This analysis is by Bloomberg Intelligence Chief European Credit Strategist Mahesh Bhimalingam and Bloomberg Intelligence Credit Strategy Associate Heema Patel. It appeared first on the Bloomberg Terminal. 

As recession fears and distress counts mount, Crossover dispersion hit a record of 137%, yet the Crossover vs. Main ratio is under 5x — but may not hold up for long. After positive 3Q earnings by big banks, Financials rallied vs. Main this month, while Main recovered vs. CDX IG but remains inverted as Europe faces more challenges and inversion will persist. Investors turned heavily to CDS indexes in 2022 with record daily trading volumes, particularly in the past two months. With negative skew, the index was preferred to single names as the curve steepened during the roll-aided rally. Bonds are tighter than CDS (positive CDS-cash basis), which could soon invert if bond illiquidity persists.

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Crossover-main ratio at 5x, may not hold up for long

The Crossover-Main ratio is still high but stabilized at 4.9x, using S38 adjusted spreads, from 5.5x at start of the year. This is despite Crossover dispersion hitting a new record, whereas Main dispersion stayed low. The ratio highlights the premium for junk vs. high grade CDS, and all kinks due to index rolls have been adjusted for S38 constituents and five years’ constant maturity.

The ratio is much less than the pandemic high of 7.5x (6.5x raw), implying that the Crossover has substantial room to widen vs. the Main, specially after the Crossover dispersion outburst led by six stressed/distressed names and an 80% chance of recession in the euro zone (ECFC <GO>). The CDS market hasn’t reacted to Crossover spreads as there are no default or fallen angels, but that won’t last when the dominoes start falling.

Financials in massive October rally vs. main

The Financials Senior vs. Main differential, after hitting a 12-month high of 16 bps earlier this month, has bounced back to 9.3 bps as financials outperformed the rest of credit, with companies reporting positive earnings this month. Recession worries and rate hikes affected financials initially as they bear more systemic risk than corporates, but now after the big banks’ positive 3Q updates, this has led to a big drop in the differential. After the S34 roll during Covid, which saw big adjustments in the differential (20 bps) due to fallen-angel exits from the Main, this month had the second largest differential drop in over two years.

With the gap at 9-10 bps, near the two-year average (54th percentile), financials can stay this wide to Main, considering that systemic risks persist and a further rally may see resistance.

CDX IG vs. iTraxx main’s big inversion reverts a bit

The CDX IG vs. Main differential is still massively inverted at minus 20 bps, but has compressed from its depths of minus 33 bps earlier this month, as European earnings are turning out not to be as bad as expected. The CDX IG roll was about 8.2 bps wider, with the iTraxx Main roll 5.5 bps wider, making the true differential about 23 bps. Inversion started immediately after Russia invaded Ukraine and has kept worsening. We believe this is a new regime, with the CDX IG vs. Main differential staying negative for the foreseeable future. Europe has been affected more by the energy crisis, given the proximity and dependence on Russian oil and gas.

With dollar strengthening and the Fed ahead of the ECB, we don’t see the relationship correcting below minus 15 bps, especially after the less hawkish tone in the recent ECB meeting.

 iTraxx main curve bull steepened in post-roll rally

The iTraxx Main curve had a massive bear flattener this year due to the credit rout, but bull steepened over the past month, after the S38 roll, as spreads rallied around 20-25 bps across the curve. This roll-aided rally reversed some of 2022 spread damage — it’s still 60-65 bps wider on the year — and partly corrected the year’s massive curve flattening.

Both 3s-5s and 5s-10s are still too flat given our view of credit-risk evolution over time, with the 3s-5s spread ratio steepening to 1.24x (1.18 last month) and the 5s-10s at 1.22x (1.18 last month). Both have ample steepening room to reach pre-virus levels, which were nearly 2x for both sections. But they may not steepen a lot — all depends on the ECB avoiding any quantitative tightening talk — as there’s no steepening without a rally.


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