2nd September 2015

Halcyon days over, but fear not

FTSE 100
6059, -189
DAX
10,015, -244
S&P 500
1,914, -58
iTraxx Main Index
74.5bp, +3bp
iTraxx X-Over Index
339bp, +16bp
10 Yr Bund
0.79%, -1bp
iBoxx Corp IG Index
B+140bp, +2bp
iBoxx Corp HY Index
B+458bp, +7bp
10 Yr US T-Bond
2.17%, -5bp

Resolute corporate bond markets… Into chapter nine of twelve and a difficult start. As ever, stock markets took the brunt of the risk-off trade with equities down by well-over 2%, oil futures moved lower some (-8%), the euro currency was bid-up while govvies only edged better. In all, it is actually a fairly exciting start to September. The newsflow centred on poor China PMIs that made for the defensive opening session of this new month. The IMF’s Lagarde threw her tuppennies worth in, warning of slower growth (again), while the data elsewhere was mixed to largely disappointing. It wasn’t quite the welcome back we wanted or needed after a choppy August. Still, no one told FIG borrowers as we were greeted with a smattering of covered bond and senior unsecured financial issuance. In a sense, the corporate bond market is continuing its merry way; the difficult macro arena these crisis years allowing it safe-haven like status (see below). Cash is king for them too. It will stay that way. Sustainable growth will be our bête noire, so we worry little. Corporate cash spreads will stay a little pressured nevertheless in these down sessions, with iTraxx indices being credit market participants’ principal tool of taking a view on equity volatility and macro event risk. The new issue market might slow with ‘odd’ deals sneaking through in periods of calm.

Sentiment remained sanguine given the quite decent primary market activity today. In the market, senior FIG deals saw Lloyds (7-year), Toronto Dominion (5-year floater) and CIBC (2-year floater) offering around 10bp of premium to get deals away. SSE (A3/A-) served up a transaction for the non-financial corporate sector, opening up the post-holiday season with a benchmark 8-year deal at midswaps+93bp, and a final 13bp NIP. Focus of the market seemed to be split between the new issues and the headlines/equities. Here, the tumble in equities left, for example, the DAX flirting with 10,000 again (-2.4%), the S&P almost 3% lower but we saw only a moderate flight-to-quality uptick for defensive govvies. The credit market’s proxy for risk off/on saw iTraxx Main up at 74.5bp (+3bp) and X-Over at 339bp (+16bp) in the synthetic arena, while cash was more resolute. No panic, little flow, low volumes and only moderate weakness. High beta saw CoCos off around half-a-point as were the corporate hybrids with low beta paper holding steady (+1-2bp). The iBoxx index closed higher at B+140bp for IG and B+458bp for HY, although month-end index composition changes accounted for some of the rise in index spreads.

Corporate bond fundamentals supportive… Fundamentals for corporate bonds remain in decent shape into all the brouhaha generated by the extended period and volatility around the macro situation. Global M&A has been on the up and loan margins have been declining, traditionally leaving many to look at this dynamic and fret. However, it appears they are not. We are actually more concerned with macro-economics/fund flows and not corporate credit fundamentals. After all, higher M&A in traditional industrial sectors should set the alarm bells ringing in terms of where we are in the (re-leveraging phase of the) cycle. But the manipulation of interest rates by the central banks over the past seven-or-eight years (and even buying of equities by the Chinese authorities!) have left us with little to fall back on in terms of historical precedent. That’s because there isn’t one. And it means we need to grapple with where we are in the cycle – we are a little blind here. It’s fair to say that corporate re-leveraging having a material impact on corporate credit quality in the broad industrial sector – in Europe, is not happening. And we don’t need to make any serious portfolio switch from a non-cyclical positioning to a more pro-growth cyclical one – or think about some sort of (clever) hedge to protect against M&A event risk. I think that dynamic is far away to start worrying.

As the economy continues to splutter… That’s because the global economy is spluttering mainly on China’s slowdown (but on many other structural issues too), while the potential for and timing of higher US rates concerns many. Greece’s woes are still lurking, oil futures and other commodities remain under pressure and we have all manner of geopolitical concerns to grapple with. Amazingly perhaps, there’s no sign of a sustainable recovery (today’s better-than-expected improved unemployment numbers notwithstanding) in the Eurozone despite a weak currency, low oil prices and rock bottom rates. Small wonder (European) corporates continue to hoard record levels of cash, that investment/capex spending has barely risen and defending current credit worthiness remains utmost. The ability to service those obligations into an uncertain Q4/year-end will stay the main support factor for corporate bonds. The attractiveness of other asset classes might become more of a competing issue for the corporate bond markets through 2016 – if growth shows signs of sustainable upside. Fat chance of that as we survey the outlook right now. It hasn’t been the case for several years, but we will need to review the environment (macro, rates, geopolitics) on a continual basis for clues that it might.

Higher beta risk still worth a look at… I think a stance towards that higher beta portfolio positioning is still the way to go in Europe. There’s some protection against higher rates (or rising yields) and why not clip higher returns and coupon income in what is still a low yielding environment? Corporate balance sheets are going to stay very defensive. The default rate is only ticking higher but at 3% or less, with little or no economic growth, that’s a very low level. You will get your money back in most cases; it’s just a case of staying out of the weak single-Bs, keep invested in the solid ones and pretty much double-Bs. Peripheral risk still works too, banking sector recovery means bank capital product does as well, while the 7-10 year part of the curve (slightly longer than benchmark duration) is also attractive as the back-end stays anchored. Quelle surprise, I still like risk.

Benchmark and absolute return funds have felt the heat… Looking at how the iBoxx index as a proxy for how spreads have moved this year we see some large moves, but on low flows and poor liquidity, hence spread moves have been exacerbated. Starting at B+111bp, the IG corporate bond index (iBoxx) has been as low as B+95bp and up at B+142bp, now settled at B+140bp. The yield of the index has been more interesting starting, low, high and now looking like 1.33%, 1.06%, 1.87% and 1.80%, respectively. That is, macro concerns pushing the underlying (bund level) have been the major yield driver. Wider spreads and higher corporate bond yields have therefore adversely impacted benchmark and total return players. Short-term weak global growth dynamics might help to keep underlying yields anchored or edging lower; while sustaining demand at a good level for corporate bonds thus offering support for spreads. The picture for the corporate HY index (iBoxx) has been similar with the index starting the year at B+435bp (4.41% yield), seeing a low of B+371bp (3.69%) and a high now at B+458bp (4.79%). Returns here have been in positive territory owing to the shorter duration of high-yielding bonds and thus the index, where weakness in underlying yields at the front end has been very limited – or there hasn’t been any. The 2-year bund yields a lowly -0.21% after all, for example.

The halcyon days for corporate bonds might be over, but fear not… The low hanging fruit may have been picked, with those now wild party-days for corporate bonds coming to an end. But one should still take the highest-beta positioning their risk tolerance allows; there is coupon income to be had, safe in the knowledge that the potential for a default over the next 3-4 years should be minimal. While I still like risk and prefer a higher-beta position, I would maintain a slightly higher-than-your-average cash position at the moment, too. That’s not because I expect material fund outflows. Quite the contrary. With the US rate move (possibly) imminent, there are going to be some portfolio shifts, and with it opportunities to pick up (cheaper) paper. Time to go shopping…

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.