- by Suki Mann
|iTraxx X-Over Index
|10 Yr Bund
|iBoxx Corp IG
|iBoxx Corp HY Index
|10 Yr US T-Bond
Income versus growth investment theme finely balanced…
Wishing you a happy and prosperous New Year.
2017 promises to be one of the most difficult years to predict for all asset classes amid an ever-growing list of imponderables, some of which could represent considerable banana skins in the investment process. Event-risk looms at every corner.
We have President Trump in just three weeks, French elections in Q2, a new government needed in Italy whenever they can get around to sorting out the process, and the triggering of Article 50 in the UK at the end of March – while the ramifications of the December terrorist attack in Berlin might have an impact on the Germany’s elections come September. Those are the known unknowns whereas, for once, the macro appears a little clearer.
We have the potential for up to 2.5% GDP growth in the US this year, accelerating in 2018 should Trump’s much-anticipated fiscal stimulus take hold. There will be a positive impact to growth elsewhere. Higher anticipated inflation will see two or three rates hikes in the US this year. Europe might not – ought not – follow the same footprint. That is, higher policy rates and market yields in the US will likely have a limited follow-through effect here. Ten-year US Treasury yields may well be up at the 2.75-3% area in due course, but without evidence of a sustained upward trend in Eurozone growth (and an Italian banking crisis possibly needed to be handled), we would expect a decoupling with Bund yields (the Eurozone’s market safe-haven and at times bellwether indicator).
It is against this sort of disjointed – almost corrupted – global market place and outlook that we need to make sense of how to position. To go long or short duration, consider equities versus fixed income asset re-allocation, think as to whether M&A will pick-up in Europe in any meaningful way and what that would mean in corporate re-leveraging terms? Will central bank accommodation finally come to an end by the time the year is out and what sort of trajectory will rate markets take as they trend back to normal levels – if indeed they start to in 2017?
Credit fundamentals appear sound
We have little to be concerned with regarding the fundamental state and outlook for the corporate bond market. The prospect of a rising default rate is limited while overall credit fundamentals remain sound. The ability for the corporate sector to service obligations remains as strong as at any point in history. The level of cash residing on corporate balance sheets is at record levels. We are still printing deals at close on record low funding levels into a still supportive investor base despite periods of secondary market weakness, as seen so obviously in Q4 2016. And fundamentally, there are low levels of event risk in Europe around capital expenditure, investment and M&A that combined or otherwise might see pressure on balance sheet strength through a re-leveraging effect.
Indeed, classically, spreads in 2017 should go tighter – if only we base it on expectations of an improvement in macro economics. There’s little fundamental reason for them not to. The world is supposedly looking at a better growth dynamic after all. Historically, a rising growth environment usually translates into tighter spreads. And who isn’t licking their lips at US fiscal profligacy to give the already buoyant US economy an additional boost that most are then expecting to help improve growth on a global basis?
Unfortunately, we can’t help thinking that spreads are at stretched valuations. Even the ECB’s heavy QE meddling has failed to see us materially tighter through 2016 and there is a sense of nervousness around corporate bond market valuations as we start the ball rolling for 2017.
But should we be fearful?
Source: Markit, CMD
|2016 (End)||2017 (Forecasts)|
|IG corporate spreads||B+135bp (-19bp)||B+120bp|
|HY corporate spreads||B+413bp (-113bp)||B+380bp|
|IG non-fin corporate supply||€273bn||€250bn|
|HY corporate supply||€47bn||€40bn|
|Senior bank supply||€145bn||€140bn|
|10-year Bund yield||0.20%||0.40%|
|IG corporate bond returns||+4.5%||+2%|
|HY corporate bond returns||+8.5%||+5%|
Rate market uncertainty will grip
The volatility around rising market yields is what injected trepidation into corporate bond markets through Q4 2016. We believe that 2017 will be one of the most difficult to predict in terms of spreads and ultimately performance.
We’re at a point where we can’t say, with any real certainty, that the corporate bond market offers a safe haven investment from a performance perspective as it did in 2016. That’s because 2017 might well be about taking higher levels of risk – the ultimate investment market risk being that of going long on equities.
We all fear Trump and his ad hoc, off-the-cuff remarks but potential expansionary fiscal policy is the first hurdle that fixed income players need to manoeuvre. The markets will expect and position for more longer-dated bond supply. That means higher back-end yields. If growth picks up significantly into it, the market will fear higher policy rates. And if all that happens, it means we have (the prospect of) higher inflation. Oh, that means higher yields still.
