11th March 2016

Corporate bonds?! Aghhh

MARKET CLOSE:
FTSE 100
6,037, -110
DAX
9,498, -224
S&P 500
1,990, unch
iTraxx Main
84bp, -7bp
iTraxx X-Over Index
358bp, -15bp
10 Yr Bund
0.30%, +6bp
iBoxx Corp IG
B+170bp, -5bp 
iBoxx Corp HY Index
B+592bp, -4bp
10 Yr US T-Bond
1.93%, +5bp

10 and 20 and the stench of more market manipulation… Ten basis points lopped off the deposit rate and €20bn added to the asset purchase programme. It is fair to say that the ECB pretty much overdelivered. But oh dear! They have added IG non-financial corporate bonds to the list of assets they can buy under the bond purchase programme. Someone has been in the asylum too long. Why corporate bonds? The market isn’t broken and doesn’t need fixing. This is a really desperate move and there was absolutely no need for the ECB to meddle. Funding costs for corporates are close to or at historical lows anyway. Corporates can access and finance easily in the capital markets. Yet the ECB decided to take on all the risks associated with buying corporate bonds. Incredible. For investors, we think this is a blow. The last thing needed in a liquidity-parched market is a marginal buyer with the deepest pockets of them all joining the party. This new kid in town is what we have always dreaded. The Bank of England did it before and, in our view, unnecessarily. This move serves to extend the hand of manipulation the central banks have employed since the crisis began, and will eventually frustrate investors in the corporate bond market. It’s now a case of “we have given you what you wanted, now do your bit”. The immediate reaction was for equities to lurch higher, the euro weakened, government bond yields ratcheted lower and credit spreads tightened meaning lower funding costs “forever” and an immediate boost to performance for all and sundry. But what next? hey will force market participants to add higher levels of risk as investors will be crowded out of the better end of the market and move lower down the risk totem pole in their search for paper and yield. The high/low beta compression trade is back on. Bottom line: we just might see those record low corporate bond yields and spreads again – and soon. Relative value was already out of the window; this is the final nail in the coffin. Buy and hold the highest beta asset (within reason) that you can. Why trade?!

Boy, did he kitchen sink it… But what if the measures don’t work? What if the euro doesn’t weaken (much more), or corporates don’t really tap into the even cheaper funding? What if the “pass-through” objective doesn’t happen? The cheap money needs to get working in the real economy. They need to see results soon, very soon. In investment, inflation, consumer spending and growth. Or the helicopter beckons. For corporates, the idea must be for them to raise even cheaper funding and use the proceeds to invest. But they are already cash-rich and frustrated that their booty isn’t yielding higher returns (invested in fixed or financial assets). Now things will get worse for corporate treasuries. And we don’t think it will necessarily open the floodgates for issuance. After all, corporate treasurers will be able to bide their time to fund, knowing that conditions will be kind for the foreseeable future. The banks will probably take the plethora of announced rate cuts on the chin.

Great for performance for Q1, we think… This is a massive risk-on signal for corporate bonds. but all risk asset classes ought to get a one-off major performance boost from it. There will be a lot of high-fiving.  Specifically, corporate bond markets will rally much more though, and we look for spreads to recover their losses (widening) seen this year through the second quarter (currently +15bp). Investors will feed into the better sentiment, feeling confident that the corporate bond market is well supported and that any future weakness in spreads is unlikely to last for a prolonged period of time. Our risk now will possibly only be around single-name events. Supply risk will no longer be an issue on wider spreads, as we likely won’t be able to get enough! New issue premiums will likely rise  given secondary will be so rich – ECB can’t buy in primary like they do covered bonds – and we might see lower-rated IG entities push for longer maturity deals. The high yield market might roar back to life and finally decorrelate from the US HY market. It’s all rather bullish for the corporate bond market.

Cock-a-hoop market response later completely reversed… The market initially greeted the ECB statement with great gusto, rallying aggressively across the board, only to fade the rally hard following comments made at the press conference where Draghi suggested further interest rate cuts were unlikely. Of course, the ECB could renege on that. Anyway, stocks came off their intra-day highs to close out deep in the red. The DAX for example was 2.5% higher at one stage but ended the session 2.3% lower! Government bond yields reversed their gains too with the 10-year Bund yield left at 0.30% (+6bp) having seen 0.15% earlier in the session. Front-end yields rose, with the 2-year at -0.46% (+9bp). In the periphery, it was a similar, if not even more dramatic a turnaround. Italian and Spanish 10-year yields dropped 15bp initially only to reverse that and climb 2bp into the close for Spain, and 4bp higher for BTPs at 1.45%. Gilts also sold off, the 10-year now yielding 1.54% (+7bp). Of more concern perhaps was that the euro fell initially versus the dollar to $1.0822 but recovered and closed the session higher (at $1.1191). Bit of the “Yen syndrome” here. Oil fell too, not because of the ECB, but because of the lack of commitments (from Iran) around production freezes. Ending on a high note, the corporate bond market rallied through to the final whistle. The Markit iBoxx index for IG corporate bonds was 5bp tighter at B+170bp and now just 15bp wider YTD. CoCos closed up (in price) such that the index was almost 60bp tighter and the index yield fell to 7.38% from 7.85%. Likewise, corporate hybrids rallied with around 35bp of index tightening and it followed through into the subordinated financials sector. The HY market was less enthused, but we think that might change eventually. The index just fell by 4bp to B+592bp. There iTraxx indices closed off their lows, but still register a strong rally. Main was eventually lower at 84bp and X-Over at 358bp as credit insurance costs plummeted.

We closing out with the market thinking it must be bad for the ECB to unleash such a heavy and broad arsenal of easing measures (which is what we actually wanted them to do). However, there is no more additional stimulus for a while; time for structural reform and fundamentals, but before that a bit of the cold turkey treatment.

Have a good weekend. Back Monday.

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.