Dr. Jochen Felsenheimer
Managing Director
Assenagon Credit Management
The Macroeconomic Picture
All of 2011 was dominated by news regarding the "European debt crisis". And there are many arguments why this will remain the driving factor in 2012. However, to understand the impact of this crisis on HY credits, it is important to differentiate between the different features of what people perceive as a rather European phenomenon. The current situation is characterized by the following phenomena:
- The government debt crisis actually refers to certain key industrialized nations’ debt situation. It is not just the usual suspects from Europe, but also countries such as the USA and Japan. As a result, this is not a geographically constrained problem, although the situation in Europe will stay in the spotlight of investors.
- The current banking crisis stems from the fact that a large number of global financial institutions (again, not an isolated European problem) have bloated balance sheets and lack stringent business models. Over decades, financial markets decoupled from the real economy as reflected, for example, in the dramatic growth in the global volume of outstanding CDS. This, as such, is not a cause of concern, as long as no external or internal shocks occur. The sub-prime crisis and the government debt crisis were trigger events which revealed the banking sector’s problems.
- The euro crisis is not a currency crisis. A currency crisis is a situation whereby the devaluation of a country’s own currency triggers a financial crisis in the respective country. This is not the case in Europe. The euro crisis is instead a crisis of the fundamental mechanisms of the European Monetary Union, which have proved to be too rigid to be able to react to internal or external imbalances. This, in turn, is purely a European problem and reflects the potential risks of monetary unions, which have been discussed in scientific publications for decades. The European Monetary Union is not an optimal currency area in the sense of Mundell’s path braking findings in the 1960’s. Hence, for a successful monetary union there must be a transfer mechanism to compensate for diverging economic developments in the different member states.
Obviously, these three problem areas are closely linked, which should not come as a surprise in a globalised world with integrated capital markets. Geographically constrained crises will always assume a global character via global goods markets and against the backdrop of free capital flows, as the sub-prime crisis has impressively demonstrated. But the causes for these three problem areas can be sharply delineated from each other. In addition, the impact on credit markets from these three dimensions of the crisis are very different.
Many economists argue that the real causes of the current high debt burden of many industrialized countries are global trade imbalances. But this phenomenon has existed for as long as there has been foreign trade. Rather, there are mechanisms in the global capital markets which counteract such imbalances, e.g. exchange rate movements or interest rate divergences. Now, one can argue that the European Monetary Union disabled these very mechanisms, aptly depicting one of the basic problems of monetary unions. However, this does not explain USA’s or Japan’s high level of debt. A country’s debt can, of course, also be explained by demographic change; however, one will find that this parameter alone cannot explain the almost exponential rise in the debt of some countries in the past few years. Ultimately, all countries with excessive debt can combat this by adopting their own economic measures. Flows of goods and demographic changes need to be addressed on an economic policy level. However, they do not need to inevitably result in spiralling debt. As banal as it may sound, high levels of government debt mostly have a very simple cause: an inefficient distribution policy.
If private financial assets are sufficient to dramatically reduce government debt, it follows that some private households must have profited at the community’s cost in the past. This may well be the case in some Eurozone countries. However, even in the USA, private financial assets significantly exceed government debt. Global imbalances can lead to one country being rich and another poor. But that is much harder to remedy than the problem of a poor country with rich citizens.
In economics, the pro-cyclical behaviour of the banking system has always been a central factor when studying banking crises. Banks tend towards excessive lending in times of low default and moderate interest rates. This is precisely what happened in the last 15 to 20 years. The development of new financial instruments, the emergence of new refinancing sources (such as sub-prime CDO) and, in turn, the integration of capital markets was all conducive to this.
Thus, a large number of effects resulted from a decoupling of the financial system from the real economy, which as mentioned, is demonstrated by inflated bank balance sheets and low core capital ratios. In times of economic prosperity, this behaviour by banks leads to temporarily high returns on equity, but makes banks extremely vulnerable to external shocks. Too many banks lack a business model which is profitable across the entire economic cycle. As people are not allowing Schumpeter to prevail in view of the much talked about systemic importance, the market’s self-healing mechanisms are not kicking in. Winding up banks ultimately leads to immense costs for the states themselves and, in turn, worsens the problem of government debt.