That’s the US story. The $64,000 question is: Where will yields go in Europe? Will the curve steepen, given that front-end ought to remain anchored as the ECB isn’t going to raise rates next year? Nor is the BoE, for that matter.
We closed out the final couple of weeks in 2016 with yields in Europe heading lower in quiet, illiquid trade. However, yields in the intermediate to longer maturities were well off the lows, while the front-end saw yields reside at around record lows as we closed out. Can a US economic recovery manage to provide some sort of catalyst for a higher growth dynamic than what we have otherwise anticipated for Europe?
Into the second quarter, market attention will shift to the French Presidential elections. Fillon is favourite to win the second round, but Le Pen might prove to be a sturdy, if not stubborn, opponent. A Le Pen victory and fixed income markets which enjoy safe haven status will benefit, credit will too. The rest will sell-off and OATs will be a big underperformer (let alone the periphery).
So, January to the end of May will prove to be nervous months, and we don’t think that bond yields will move much out of their recently established ranges. For the 10-year Bund, we look for a trading range through this year of 0.15-0.40%, pivoted somewhere around -0.80% in yield for the 2-year Bund while Gilt yields ought not to push much higher than 1.50% in the 10-year.
Ultimately, we expect further decoupling between US Treasury yields and those of government bonds in Europe. Italian politics will be a constant “event-risk” in this period, but their likely impact will be on BTPs and perhaps Bonos.
ECB and the corporate bond market
The European Central Bank has done its utmost – and been generally successful – in preventing a beleaguered Eurozone economy from falling into the abyss over the past eight years. It’s been very bad, and we’ve had an economy that has huffed and puffed off some very low growth, low inflation, high unemployment levels – but only because the level of market manipulation by the central bank has been at unprecedented levels. While the ECB has endeavoured to fulfil its own mandate, the political establishment has been slow to act and reform – sticking with established policy constrained by the criteria laid out as per the Maastricht Treaty.
The ECB’s involvement in “the market” has seen the front-end of the Bund curve at record low yield levels (2-year at -0.82%) and at one stage the 10-year dropped to -0.16%, before heading higher to 0.20% currently. Fixed income investors have been cock-a-hoop as returns shot through the roof on the back of those record low levels. The early summer of 2016 saw them reach the best levels of the year (over 6% for IG).
Corporate bond investors were further emboldened by the ECB’s announcement of corporate bond QE which after nigh-on 30 weeks has seen the central bank lift €51,216m of non-financial IG debt, or almost 10% of the eligible market. And, because the ECB will run down their hoard of corporate debt stock, they have effectively taken 10% of the corporate bond market away – for ever. The subsequent squeeze on secondary market liquidity has barely supported the market.
Investors might have been overjoyed early on, because spreads crunched tighter from B+154bp to B+118bp, and at which stage B+100bp (all Markit iBoxx index) looked an odds-on certainty. But some US pre-election jitters – despite an increased weekly average lift from October through to the end of November of €2bn – failed to quell subsequent weakness, which accelerated beyond Trump’s victory. The market won out, and spreads have backed up to B+135bp, into a higher high yielding environment around government bonds driven by the potential for that more lax US fiscal policy.
Corporate bond fund outflows along with the ECB likely not prepared to act as a backstop bid into the outflow pressure, is a timely reminder that when the tide turns against the corporate bond market, the revaluation of risk might be quite brutal.
The Street bid, back in the 1990s and early in the new millennium, might have acted as a shock-absorber for the first few bonds which emerged in extremis, but the lack of capital deployed for trading book risk makes that possibility redundant. In a sense, we’re all one way (long), in it together and are going to have to take the pain of any revaluation en masse.
It’s quite telling that the moderate market jitters in November were enough to see spreads back-up hard (+15bp for the index, or almost half of 2016’s gains), even while the primary market was open and functioning normally with pricing tightened versus initial guidance in the usual 10-20bp range. That is, there is robust demand for anything new (primary), but little interest by investors to suck up cheaper paper in secondary which might emerge on any panic-like selling. Safety in numbers?
Spread and returns expectations 2017
With just about everything in favour for materially tighter spreads in 2016, there is huge disappointment at the meagre 20bp of spread tightening we eventually ended up with. Corporate credit fundamentals, the low default rate, the manipulative hand of the ECB (through QE), low rates and barely any material credit specific single name event risk (Volkswagen-esque) ought to have seen us significantly tighter – if not at record low levels.
