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- Q: Which bond yields are rising? A: All of them
Q: Which bond yields are rising? A: All of them
If you have been reading and watching UK media recently, you're probably quite aware of the furore surrounding what the BoE has been up to in apparent response to the mini-budget shenanigans of the new Tory government.
The problem with the media, as I have been saying quite a lot on good old, GB News recently, is that there is a belief things in the economy are isolated and work linearly.
'This one event led to XYZ right away, so this must be the cause!'
I stated here that the market is 'forward looking' and we shouldn't simply jump to conclusions based on short term policy.
'At the moment, it's a battle between the Treasury and the Bank of England.'
Financial expert David Belle reacts as the pound plummeted to an all-time low against the dollar yesterday.
📺 Freeview 236, Sky 515, Virgin 626
💻 GB News on YouTube https://t.co/KHMl3BS8eC pic.twitter.com/ZNAxnB9BmL— GB News (@GBNEWS) September 27, 2022
If you want to get into causation, you can come up with a narrative going back 20 years to pre-GFC.
But then that would be a little too complex for the front pages and headline grabbing media, wouldn't it?
Let's take stock (or bond) of the situation
Here's the UK, US, German and Swiss 10 year yields.
What do we notice?
Well, the economies that have hiked harder and faster have... higher yields.
See the US and UK 10 year yields right now...
They're pretty much at parity.
This is a far cry on how things are viewed though.
As of writing, the UK 10 year yield has ticked to LOWER than the US 10 year treasury yield.
Media will be silent though, of course.
And that's OK!
This is all very complex stuff, but does certainly leave space for us at Macrodesiac to try and right some wrongs when it comes to perspectives and broadening the view on how global markets and economics works.
The overriding point here is that things break in hike cycles.
One week you have UK liability driven investments being the issue, the next week you have something else cropping up.
And we reckon there's something very specific to Germany that is going to crop up...
Leveraged Loans!
Have a read of this synopsis from Fitch Ratings...
This is Fitch Ratings’ inaugural report on the DACH (Germany-Austria-Switzerland) high-yield bonds and leveraged finance markets. From 2009-2022 YTD, Germany accounted for 84% of total DACH issuance.
The report includes a market overview and a portfolio overview section. The data and analysis provided are based on Fitch’s European High-Yield Insight Index and on Fitch’s European Leveraged Loan Insight Index. Fitch's portfolio overview section is based on Fitch’s portfolio of private Credit Opinions and public ratings of DACH leveraged credits, mostly LBOs. Loans slightly prevail in DACH high-yield and leveraged credits The DACH market is led by leveraged loan issuance, which accounted for 56% of the market between 2011-1H22.
High-yield and loan issuance, notably for ‘BB’ category issuers in the DACH regions, has been constrained by competing capital sources from the unsecured loan market. Domestic bank lending and the development of the Schuldschein market, a private debt syndicated loan instrument, has migrated from investment-grade issuers towards ‘BB’ issuers since the eurozone crisis.
The share of bonds in new issuances has been on the rise between 2016 and 2020, rising from 30% to around 60% of the total issued volume.
So not only do we have a shift from a 'strong' rated firm doing the borrowing (shift from IG to BB), but we also have an instrument that had prominence post the Eurozone crisis where bond yields and interest rates were low, to an even more prominent market (see Bloomberg tweet below) when the ECB is raising rates and Germany is in a mess...
Issuance of Schuldschein, a quirky German credit instrument, doubled in the first six months of 2022, its best start to a year https://t.co/EqjSQs7Yb0 pic.twitter.com/BPUe6q0WZz— Bloomberg (@business) August 22, 2022
And there are two kickers here...
Schuldschein are favored in Germany because they’re private, simple to use and based on local law. The market is light on paperwork, with even 2 billion-euro deals only having agreements comprising a few pages at most -- a marked difference from doorstop-sized bond prospectuses. There’s no requirement to publish deal terms because Schuldschein aren’t publicly traded or covered by transparency rules under the European Union’s MiFID II regime. Further cost savings come from not needing a credit rating.
Yeah, sounds great. 'Doc-lite' is what this is called.
See this article from Schroders on this type of deal...
The second kicker comes into play when we look at who the issuers are...
German banks often use Schuldschein to make loans to the Mittelstand, the nation’s network of small manufacturers. Local lenders dominate the arrangers league table, with Landesbank Baden-Wuerttemberg, or LBBW, Helaba Landesbank Hessen-Thueringen and Bayerische Landesbank at the top of the tree. About three-quarters of borrowers are smaller companies with less than 5 billion euros of annual sales, according to a European Commission report.
And we know how fucked up Germany is right now, as linked above (Tim's great article on Germany being in deep shit).
But let's grab some points to show how week the outlook is, and see how this might affect this murky part of the German credit market.
From Goldman...
High Domestic Exposure
Small companies have generally more domestic sales exposure than large
companies.
We find that STOXX Large and Euro STOXX 50 have revenue exposure of c.40% to Europe, while STOXX Small and Mid-Cap have revenue exposure of about 60% or more to Europe (Exhibit 2). As a result, Small and Mid-Cap tend to underperform when a weak EUR (or GBP) helps large international companies.
We note that: A weak domestic currency is often a reflection of a weaker domestic environment that small domestic companies cannot escape.
A weak domestic currency makes any imported goods more expensive, pushing up inflation pressures and increasing risks to margins - at a time of greater concern.
A weak domestic currency benefits large international companies with translation gains when they bring back their (high value) international profits in their consolidated statements (in weak local currency).
A weak domestic currency increases the competitiveness of large international companies which can employ aggressive prices in foreign currencies.
Low Profitability
Exhibit 4 and Exhibit 5 below shows the margins and ROE for Small and Large caps. At the index level, Small caps have always been less profitable than Large caps.
Even at the current level, which is close to a historical high, the margins of Small caps are close to the historical low for Large caps.
Moreover, we note that their ROE and Margins have recently started to fall compared with Large caps, which continue to improve their profitability (this is, of course, a function of FX and exposure to commodities).
We starting to get a picture of things now?
And we must remember the Germans are not averse to 'hidden' financials.
Wirecard...
And obviously, they had the hidden emissions scandal too.
Could the Schuldschein situation be a similar issue?
I think we'll see, but the point to reinforce here is that higher rates cause things to break, especially when they have been opaque.
I should be a rapper.
And do recall, that the ECB hasn't raised rates THAT much.
Ask yourself... would you be a buyer of the German 10y here at 2.24% vs the US 10y here at ~4%?
I wouldn't, so that should give some idea to the situation Germany is facing.
In an increasing interest rate world, things break.
Just like with LDIs in the UK, other nations have risks that have done well in low interest rate policy, but as soon as we start seeing higher rates, they get exposed.
We're just getting started!