14th November 2016

Trump, the fixed income market’s bête noire

MARKET CLOSE:
FTSE 100
6,730, -98
DAX
10,668, +38
S&P 500
2,164, -3
iTraxx Main
78.5bp, +4bp
iTraxx X-Over Index
351bp, +16bp
10 Yr Bund
0.31%, +3.5bp
iBoxx Corp IG
B+126.7bp, +1.5bp 
iBoxx Corp HY Index
B+424bp, +7bp
10 Yr US T-Bond
2.15%, unchanged

Trump’s expected policies derail fixed income…

trump-sinisterIt was going just swell for the income markets – until President-elect Trump came along. Love or loathe him, the expected unleashing of the fiscal dogs come 2017 has just about ruined fixed income’s 2016 performance.

The markets haven’t taken any chances in deciding to wait to see if he will carry out any of his policies as stated. They have reacted immediately. The initial euphoria that comes with higher spending, potentially sharply higher growth, tariffs and so on – that is higher equities, weaker government bonds, emerging market jitters and so on has faded or escalated to varying degrees. It’s a game changer for sure, and we’re going to have to adapt to the changing of the guard and the different circumstances. Right on, Mr Trump.

The performance of the corporate bond market remains very good with IG and HY returns YTD holding above 4% and 7%, respectively. In a normal year, we would take that. But with the former having been up at 6% just weeks ago on the back of the year-long rally in duration, we’re naturally concerned and now dissatisfied with the pull back. It has been unnecessary to hedge this because of the unlikelihood of a sell-off in government bonds. The firmness in underlying was hitherto bang-on supportive (helped by ECB QE), but the weaker outlook now for government bonds has come back to haunt us. Thank you, Donald.

There’s nothing wrong with fundamentals. Don’t get us wrong, this is all technically driven. The ECB’s manipulation of the Eurozone’s government bond market isn’t powerful enough to offset market forces, but the central bank does have the ability to support the corporate bond market should any weakness emerge, given its relative smaller size and illiquidity. So benchmark players will be sitting a little more comfortable knowing spreads are unlikely to gap higher, while total return investors have their eyes firmly on any policy impact on government bond direction.

Nowhere to run or hide: Rotation trade going to hammer us

Corporate bond market investors (and government bond ones too) have nowhere to run. Inflows into credit funds have stopped, but we don’t see much evidence of any material outflows. Fund managers will be wise to hold onto cash positions, while the primary market might be set to suffer a little as demand for corporate debt into the uncertainties around US fiscal policy and its impact on valuations start to niggle away at whether one should be adding exposure right now.

Why? After all, credit fundamentals are rock solid. That default rate is below 2% in Europe and under 3% globally and isn’t going to go much higher if we see a US/global (?) growth spurt in 2017. The ability to service debt (credit worthiness) is the best it has ever been and generally, markets are super responsive to new deals. Borrowers are still funding at or close to their all time lowest funding costs. No need to fret from a fundamental perspective.

However, we always opined that the corporate bond markets biggest fear was growth. Anything that was short and sharp and effective – and we could see what would be the catalyst. Trump is. Global investors have sought capital preservation strategies for several years now as this crisis took root. Given those aforementioned fundamentals, the corporate bond market was/is a winner, eliciting massive inflows into the asset class and doubling in size in Europe in these crisis years (to almost €2trn).

Funding well and truly disintermediated away from the reliance on banks and instead allowed the capital markets to flourish. If Trump’s policies are about a dash for growth, then credit fundamentals gain much support. But that support will pale into insignificance if investors chase capital appreciation strategies and switch from corporate bonds to equities. We’re not calling it yet.

Rotation will kill the goose which laid the golden egg for corporate credit and the explosive growth of the European corporate bond market. And we will not need a double digit outflow as a total of the invested money in corporate bonds to make a difference. Illiquidity in the secondary markets will be worth several tens of basis points from a cash index perspective. We’re seeing how performance is being sapped by the rise in government bond yields (see below) even as spreads hold relatively firm. There could be a lot more of the same. And there’s no crisis! It’s a funny old game, it really is.

Pain trade leaves much head scratching

Let’s look at the raw numbers. They’re the ones which matter after all. IG credit widened by 3bp in the week as measured by the Markit iBoxx index, with 1.5bp of that in Friday’s session and returns for this market sit at 4.2% YTD. IG sterling risk – as measured by the same index, was just over a basis point higher but barely changed in the week (at G+156bp, -35bp YTD) and returns for the year so far are at 9.2%. That’s very good, but those returns were up at over 17% in the year to August. It’s only natural and understandable that we start thinking about booking profits given we’re so close to year-end. This far, investors are sitting tight.

In the high yield market, any sharp rise in stocks on better growth dynamics clearly underpins fundamentals (very crucial) but also helps technicals because the improvement in credit quality can be significant. So spreads usually tighten and because the product is by its very nature short duration (higher risk), the lack of a sell-off in government bonds at the front-end is a net supportive for performance (read returns). That wasn’t the case come last week’s final session as spreads widened by 7bp and returns dipped below 7% year to date (to 6.9%).

As for the iTraxx indices, it was risk-off and spectacularly so, as we witnessed some of the biggest moves (widening) for a long time. The cost of protection soared as Main moved 4bp higher to 78.5bp and X-Over to 351bp (+16bp). There is no technical support as such for synthetic markets, unlike cash credit where the ECB is lifting the market. This is purely and fundamentally directionally (sentiment) driven and the market is running scared.

We think it is premature to be hedging out credit risk, but maybe the index moves are anticipating weaker cash markets (cash fund portfolio outflows) given the weakness in government bonds as highlighted above. However, one might well be overpaying for protection because if corporate cash spreads move wider they will do only very slowly, if those outflows don’t materialise.

So, we’re scratching our heads wondering, “what next?”. The 10-year Gilt yield has backed up to 1.36% (+2bp on Friday), and the 10-year Bund yield to an eye-watering, performance busting 0.31% (+3.5bp). Italian 10-year debt is yielding 2.02% and that yield jumped a stunning 12bp alone on Friday! 10-year Bonos yield 1.47% (+8.5bp) – the list goes on. Italian debt was yielding 1.00% a few weeks ago. The 2-year Bund yield is still -0.62%! Equities have been on a roll but then the rally stopped and we had some chips taken off the table as the euphoria waned.

Next week is a light one in terms of the data dump, but Yellen and Carney are up before various committees. Hopefully, headline risk will be low and volatility recedes such that the market can get on with business.

Have a good day, back again tomorrow.

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.