Credit steams on after ECB boost

Mon Jun 9, 2014 9:57am EDT

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(This article first appeared in the June 7 edition of the International Financing Review, a Thomson Reuters publication)

By Christopher Whittall

LONDON, June 9 (IFR) - European credit spreads will fall to their lowest levels since 2007 by year-end, market strategists say, after the European Central Bank delivered a raft of new policies aimed at easing lending conditions in the eurozone last week.

While ECB president Mario Draghi had widely flagged policy easing ahead of last week's meeting, market participants were unwilling to bet the house on the central bank meeting their lofty expectations as it moves to ease monetary policy to fight off deflationary pressures.

But credit markets swiftly showed their approval of the measures as iTraxx Main and Crossover - the bellwethers for European investment-grade and high-yield debt - closed the day 6.1% and 5.6% tighter, respectively.

"The recent price action shows clients were not as long as they would've liked to have been given the market moves. It felt like people were not prepared for the ECB to meet expectations," said Saul Doctor, credit derivatives strategist at JP Morgan.

Comments from one credit hedge fund manager support this theory. "We didn't want to have a big positioning going into the meeting as it was so binary. We were just long volatility in case spreads spiked much tighter or wider," he said.

After the ECB presented easing measures, including a targeted SME lending liquidity programme, investors are almost universally positioning for tighter European credit spreads. Bank of America Merrill Lynch analysts reported USD1.6bn poured into high-grade European credit funds and ETFs in the week ending June 4 - the 27th consecutive week of inflows.

Citigroup analysts noted that real-money managers had taken to CDS indices over the past few weeks to put risk on given the dearth of primary supply. This has caused CDS to sharply outperform bonds recently and helped send non-dealer long positions in iTraxx Main to reach record highs.

"Positioning indicators show clients have been long versus dealers for the last few weeks and we expect they'll get longer still, which points to more of a rally," said Doctor.

At 58bp and 224bp respectively at Friday's close, iTraxx Main and Crossover have already broken through year-end target levels for Citigroup analysts, who now expect spreads to test the 50bp and 200bp barriers soon.

HOW LOW CAN YOU GO?

In terms of how tight spreads could go in absolute terms, JP Morgan strategists say the 20bp record tight on Main in June 2007 is unlikely to be reached due to the lack of leverage in the market compared to this period. However, spreads could grind into 40bp eventually if the benign macro-volatility environment persists.

Much of this performance is likely to come from higher beta credits that have not rallied as much as their more creditworthy peers. Only 11% of the constituents in iTraxx Main are currently trading below 40bp, according to JP Morgan, and more names are expected to trade in the 40bp-50bp range as spreads rally.

"The potential P&L from stock picking is low as market volatility is depressed and correlation is high. We see carry from picking higher beta names and playing for spread compression," said Doctor.

The credit hedge fund manager says there are some interesting single-name stories at the moment, particularly among European financials given the new ECB liquidity measures, which will further curtail negative net debt issuance from the sector.

"The new LTRO means banks won't have to issue so much senior debt, which creates a very powerful technical," he said.

Doctor agrees that financials remain a compelling buy for investors. "People are definitely looking at financials. As banks have less reason to go to public funding markets, bond prices will be driven up and CDS spreads lower. We expect Senior Financials to trade in line, or even tighter, than Main," he said. (Reporting By Christopher Whittall, editing by Helen Bartholomew)

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