In addition to the problems of government debt being too high and the banking system too fragile, a third trouble spot can be identified in the deficient mechanisms within the European Monetary Union. This is not a problem of the euro per se. Instead, it becomes clear that the Maastricht Treaty ex post turns out to be the lowest common denominator politically achievable at the time. The mechanisms set out in the Treaty are unsuitable for combating economic divergence and are further weakened by the fact that member states have shown little willingness to adhere to the relevant criteria (i.e. a deficit of 3% and maximum GDP to debt ratio of 60%).
It is thus, within the nature of those monetary unions which do not satisfy the criteria of an optimum single currency area that divergences will appear in the economic cycle. In view of the limited opportunities for member states to react through economic policy (no monetary policy of their own and no ability to devalue their own currency), such divergences can become permanent. At the level of the state, individual national problems can accordingly only be addressed through fiscal policy, as a result of which, room for manoeuvre is severely limited. The participants were well aware of these developments while creating the monetary union. But the political will for a united Europe was much stronger than the doubts about whether a monetary union of economies with completely different structures would be able to function. Even though the individual member states’ fiscal freedoms have now been curtailed, the move toward a transfer union is unavoidable. This is precisely what is happening in Europe right now, even if politicians avoid this term at all costs. If the political will for transfers exists, monetary unions can be maintained, even for member states with different levels of competitiveness. This is the case in the USA and also in Germany (inter-state fiscal adjustment). Moreover, this very principle has been used within the EU since it came into existence, for instance with the aid of structural funds for assisting structurally weaker regions. One simply has to be cognisant of the fact that national competency is reduced and transfers will not just be of a temporary nature.
This is the exact opposite of the much debated demands of recent months. Many investors and politicians alike prefer simple, comprehensible measures, which above all promise to have a positive impact on the market. In other words, combating the symptoms and simply papering over structural problems through artificially generated growth. The call for more active intervention by the ECB and the creation of Eurobonds are the two most prominent examples of this. But can these really remedy the aforementioned problem areas? We have our doubts and the latest developments in Europe argue against a “bazooka-styled bailout”. We rather think that the solution to the aforementioned problems is a long bumpy road rather than a highway to hell!
What does this mean for the long term outlook of HY credits?
The enormous government debt of some countries and the bloating of bank balance sheets far above a level acceptable in real economic terms materialised over many years. The European Monetary Union’s mechanisms were agreed more than 20 years ago and have been causing economic misallocations ever since. It seems too optimistic to believe that these problem areas, which have been building over decades, can be solved within a short period of time. The only logical conclusion is that there is no simple way out of the current situation and that combating the causes of this crisis will take a long time. In our view this has the following impact:
A prompt and sustainable reduction of government debt is completely unrealistic in view of very moderate growth expectations. Extreme savings efforts are already needed for some countries to be able to achieve a balanced budget, if at all. These savings efforts will likewise involve long-term low growth, which will ultimately be far below potential. Japan serves well as an example of this. Since the real estate bubble burst at the start of the 1990’s, Japan has had extremely high government debt paired with limited growth rates. Even after 20 years, no improvement is in sight anytime soon.
The consolidation of the banking system is a mammoth task, not least in view of the systemic importance of the sector. At the same time, we should not expect to be able to achieve the increased capital requirements that Basel III prescribes by creating new capital. Instead, this will primarily be done by reducing risk-weighted assets, which will in turn have a negative impact on growth. The central banks can play a supporting role in this process (as they did at the end of 2011 with the Euro 489 bn lending facility), which is not to say that all banks will continue on in their current form. It should not come as a surprise if in 10 years, not only the relationship of bank balance sheets to a country’s gross domestic product will have dropped significantly, but also the absolute number of banks will have decreased. Only banks which have a sustainably profitable business case will survive this evolutionary process. A number of business areas which were typically seen as the business of banks will be undertaken in the future by other intermediaries.
The systemic character of the crisis is also reflected in the following chart. Comparing the iTraxx Crossover with the iTraxx financial sub index (5y bracket), it becomes obvious that during the last couple of months HY spreads remain far below the all time high reached at the beginning of 2009 (close to 1,200 bps), while financial spreads headed from one record high to another.
The obvious risk is that there will be negative spillover effects from the banking system on HY credits. The basic argument in this respect is that banks will be much more restrictive in their lending business and consequently, refinancing costs for HY companies will increase dramatically. A matter of fact is that banks will be forced to improve their capital ratios, while the 29 systemically relevant institutions have to reach a tier-1 ratio of 9% in mid 2012. This can be done by raising equity and/or reducing risk-weighted assets. In the current environment, we do not expect that banks will be able to resolve this issue just by raising equity; they will be forced to shrink their balance sheets as well. As HY loans/credit facilities are particularly RWA-consuming, lower-rated companies will experience a funding squeeze as banks reduce their loan allocation, under such a scenario.
