2nd December 2016

Italy front and centre

MARKET CLOSE:
FTSE 100
6,753, -31
DAX
10,534, -106
S&P 500
2,191, -8
iTraxx Main
79bp, -1bp
iTraxx X-Over Index
339bp, -1bp
10 Yr Bund
0.36%, +9bp
iBoxx Corp IG
B+138bp, -3bp 
iBoxx Corp HY Index
B+451bp, +7bp
10 Yr US T-Bond
2.45%, +7bp

Rising rate complex to test markets…

The macro newsflow was off to a flying start as we turned the page into December. Eurozone unemployment dropped below 10% – and is the lowest level since 2009. Manufacturing activity in the region held up very well, probably on the back of a weaker euro and factory gate pricing pressures on the up – some nascent signs of inflation.

The ECB meets next week and there is much for them to mull over in the recent data streams. Net net we look for an extension to the current QE programme for a further six months, at least. Anyway, that economic news flow (and US manufacturing later in the session) will have unnerved some and the markets reacted as we would expect. Government bond yields pushed higher across the board. Equities dropped, probably on fear of those higher yields while markets await the profit recovery.

As for the corporate bond market… deals! We had three non-financial borrowers in euro-IG alongside Marks & Spencer which came in sterling. Primary markets, in our view, have two weeks worth of business left in them before we pretty much close out for 2016’s activity. It’s been a very good year for issuance – and for borrowers. We haven’t quite hit record levels, but there is a good chance that 2016 becomes the second best year ever for non-financial issuance.

Low funding levels – courtesy of the ECB, have allowed for copious amounts of capital markets activity. At the same time, cash (until very recently) has poured into the corporate bond market looking for a safe-haven fixed income asset which offers a little more juice than government bonds. Next year is going to be interesting for the corporate bond market.

We wrote yesterday that the ECB’s QE efforts had failed to stop corporate bond spreads from widening through November – by some 20bp – while sterling spreads had only widened by 5bp on an index basis. The sterling market is much smaller and the BoE is also purchasing corporate bonds as part of its own QE programme. Since the UK central bank started operations, in two months it has purchased £3.96bn of corporate bonds as it seeks to acquire £10bn over 18 months. £490m of debt was purchased last week. We believe that the vagaries of the sterling corporate bond market – size, liquidity & supply have allowed the BoE much more success in stemming the recent spread weakness (this was not their intention), especially given the massive weakness in Gilts over the past several weeks.

Deals, deals, deals

€1bn deal: Becton Dickinson and Co

€1bn deal: Becton, Dickinson and Co

Whatever goes on elsewhere, as long as there are no big risk-off moves we always have a functioning primary corporate bond market. Even yesterday, with rate markets selling-off and stocks down by up to 1% amid little appetite for secondary corporate risk, the primary market delivered a decent block of deals.

Non-financial IG issues came from Becton, Dickinson and Co which took €1bn in two-tranches and just 5-10bp inside the initial guidance. Ecolab followed with a €575m deal some 15bp tighter than opening indications while Knorr-Bremse sold €500m of bonds at midswaps+45bp and 15-20bp inside the initial guidance. For sure, the appetite for risk through primary is intact, given the pricing dynamics of these deals alone. Troubled retail group Marks & Spencer sold an upsized £300m for the sterling market.

Financial issuance came from insurer Aegon (€500m), Barclays (€1bn) and medical care group BUPA in sterling for £400m and a subordinated T2 structure. Something there for everyone, with the promise of several high yield deals today.

But eyes transfixed on rate markets

It’s not often that almost 10bp are added to the yield in 10-year Bunds. It happened yesterday as it closed up at 0.36% (+9bp) although the front-end was unchanged at -0.75%. The same maturity Gilt was up at 1.49% (+8bp).  To think that it was at 0.60% in the summer. These are big moves. A reversal could come next week in “safe-haven” terms if the Italian referendum calls a win for the “No” (to constitutional reform) side and Renzi steps down.

The ECB might be adding more Italian risk at the moment but that didn’t stop BTPs from selling off with the 10-year yield up at 2.05% (+6bp), although they didn’t underperform. The 10-year US Treasury yield rose an eye-watering 11bp to 2.49% during the session, before edging down to 2.45%! US stocks were more mixed with the S&P index lower, while the Dow was higher.

We are surprised at the back-up in European rate markets and although they were initially dragged higher by Trump’s victory (more spending in the US, more debt issuance to fund it, higher growth, potential for higher US policy rates), they are still moving higher by some margin too – judging by yesterday’s moves. The recent Eurozone data dump has been encouraging, with a recovery – albeit slow – seemingly intact. That might be giving the markets hope that higher US growth allied with the more encouraging Eurozone news flow might mean we’re firmly entrenched in some kind of “recovery mode”. If so, rates can only go higher from here.

Credit markets are massively transfixed by rate markets. They have the potential to quite possibly kill performance for corporate bond market investors from a total return perspective in 2017. Back of the envelope calculations have us thinking that total returns in IG of 2-2.5% are possible on 20bp of spread tightening in investment grade credit. However, that is all at risk if rates shoot higher.

As for Thursday’s moves in credit, IG spreads were essentially unchanged but the Markit iBoxx index was tighter owing largely to month-end index changes (left at B+138bp, -3bp). The high yield cash index moved 7bp higher with some of the weakness here expected given the weakness in stocks (and likely the upcoming supply load). The iTraxx indices ended with Main at 79bp and X-Over at 339bp (both a basis point tighter).

It’s non-farm payrolls next, then that crucial Italian referendum. Have a good weekend.

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.