPG for Heat Exchangers, BMBGBN for Monier, etc.). All in all, as he put it “it’s getting tough out there to know which name you’re trading…”. However caricatural that piece about tickers may be, it does evidence one fact: market participants are being overwhelmed with a tidal wave of new issues and under-researched companies. And that fact has a simple, direct consequence: there are lots of mispricings out there. Capturing mispricings on the short side continues to be challenging in the current environment, with such refinancing options available to companies, even ones that do not perform. Capturing mispricing on the long side is equally challenging, with spreads tighter every day. But the average should not hide the specifics: there are companies that are not priced correctly relative to the rest of the market. Our thoughtful and selective approach to the new issues market - we participated in only 10% of the new issues year-to-date - allowed the Fund to generate ca. +1.2% of gross performance.

This market growth is good news for a long-short strategy. As we pointed out in last month’s newsletter, some of these new issuers are fundamentally weak and are potential future shorts for the Fund.


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