This argument is generally true, but the current state of the banking system argues against a general funding squeeze. The reason for this is simply that banks have to react to Basel III requirements by significantly adjusting their lending business. For example, long-dated project finance activities could be reduced drastically as the maturity mismatch between bank funding and project loans is becoming more expensive, while sovereign holdings could also be decreased, especially in the lower-rated segment due to the same reason. Moreover, many investment-grade companies are currently able to tap the market for relatively cheap refinancing, replacing parts of their bank refinancing via bonds issuance. All in all, banks will reduce their business activity in many segments, while refinancing of mid-cap companies will remain attractive given the fact that there is still a huge gap between funding levels for banks and lower-rated issuers.
Banks will remain able to generate a positive return by lending to sub investment grade names, arguing against a shutdown of refinancing activities to the HY segment and consequently against a general funding squeeze.
However, lending business should become much more selective in an economic downturn, which argues for tougher conditions for those companies which are ranging at the lower end of the quality spectrum within the HY universe. The unavailing Seat Pagine (Lighthouse) restructuring effort in November last year has already reflected this trend, as it was also, at least partly, driven by the unwillingness of banks to bailout bondholders at an acceptable price.
The “quickest” successes can be achieved within the European Union if we do not just take the Brussels resolutions as a flash in the pan. However, this will need permanent rescue mechanisms and transfer mechanisms, creating a constant need for adjustment. But maintaining the system’s stability in the longer term will take more than the consistent implementation of the Brussels resolutions. National distribution policies are also of particular importance in this respect. If the European Union represents a political aim, the achievement of which justifies redistribution between member states on all levels, then the same must be true for redistribution within the member states. The same holds true for privatisation measures or the gold reserves of some high-debt countries’ central banks.
The structural imbalances which emerged over decades will have to be reduced over the long term. In this scenario, we would experience Japanese symptoms. Growth rates will remain low over the long term, and the continuation of an expansive monetary policy will retain interest rates low. There will not be any inflationary tendencies, as the liquidity the central bank makes available will seep into the financial markets and will not have any effect on the price of goods in the real economy. The equity markets will suffer and trade far below their peaks (see the Nikkei), but default rates will remain at a relatively low level in a scenario of this sort. This speaks in favour of credits, in view of the immense implied default probability currently discounted in the market.
2012 – Between Panic and Paradise
We do not ignore that this rather optimistic view is driven by the assumption that the political willingness to sustain the European Currency Union will be successful, at least in the short-term. The key element in this respect will be the private sector involvement (PSI) regarding the debt-restructuring in Greece, scheduled at the beginning of the year. As Greece has to redeem close to EUR 15 bn in debt in March this year (which is completely out of the realm of possibility), a quick (and probably dirty) solution of the PSI will be a necessary condition to solve the Greek debt problem. Especially non-European investors are closely monitoring the progress in Greece, arguing that if the EU is not able to solve a “small” problem like Greece, it will be never able to solve the larger ones like Italy and Spain.
If the PSI is successful (participation rate should be above 75% in our view, although Greece officially stated that 90% would be required), the risk of a Greek default scenario with all the potential negative spillover effects will decline significantly. In such a scenario, sovereign spreads in Europe will also trade far below the record levels seen in 2011. In turn, this will eventually also relieve the banks’ balance sheets. Besides the PSI, assuming this is successful one way or the other, the most important thing to watch during the next couple of months is the EU Summit (June 28/29), where the final approval for the ESM is expected. Although there are many economic concerns regarding a persistent bailout mechanism for Euro member states, the ESM (assuming an implementation in line with the current suggestions, i.e. including a leverage mechanism) will be a rather strong tool, which should be able to discourage speculation for a break-up scenario. In this scenario, the declining risk appetite of investors should also support the European HY segment. In the event the EU is unable to find a “smooth” solution to the Greek debt problem, the credit markets in 2012 will mimic the development in 2011.
But even a successful PSI cannot keep at bay declining economic growth in the Eurozone. The decisive question is not if growth declines, but how strong the decline will be. And there will be a diverging trend between the “good ones” and the “bad ones”, i.e. the North coalition and the South coalition within the European Union. However, this decline in economic activity should remain moderate, arguing against a 2002/2003 scenario with default rates reaching record highs. From the perspective of HY credits, there is even a positive interpretation of the low growth scenario: the ECB will keep interest rates at very low levels to generate further monetary impetus, while continuing to substitute the inter banking market.
