What Downgrades Are “Priced” In?

Posted by on Jan 13, 2012 in Uncategorized | No Comments

Rumors of European downgrades are out there again today, and it feels pretty real.  Multiple sources, no angry French finance ministry employee denying them, so we will see what, if anything is priced in.

I’m hearing from a lot of people that a 1-notch downgrade is “priced” in.  I’m not sure that is true.  So many people have been complacent that I don’t think even a 1 notch is fully priced in.  If it was, why we do sell off on every rumor and then gradually rally, totally forgetting that it is likely to be downgraded?

I think this is a bigger deal than people are making it out to be.  If France gets 1 notch then EFSF is no longer AAA.  ESM won’t be AAA (in spite of the headlines, the paid in capital was low and they were still largely relying on capital call rights to back issuance).  The EIB (European Investment Bank) may also have to get notched.

I think the market doesn’t have downgrades priced in, and on top of that, I think the downgrades might be more widespread and deeper than people originally thought.  Very little progress has been made, and lots of negatives have come out – Spain’s deficit was bigger than expected, Countries are slapping guarantees on bonds issued by banks at a rapid pace, the last summit does nothing to immediately force countries to fix their deficits, and the economic situation (globally) is not great and there are specific signs of weakness.

We may see a bounce from these levels, but I do not believe that the market has priced in much for potential downgrades so there is significant downside risk and I don’t think news coming out of Greece is going to help things either.

For what it is worth, HY17 is underperforming HYG as institutional players are quick to short and retail still seems more focused on potential yield.  The duo of HYG and JNK have attracted close to $1.5 billion of money this year (probably about half of all the high yield fund flows are going into these two behemoths).