Corporate Credit: A stormy but relatively safe harbor

Corporate Credit: A stormy but relatively safe harbor

Corporate credit has historically done well in the low but positive growth environment that we are forecasting.
However, credit has significant exposure to the European sovereign situation, both directly through financial
credits and indirectly through the impact on broader credit conditions. While we view valuation as attractive,
especially in the light of current robust balance-sheet credit fundamentals, we remain bearish on the direction of
credit spread in the short term. We think funding conditions for banks need to normalize before volatility can fall
and allow “search for yield” motives to resurface.

Last month we laid out our key themes and views for 2012 (see
“Slow growth and sovereign risk: stay on defense,” 2012 Global
Credit Outlook, Dec. 8, 2011). We adopted a directionally
negative stance on global credit spreads on the view that the
global economy has lost considerable momentum, facing
greater uncertainty as a safe landing for the European debt
crisis becomes harder to predict.

Reflecting our negative directional view on spreads, we
recommended the following relative value themes, which we
still maintain:

Up in quality. It paid to be “short beta” in the second half of
last year, both in the US and Europe, and while the return to
this strategy has been more sideways of late, it has at least
minimized volatility. We think soft growth and an increasingly
complex and uncertain path for Europe leave us vulnerable to
continued volatility and elevated risk of meaningful further
spread widening. We therefore continue to recommend a
defensive posture: cautious on cyclicals, up in rating, and
shorter in duration.

Underweight Europe. We have been more cautious on
European non-financial credits vs. their US counterparts. In
addition to weaker fundamentals, we think Europe faces a
weaker macro outlook, a potential contraction in credit
availability, and reduced prospects for sovereign support (see
also “European credit quality: not so good,” The Credit Line,
Nov. 7, 2011). We continue to express this view via our short
iTraxx Xover trade, which is one of our 2012 top trades.

Underweight financials. Banks and financials remain
disproportionately exposed to the interaction of downside
macro risk and deleveraging pressures. Policymakers have so
far been highly reluctant to push back against the market’s
recent repricing of sovereign risk by any policy means other
than aggressive austerity. We cannot easily envision scenarios
featuring a rapid reversal of this sovereign repricing. We
therefore think bank credit spreads will continue to display a
high beta to the continued unfolding of the European sovereign
crisis, and thus should embed a much higher-than-usual credit
premium for a sustained period.

Two key developments have materialized since we published
our 2012 Global Credit Outlook, and these have shifted our
views somewhat: (1) the ECB significantly strengthened its
medium-term funding support for European banks by extending
the maturity of the LTRO to three years and significantly
loosening its collateral requirements; and (2) US macro data
have continued to track better than we expected, which
prompted our US economic team to raise their GDP forecast
for 1Q2012 to 2.0% from 0.5%. Below, we discuss potential
implications of these developments on our views.

LTRO pushes credit risk further out the curve
How does the ECB’s new LTRO change our view on European
credit? Our baseline case – despite our bearish directional view
on spreads – has been that the ECB would ultimately respond
firmly (though reluctantly) to address stresses on the financial
system caused by the sovereign crisis.

That said, we were surprised by the aggressiveness of the
ECB’s intent to provide funding support for banks, in
particularly the clarity with which they seemed to choose to
support the banks over sovereigns. We think LTRO funding
has meaningfully reduced the near-term default risk of banks,
mainly due to the reduction of short-term funding risk.

Banks have used the LTRO to reduce their reliance on
wholesale funding and have also used it to aggressively
prefund upcoming bond maturities. We think this reduction in
short-term funding risk has done much to reduce banks’ risk
aversion, and we think this combined with the resulting excess
liquidity now sitting at the ECB easily explains why we’ve seen
short-dated credit spreads in sovereigns and corporates gap
tighter.

With another tranche of LTRO still to come, we think this
liquidity will continue bidding aggressively for short-dated
assets. We therefore expect bank short-dated credit will
continue to outperform longer-dated bonds, especially in
Europe and especially for financials.

A bigger bandage, not a cure
Securing banks’ access to medium-term funding clearly helps
to reduce bank credit risk on the front end, but as far as
solvency risks are concerned, it is no substitute for bank capital.
We view the ECB’s decision to provide full allotment secured funding for three years as a continuation of
the “kick the can down the road” approach. The can has been
kicked rather far this time around but the root causes of the
problem — a failure to “mutualize” sovereign risk and the
problems this poses for an undercapitalized banking system —
have yet to be addressed. And as our colleagues Louise Pitt
and Ron Perrotta have pointed out, the greater availability of
secured financing options for the banks may complicate efforts
to open up access to the unsecured markets once again (see
“Balancing short-term positives with medium-term challenges,”
The Banks and Finance Pitt Stop, December 13, 2011). We
consequently do not expect any sustained tightening of longerdated
bank spreads.