Low interest rates, low default rates and relatively wide credit spreads support a more bullish stance towards lower quality names, at least in the short-term (6-12 months). Assuming a recovery rate of 20%, the iTraxx X-Over at a level of 750 bps in the 5y bucket accounts for an implied default probability of more than 37%. In a base-case scenario (no break-up of the Eurozone), the current spread level is more than a fair compensation for default risk! That said, spread volatility will remain driven by sovereign spreads as was the case in 2011, which implies that against the background of many decisive political decisions in 2012, spread volatility rather than default risk will be the crucial risk factor in HY credit markets.
A final word on equity markets: while we like Merton-styled investment decisions, we do not ignore that there are periods of decoupling between equity and debt markets. The crucial parameters determining the equity-debt cycle are profit growth and leverage. In cases of rising profit growth and declining leverage (and vice versa) equity and credit markets move hand in hand. But 2012 might show a different picture. Given the scenario outlined above, 2012 could be characterized by rather declining profit growth (arguing against equities) but stable or even declining leverage (given the current high costs for increasing leverage). From a cross asset perspective, credits are currently cheap versus equities and credit spreads might be able to tighten further even in the event equity markets remain stable or moderately underperform in 2012.
As mentioned above, risk reward looks supportive for European HY markets, assuming a no break-up scenario for the monetary union. This potential break-up risk of the European Currency Union raises a very important question, which is directly linked to CDS rather than cash bonds. Especially so given the discussions surrounding the famous Seat-case last year, which showed that the ISDA Credit Derivatives Definitions provides a certain room for interpretation. According to the ISDA, a restructuring event includes the change of the currency (redenomination) to any currency which is not legal tender of an AAA-rated OECD or a G-7 country. This means that for Italy, France, and Germany (G7 countries) the redenomination into Lira, Franc, and Mark would most likely not result in a restructuring event, while this is not as clear for the rest of the member states of the currency union. The key point here is whether deliverables would exist after the redenomination, as a deliverable obligation must be denominated in a specific currency. This pack of currencies includes the euro and any successor currency of the euro. At first glance, it is not clear if all European currencies would qualify as a successor currency to the euro, which would be a prerequisite to deliver any local law bonds (which will be redenominated) into a CDS contract. That said, international law bonds (which are not likely to be redenominated) will keep their status as a deliverable obligation, making them much more attractive in a break-up scenario compared to local law bonds. This is true for investors using CDS as a hedging tool and particularly important for basis players, which are active in non G7 countries.
Negative basis remains an attractive investment strategy in all potential scenarios, although basis on average is less attractive than in 2009 and 2010. However, it is important to note that there are many potential traps, and basis investments require a detailed legal and economic analysis. Besides the redenomination risk, orphanic risk (i.e. the lack of deliverables) remains the crucial factor. The Seat restructuring event in November/December revealed that some investors are getting cold feet ahead of a potential restructuring event following the experience in the restructuring of Irish banks (removing some specific bonds from the deliverable obligation list). Some investors sold Seat basis packages in the low to mid 80s just one week before the credit event was finally determined by the ISDA, and basis investors received 100 in the auction. Seat was definitely a very special event, however we would not be surprised if we see similar events in the next couple of years. While the average basis in the European HY universe trades flat, there are some straight opportunities which offer around 100-150 bps, while buying into 200-250 bps is possible from time to time. Packages which provide investors with more than 200-250 bps often do have some tricky features, which have to be compensated by more carry.
There are some arguments why cash could outperform CDS in 2012 in a base-case scenario (no break-up of the Eurozone). Cash rich investors will prefer cash versus CDS, especially in those names which trade at a negative basis. CDS will stay more volatile, offering basis opportunities from time to time, while declining risk aversion should be beneficial for both cash and CDS players.
To sum up, we definitely do see some investment opportunities given the current valuation levels. The 5y X-Over trading at 750 bps leaves investors with a breakeven of around 250 bps (delta @ 3.3 and assuming roll down), which means that a widening towards 1,000 bps (the 2009 scenario) would be compensated by carry income. A 2009-like scenario is, in our view, less likely as currently discounted in European HY spreads. We would not argue that we are in paradise, however we also see no reason for panic.