Europe’s Credit Markets React To Brexit – $11 Trillion Of Negative Yield

The knee-jerk reaction to Brexit in the credit markets is similar to that as seen in the equity markets but has been exacerbated by illiquidity and rising levels of bank stress.

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Bank of America credit analyst Barnaby Martin points out that since Thursday, Euro Investment Grade spreads are 14 basis points wider, Sterling Investment Grade spreads are 18 bps wider, and EUR high-yield spreads are 65 bps higher. Most of the reactions were in line with the bank’s initial knee-jerk reaction forecasts with the exception of Sterling Credit Spreads.
Indeed, Bank of America was initially predicting a widening of spreads of 30 bps to 40 bps in the event of Brexit. With spreads wider by only 18 bps at time of writing, credit analysts believe the spreads are still too tight to price the risk in effectively. Some other observations by Bank of America on the credit market:

“Of note: bonds have outperformed CDS (CSPP effect), Euro IG non-financials have outperformed banks (CSPP effect), AT1s have outperformed bank equities (search for income), corporate hybrids have significantly underperformed their senior debt, peripheral corporates have underperformed peripheral sovereigns (despite the Spanish election), and BBs (+49bp) have widened much more than BBBs (+18bp) would imply.” — Bank of America

So far, the reaction to Brexit in the credit markets has been relatively subdued, considering some analysts are going so far as to call this the next Lehman event. There is no denying that the situation could become a lot worse for credit investors. BoA speculates that the most important barometer for credit investors is bank shares. European banking equities are being hit hard in recent days and if they keep falling, as history has shown, it can lead to tighter credit conditions, exacerbating the Eurozone growth slowed down, which would lead to greater deflationary pressure bolstering the “quantitative failure” narrative, risking a more systemic sell-off.

Europe’s Credit Markets React To Brexit

Credit markets: High-yield share shrinking 

Unfortunately, Brexit will make life a lot harder for European high-yield credit investors. Part of Mario Draghi’s “big plan” in Europe is to improve credit conditions and in particular bank lending to the SME sector. It’s more than likely the ECB will move to extend and accelerate lending in the wake of the UK’s referendum. If banks begin to lend more to SMEs, then they high yield bond market will face competition for funding. European high-yield market is already showing some signs of this trend. In 2016, the share of bonds rated BB in the European high-yield market has grown from 65% to 68%, while the single-Bs share has shrunk from 30% to 26%.

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Meanwhile, the ECB is gobbling up European corporate bonds with its Corporate Sector Purchase Programme. After 11 days of buying, the ECB has managed to acquire €4.9 billion of corporate bonds, implying a monthly run rate of between €9 billion and €10 billion. If this continues (there is a chance the bank could be front-loading its purchases), CSPP purchases should hit €43 billion by week 20. BoA notes these initial figures are impressive for a number of reasons:

“Firstly, the ECB managed down the market’s expectation of corporate buying, hinting that they may begin slowly until familiar with the credit market.”

“Secondly, the “delta” of CSPP buying will always be a function of healthy primary market issuance. But post on start of CSPP on June 8th, primary issuance has been virtually absent. This means the ECB is achieving its current run rate with a lot of heavy lifting in secondary markets.”— Bank of America

With this big corporate bond bazooka in place, the ECB has what it takes to calm down the bond market and pull spreads tighter after the Brexit shock. Bank stocks need to rally as well, and banks need to continue lending to calm the markets completely and offset any possible “quantitative failure” speculation.

The global stock of negative yielding fixed income debt has jumped

In other credit news, since last Thursday the global stock of negative yielding fixed income debt has jumped by almost $1 trillion and now stands at around $11 trillion. Japan accounts for the largest proportion of this debt.

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Japan’s negative debt now stands at $6.2 trillion, 70% more than the $3.7 trillion of negative yielding Eurozone debt — despite the latter having a large amount of negative yielding corporate, agency and securitized bonds.

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