Some Quick Thoughts on 2016 Credit

The environment for the U.S. credit markets will remain extremely challenging. The uncertainties associated with Fed interest-rate policy are resolving to no more rates hikes through 2016, but North America will have continuing problems in energy and mining/materials sectors. Economic weakness will have an impact on default rates all over the planet.

Implications:

European credit markets will clearly outperform their American counterparts (vs. iTraxx main CDX IG).

This will be more pronounced in the HY/Crossover area, as energy names have a heavier weight in North America than in the European counterpart. Spreads between the American (CDX HY) and European (iTraxx crossover) HY markets already at a record high is (160+ bp). The gap shown below results from the most recent NA.HY index roll.

Heterogeneity in the credit markets will remain high. Default rates will increase driven primarily in the US by certain sectors (energy, yet again) while in Europe, macroeonomic weakness will manifest in a more idiosyncratic way (an example being the Spanish company Abengoa and Isolux).

Implied volatility was too cheap, but not anymore. If I had been smart, I would have bought US stocks vol (VIX) and sold European equity vol (V2X). As it stands now, big shocks will make them track each other further. The volatility spike seen busts the long/short strategies I posted about in December. Instead, look for negative basis trades (long cash, long CDS protection) as they develop.

In 2016, EM countries will remain a challenge, but for a different reason. Emerging market credit is now pricing in multiple downgrade from investment grade (see chart). You can get carry at a decent price here in local currency, provided that one can currency hedge. The cost of this hedging is high. A possible solution to this cost is to offset FX puts costs by selling credit risk and collecting premium in some liquid names. This is tricky to structure but profiles can be built to approximate zero cost protection. In most cases, the meaningful option is to buy the cash bond and hedge currency opportunistically only when it is not cost prohibitive.


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