As measured by the Markit iBoxx index, we ended at B+134bp for the benchmark IG index, having seen B+118bp in the summer months and off a Q1 high of B+194bp. Our view is that we should have tested B+100bp.
As we look ahead, hopefully better growth will overcome some of the potential negatives that come with some of the aforementioned event-risks. So periods where we might fret, for example into the various elections or the evolving Italian banking situation should be more than offset by the improving (?) economic growth outlook.
If that is the case – and we don’t see much by way of rotation of money from credit to equities, then we are expecting spreads, as measured by the cash Markit iBoxx index, to make the B+120bp area by year-end 2017. Judging by the final quarter of 2016, we can at best hope for a steady grind (rather than any sustained periods) of more significant tightening.
Gaining 20bp of performance will have returns pitched up at around 2% for the year, assuming we don’t get a big sell-off in government bonds. The 10-year Bund yield is back at 0.17% having been as high as 0.39% at the beginning of December and seen -0.18% back in October! Much additional weakness in the government bond market and total returns will be reduced proportionately – and could take us into the 1%-like area for corporate bond returns for the full-year 2017.
We’re staying fairly upbeat about corporate bond returns for now though, given that we look for duration to hold firm at around current levels or sell-off only moderately (at worst 0.40% for the 10-year Bund yield), while the corporate bond market ought to be able to withstand moderate levels of (inevitable) outflows.
In high yield, better growth will be credit supportive, while any moderate sell-off in duration will not necessarily reduce the lure of this asset class. The high yield market had a very good 2016 and returns have recovered to deliver investors 8.5%. We look for around 33bp of spread tightening on an index basis, which ought to provide total returns of around 5%.
Sterling markets had a good time of it in 2016, but lost a little of their lustre into the final quarter as rate markets sold off on currency weakness, pushing inflation expectations materially higher.
Spreads for the Markit iBoxx sterling corporate bond index tightened 27bp in the year as a whole, but that hides the 50bp of performance since the Brexit vote – and the sterling market managed to hold on to most of the gains. Higher Gilt yields chipped away at performance though, and the 17% returns investors were sitting on through the summer months dropped 30% to end up at just over (a still spectacular) 11%.
For 2017, we don’t expect to see much spread tightening. Even the BoE, having reached half of its potential £10bn of bond purchases (over 18 months) in just 4 months, has also failed to help this smaller, illiquid market to push on. So, given we don’t expect spreads to tighten much from here, returns therefore will probably sit somewhere in the 3%+ area – again dependent on movements in rate (Gilt) markets.
Finally, equities had a rollercoaster time of it in 2016. The DAX was down 18% at one stage before a late recovery saw the index up 7% for the full year. The S&P, Dow and FTSE all set records and closed up 9.5%, 13.4% and 14.5%, respectively.
Primary bond issuance to reside with the average
We have just seen the second best ever year for issuance of investment grade non-financial debt. Some will suggest it is a record, depending on the parameters used and method of data collection. After barely €20bn of IG supply 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 closed out 2016 with issuance up at €273bn in IG non-financials – just €20bn shy of the record €290bn from 2009 (according to Dealogic data).
The Americans were over, taking some 22% of the market again and a record-equalling year for them (Dealogic data), as they tapped into the lower all-in cost advantage by printing in euros versus dollars as well as a receptive investor helping to broaden their funding base. M&A-driven issuance was lighter in Europe while being more of a theme for US players.
As for 2017, we will work around the same variables as we have in previous years when assessing the drivers contributing to the level of supply we might achieve for the year. That means trying to judge the level of M&A (we think it stays limited) and capital expenditure and investment as corporates contemplate spending some of their cash hoard (we believe below long-term average levels). We also believe the need to hoard more cash will be of limited value promoting supply dynamics given record amounts of it reside on balance sheets of corporates across Europe (over €1trillion for the top 500 companies).
The level of 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, for this product. We wouldn’t think much will be issued unless volatility and rate markets remain kind in 2017.
Hybrid debt issuance depends on willing borrowers but also market confidence and therefore stability in those two areas (volatility and rates). In the same way, CoCo/AT1 issuance levels have also disappointed and given the fears around the Italian banking sector of late (haircuts coming for Monte de Paschi junior bondholders) it could be another lighter year of issuance for the CoCo market.
There seems to be little in terms of game-changing dynamics which might catapult the level of supply into the €300bn+ arena. We will grapple with much event-risk possibilities which have the ability to close the market – or see levels of higher volatility and lower issuance as a result – for considerable periods of time. Then the rush to issue when windows are open might deter some who might not be willing to pay higher premiums.