On the other hand, secure access to cheaper funding will
clearly provide banks with more breathing room and relieve
some of the near-term funding pressure on their balance
sheets. This should considerably reduce “jump-to-default” risk
and is thus positive on the margin for bank credit risk. On a
relative basis, this should also allow the front-end of bank
spread curves to outperform both longer-dated bank spreads
and short-dated sovereign spreads. As shown by Exhibits 14
and 15, this is reflected in the recent steepening of spread
curves, especially for banks

The LTRO is merely a bigger bandage, not a cure (it may even
slow progress toward real solutions since it eases market
pressures on the political process). We therefore think
sovereign concerns will soon be back in focus. We expect
macro fundamentals in Europe to weaken further, casting
doubt on the success of austerity measures, and event risk will
re-elevate around upcoming reviews and disbursements for
program countries as well as sovereign debt auctions. Our
European team thinks renewed market pressures are almost
unavoidable given the magnitude of the political decisions and
institution building required to achieve mutualisation of fiscal
risks via true fiscal union rather than the mere enforcement of
sovereign austerity measures.

The roadmap followed by European policymakers will
eventually require new fiscal rules and more risk sharing, but
as Dominic Wilson has recently argued, there is a long road
ahead (see “New Questions for the New Year”, Global
Economics Weekly, January 4, 2012). Along that road, we can
expect elevated volatility and wider spreads.

Could better US data push spreads tighter?
US data has continued to beat expectations over the past few
months with 4Q GDP now tracking at roughly 3.2%, well above
our initial forecast back in the summer. This improvement in US
macro data has been broad-based. Hard data such as
consumer spending have been stronger than expected while
higher frequency indicators like initial jobless claims have fallen
to their lowest levels since the peak of the crisis in 2008.
Survey data such as the ISM indices also remain quite robust.
And December payroll data were stronger than expected even
though some of the gain was partly related to seasonal hiring.

The strength of the macro data, albeit relative to low
expectations, recently caused our US MAP index of data
surprises to approach its highest levels on record. It also
prompted our US economic team to raise their GDP forecast
for 1Q2012 to 2.0% from 0.5%.

While the risk around this new forecast path are roughly
balanced, recent market expectations may well have run far
enough on the back of these surprises. This means that the
risk for markets may now lie to the downside. And looking over
the medium terms, we still expect recession in Europe, and
think that US growth bears downside risk due to the potential
for spillover from the European debt crisis.

US likely to outperform Europe in credit
Across regions, US credit should outperform. North American
balance sheet fundamentals are in better shape than their
European counterparts. Leverage is improving on both sides of
the Atlantic, but remains higher than pre-crisis levels in the
Eurozone. The median debt-to-EBITDA ratio for non-financial
firms in the Eurozone has dropped to 3.1x from 3.6x at the
peak of the crisis. This is still higher than pre-crisis levels of just
over 2.6x.

US firms, by contrast, have seen leverage ratios drop to 25-
year lows. North American firms appear to have deleveraged
throughout the early to mid-2000s, whereas European firms
appear to have maintained constant leverage over the same
period. This divergence in credit quality is reflected in the
relative pace of rating upgrades to downgrades, which in
Europe has been net negative and declining over the past year,
whereas in the US it has been net positive and relatively stable
(Exhibit 16).

European non-financials are also more reliant on bank lending
than in the US. Evidence from ECB flow of fund data shows
that more than 84% of the total aggregate long-term debt of
European non-financial corporations is in the form of bank
loans. In the US, by contrast, Fed flow of funds data show that
non-financial corporations rely on bonds for up to 64% of their
total funding needs.

In addition to these bottom-up differences between the two
regions, the macro outlook is weaker and policy more
constrained in Europe than in the US. In contrast to the US
policy stance in 2008, Europe’s fiscal and monetary policy tools
are comparatively limited. In 2008, for example, the US fiscal
policy responded to the sharp contraction in private demand
with massive stimulus and an aggressive recapitalization of the
banking system. Monetary policy complemented this with
aggressive rate cuts and an unprecedented expansion of the
Fed’s balance sheet.

In Europe today, by contrast, policy makers are constrained by
the lack of Euro-wide fiscal institutions, rendering the whole
less than the sum of the parts. Diplomatic efforts to mollify
markets have thus far focused primarily on plans for mutual
enforcement of fiscal austerity measures. While such efforts, if
successfully, may partly compensate for the Eurozone’s lack of
true fiscal institutions, they run a high risk of failure due to the
high social and economic costs of their recessionary impact on
growth.

If the recent tight correlation between corporate bond markets
in the US and Europe begin to weaken over the coming year,
as we think likely, we expect US credit to outperform.
Asia credit will likely perform inline with the US
We would move up in quality in China on the view that lowerquality
credits may suffer from the combined effects of
crowding out (due to tight credit) and the risk that overtightening
poses for real estate demand and exports. We are
negative on credit in India as the economy continues to
struggle with high inflation and a worsening current account
deficit. In the IG space we maintain our preference for strong
Hong Kong and Singapore. We also see value in selective
Malaysia and Thailand credit. For Korea, we see further supply
as a potential headwind and would therefore be cautious.