16th December 2016

2016 was no annus horribilis

MARKET CLOSE:
FTSE 100
6,999, +50
DAX
11,366, +122
S&P 500
2,262, +9
iTraxx Main
73bp
iTraxx X-Over Index
295bp
10 Yr Bund
0.36%
iBoxx Corp IG
B+134bp, -0.5bp 
iBoxx Corp HY Index
B+413bp, -4bp
10 Yr US T-Bond
2.60%

Be bold, the volatility will help safe havens…

It is so tempting to believe that 2016 was the markets’ annus horribilis. It wasn’t. Far from it, in fact. We’ve had much worse years and that includes since before the crisis started back in 2008! But because we’re ending on a little sour note for fixed income – and performance matters for all fund managers – it does feel like we’ve snatched defeat from the jaws of victory.

The corporate bond market will have returned a little over 4% this year and the high yield market some 6%+. They are performance levels in excess of most predictions when we started 2016. Admittedly, both were 2% higher in the summer, but we won’t scoff at the performance.

Most of it for corporate bond total return players has come from the rally this year in government bonds. Next year’s corporate bond performance will depend on how much weakness we experience in this market. There are so many imponderables in 2017 which right now looks like it will turn out to be one the most difficult to predict in this sense. After all, it is riddled with massive event-risk. The Fed has set its stall out early, with the potential for three hikes following on from the one this week. Elsewhere, some of 2016’s situations are ongoing and will carry over into the new year. It promises to be exciting, volatile and perhaps even dangerous – but promises much angst and uncertainty for sure.

The hurdles that we will need to manoeuvre include Trump’s inauguration in January and his almost off-the-cuff economic and geopolitical policy responses. Italy isn’t out of the woods despite installing a new technocratic Prime Minister, with elections likely in due course. France’s elections in April/May are sure to see markets volatile hoping for the steady hand of Fillon to be victorious which would then see us through to the German election in September. How to play it? We think no differently to 2016’s strategy until we see Trump’s economic policy.

That’s still probably long credit duration (but less so than in 2016) while maintaining a positioning bias towards higher beta credit (again this won’t be overly aggressive). The government bond market in Europe isn’t going to fall out of bed (despite the recent data suggesting a firming recovery). Equities will have a bigger say, though, and we might get some rotation out of credit into them. But the ECB stays supportive, credit fundamentals remain intact and the default rate at low levels. The aforementioned risks might just help provide a good level of support, too. But get used to the idea that total returns will fall markedly versus this year (and there is more on this when we come back in January).

Primary markets kept investors focused

It hasn’t been a record year for issuance, but it has been a very good one. Actually, it’s been the second best ever. After barely €20bn passed our way in IG non-financial issuance during those difficult opening months in January and February combined, we came back hard as almost €120bn was printed in three-months from March through to the end of May. A relatively limited level of issuance through the summer months then led to an average of €28bn per month in the September/October/November months.

We are closing out 2016 with issuance up at €271bn in IG non-financials – just €20bn shy of the record €290bn from 2009 (according to Dealogic data).

Specifically, CoCo/AT1 issuance levels have disappointed, the product a victim of the volatility in the markets. The level non-financial corporate hybrid supply has also come in lower than we ought to have expected, victims of the market volatility too but also changing rating methodologies, confusing investors and reducing comfort levels for some. Higher rate markets have seen costs become a little prohibitive, too. Senior bank issuance remains at post-crisis average levels, some 50% lower than the average we had in the 1990s and pre-crisis. Then league table driven (short-dated) supply exceeding €350n per year was common. The €145.5bn issuance in senior debt is the second lowest on record.

The HY markets could have seen more issuance but again, the higher levels of market volatility in Q1, through some of the summer months and into year-end have scared borrowers off, with investors demanding higher premiums to fund them. Still, €49bn of high yield supply is around the average of the past four years. The wall of refinancing isn’t yet a problem for borrowers, given their reduced funding needs as a result of the higher levels of capital markets borrowing since 2013, as corporates termed out debt into longer maturities.

The year should have delivered much more, while Draghi suggesting the ECB’s corporate bond QE programme boosted capital markets activity is an incorrect observation in our view. Most of the major corporates did their own funding before the programme started, and the level of issuance since the beginning of it hasn’t risen to any noticeable extent. The back-up in rate markets since October has actually seen funding costs rise while Trump’s election victory has seen to it that yields stay at a higher base level on expectations of fiscal profligacy in the US come 2017.

Fortunately, the corporate sector is cash rich, boasting record levels of balance sheet liquidity, with much of it raised at record low funding levels but with nowhere to go from an investment (or, rather, reinvestment) perspective. The economic outlook needs to feel a little brighter and be more certain from a sustainability perspective. With political event risk rising and likely to be a key feature throughout 2017, we don’t anticipate any material pick-up in investment, capital expenditure or M&A in the Eurozone in 2017. Steady as she goes will be the corporate industrial sector’s mantra.

Holding on to what we’ve got

Performance might have waned into the final quarter, but we have managed to hold on to above average levels of returns for the year. Some equity markets (US, UK for example) have outperformed corporate bonds, but we have to be very happy with the year’s returns. Spread performance, though, has disappointed and benchmarked investors will be disappointed. They’re tighter by only 20bp in IG on an index basis (Markit iBoxx) and we believe that the ECB’s heavy lifting of non-financial IG corporate bonds (€50bn in six months as at the time of writing) ought to have seen the index through B+100bp (at B+134bp currently).

Non-financials have returned just shy of 5% while financials have lagged and delivered just 2.9% of performance. Sterling IG credit is almost 10% up in the year for investors, but that hides the fact that returns were riding as high as 17.2% at one stage. The returns for 2017 are going to be lower than this year and, as suggested in previous comments, 2-2.5% in IG €-denominated credit would be a good result.

Support in the past has come from improving credit fundamentals feeding through into tighter spreads, but with spreads already at close to historic tights in many cases (admittedly the index isn’t) we’re going to need some help to eke out anything on the spread front. With that “fundamentals” support absent, it’s going be more about intrinsic value and relative value against other asset classes.

Finally, the case for credit might not be helped if the asset class is not needed as an alternative (to government bonds) higher yielding safe-haven investment in 2017. More on this when we return in January.

That’s it for 2016, unless events over the next couple of weeks warrant a comment. We wish you a very merry Christmas and a happy New Year.

Suki Mann

A 25-year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on Credit Market Daily.