On the demand side, the ECB might be lifting nigh on €2bn of debt per week but the cash pouring into corporate bond funds in recent years is wearing a little thin and credit-to-equity rotation might be arresting the lure of corporate debt. Our view is that somewhere around the €250bn would be some achievement.
Senior bank issuance remains at post-crisis average levels, some 50% lower than the average we had in the 1990s and pre-crisis. The €145.5bn issuance in senior debt is the second lowest on record. While new-type bail-in’able senior debt will come to the fore in 2017 and replace the traditional instrument (which ranks pari passu with depositors in most jurisdictions, hence the need for the new instrument), we think issuance might struggle again to break through the €150bn level absent any significant change in rate, economic and bank lending dynamics.
We were surprised that the level of issuance in the high yield market didn’t achieve record levels, though. All the technical dynamics of the market place were in favour of a glut of supply. Borrowers, in the main, were sidelined. Admittedly, we lost a couple of months of issuance at the beginning of the year and some throughout as volatility in oil and equities kept the riskier side of the corporate bond market sidelined. Still, low rates, yields, default rates and some ECB crowding out in IG failed to promote a feel-good factor around the HY market. Issuance came in at €47bn.
We believe that the ECB has not quite managed to promote the level of funding disintermediation it would have as a result of its investment grade QE programme, and the issuance levels will remain relatively meagre in 2017. That’s why we think a target level of €40bn is appropriate for issuance in high yield. The wall of funding has also been pushed back owing to the higher levels of issuance of the past few years with little desperation from borrowers needing to get funded for the moment.
Positioning for 2017
The pitfalls are plenty. See above. The corporate bond market’s biggest unknown though is going to centre around Eurozone (and we suppose global) growth dynamics and the rate markets. The latter has kept the lure of corporate bonds intact through several years of a depressed economic outlook. Low rates have seen fixed income (and other) investors search for a supposed “guaranteed” return from another risk-free asset. Corporate bonds were it. 2017 might change all that and it will be a case of how investors might need to manage the potential change.
We might have met with some brutality in rates markets following Trump’s shock election win (and wider spreads/fund outflows), but yields have recovered off their post-Trump highs to consolidate at lower levels. If indeed the view is that fiscal profligacy in the US will create the rising tide that lifts all boats, then higher growth everywhere will impact corporate bond markets.
The subtlety in the change comes about from understanding the classical relationship between higher growth and credit quality where usually the former boosts corporate fundamentals to improve corporate credit worthiness – and helps spreads to tighten. We suggest that spread markets will come under pressure if growth sustainability becomes deep-rooted. Be careful what you wish for.
Why? Well, we’ve mentioned elsewhere in our comment that the credit market’s biggest fear is growth – and credit to equity rotation. That is, capital preservation to capital appreciation. Years of consumer/investor belt-tightening will be over. But, because we think we are at a crossroads, where we are not sure how the situation might evolve – a slow burning fuse, a whirlwind growth spurt or neither – we believe positioning ought to err on the side of caution.
We would go for a portfolio beta position of just greater than 1.0. We would be slightly long index duration. We also favour higher yielding debt (high yield too) versus low beta bonds as this will insulate us if rates do shoot higher (because of higher growth).
Any credit to equity rotation (and there will be some) will be managed but pressure low beta credit – although we don’t see any proverbial rush for the exits through 2017. We therefore like peripheral debt, but might think about reducing some risk to Italian corporate bonds which might get caught up in the contagion around the country’s banking sector.
Generally we still favour triple-Bs and lower rated risk versus Single-As and higher. Traditional senior debt on the other hand will be replaced by new style bail-in’able senior obligations and the former’s potential rarity might elicit some outperformance. There will be a good bid for new style senior debt especially for banks which are seen to be fairly safe from any potential future market event risk. Non-financial hybrids also might offer some rarity value in a rising yield, but fundamentally credit improving environment.
And finally, for the synthetic indices, we stay positive too. After all, expectations of an improving macro outlook allied with the potential for stable to better stocks and improving credit fundamentals ought to help push the cost of protection lower. Event risk and hedging cash risk will work against that trade into any risk-off periods, but we are still looking for Main to drop to 60bp or below and X-Over into the 200bp area on the improved macro outlook.
The argument for X-Over (currently 288bp) to improve more than Main (now at 72bp) is also favourable, given the latter might see some push back on any European banking woes and the ratio between them might then head for 3.5x (versus 4x currently).
That’s it for now. Have a good day – We’re back again tomorrow.