11th July 2016

Keep your nerve

FTSE 100
6,592, +58
9,629, +210
S&P 500
2,130, +32
iTraxx Main
76.5bp, -5bp
iTraxx X-Over Index
341bp, -25bp
10 Yr Bund
-0.19%, -2bp
iBoxx Corp IG
B+148bp, +1bp 
iBoxx Corp HY Index
B+504bp, -2bp
10 Yr US T-Bond
1.36%, -3bp

Bearish macro sets the scene for record low corporate bond yields (and spreads)…

Corporate bond spreads and yields are heading towards record lows, leaving some to question whether they’re overcooked, and ponder the risks to current positions. It feels like we should be getting mightily concerned at current valuations. After all, there are a growing number of corporate bonds (which are not your traditional risk free asset) offering negative yields. The index as a whole is closing in on record low yielding territory (which can only end in tears). Bond spreads are going tighter but are not at historical lows. They’ll get there because the corporate bond market is now being directly manipulated by the ECB – and it is their will that we do. Investors are being forced to add incrementally higher levels of risk in order to fulfil their mandates.

However, when looking at macro, we can see why the corporate bond market will continue to shine. With the global economy failing to offer any material upside in growth – let alone which might be sustainable, current loose monetary policy will remain in place. In fact, we think that it will become more accommodative. So rates will go lower, yields too as more liquidity floods into the financial system. As a marker, we’re looking for the 10-year Bund to see a yield level of -0.35% (from -0.17% currently). We also believe the ECB will expand its current QE programme in the not too distant future, while a UK rate cut (or more) is imminent. With investors scratching around for higher yielding fixed income assets in the face of considerable and growing macro uncertainty and the continued easing in policy, corporate bonds will retain their lustre.

We therefore expect confidence to be maintained in the asset class for a while yet. This is not the time to be thinking that the corporate bond market is too rich and that it is time to reduce exposures to it. The technical and fundamental support for current valuations are as strong as ever. For instance, the European corporate bond default rate is still below 2% and has only popped higher in the US because of the problems around the oil and commodity sectors. That is, the low growth environment has failed to elicit a higher default rate. Low interest rates have helped corporates extend maturities and reduce financing costs such that high levels of debt are being serviced relatively easily (everywhere).

Using the Markit iBoxx index as a broad guide for the market, the IG index corporate spread is currently at B+146bp and the yield at 1.05% with returns at 4.7% YTD. As we suggested in our H1 Corporate Bond Market Review document last week, we target record lows for spreads and yields. B+94bp and 1.02% are those record lows and while the former looks a tough ask at the moment, the latter certainly is within reach – very soon.

While the ECB rams home the message

The ECB’s involvement in the corporate bond market is seeing them lift, on average, €450m of IG corporate debt a day (€2.25bn a week). This has now become the principal reason why our market is well-supported in the face of much volatility elsewhere, but also why those previous lows will be surpassed. There are not going to be enough bonds to satisfy the demand. The scramble for paper through primary will see new issue premiums drop precipitously; while secondary is just a busted flush. There will be enough investors thinking that taking some profits and freeing up cash for new deals will work. It won’t. Not seamlessly anyway. That’s because the ECB’s shopping spree has changed the nature of the game. It means reduced allocations in primary than one might have been used to. It also means that liquidity in the secondary market is going to drain further (as if it could). We’re squeezing tighter in corporate bond spreads and going lower in yield. High/low beta compression trades will work.

It all goes awry, of course, if we see a return to a decent level of growth – and if it is sustainable. Current capital preservation strategies while clipping a bit of yield (corporate bonds, coupon income) will then switch to capital appreciation strategies. Equities will be back in vogue into a central bank tightening cycle. Rotation will kill the corporate bond market. Imagine the carnage. Higher rates and government bond yields; fixed income becomes a risk proxy – and a rush for the door, which will be slammed shut. Credit spreads wider, corporate bond yields higher and prices crashing through the floor. And all that absent a systemic financial crisis. A material and sustainable return to growth will not be the fixed income market’s friend. Don’t worry; This scenario is extremely remote.

And US non-farms warmed the cockles as we closed out

The non-farms report, where the headline figure (287,000) came in way above expectation (although the unemployment rate increased and hourly wages increased by a paltry 0.1%), offered much food-for-thought.  It left the markets to close out last week on a high, but we think with mixed feelings. US rate rises – or not, were back in the news, but the main conclusion we draw from the session’s activity is that a hike is still less likely for September. Stocks rose hard in the US (S&P close to record high, up 32 points to 2130) and zoomed past their pre-Brexit levels giving an additional fillip to equities in Europe.

The markets here rose with the DAX putting on over 2% and the FTSE just under 1%. Government bond markets were still circumspect to it all, the 10-year Gilt yield lower at a record low close of 0.73% (-5bp) as was the equivalent Bund yield at -0.19% (-2bp). The periphery has had a decent run of late, Italian BTPs at around record lows 1.19% (-5bp) and Spanish Bonos just off them at 1.14% (-3bp).

Credit wasn’t left behind. The inexorable grind tighter in spreads continued (with some recovery in higher beta IG risk) while the yield at 1.05% for the Markit iBoxx corporate index dropped to the lowest in well over a year, and is now just 3bp off the record low set in April 2015. The high yield market closed the session with little happening and spreads close to unchanged. With equities riding high, the cost of credit protection fell with Main closing at 76.5bp and X-Over at 341bp, some 5bp and 25bp lower, respectively.

The BoE’s monetary policy get-together is something to look forward to this week – the first such meeting since the UK referendum. Alcoa kicks off the US quarterly earnings season after the closing bell tonight, and there is a fair amount of US economic data to look out for. Over the weekend we had Chinese CPI which rose 1.9% yoy versus expectations of 1.8% (but down from 2% in May), and still well-below the government 3% target. Second-quarter GDP is due later in the week as are numbers for industrial output, investment and retail sales. More stimulus here is likely too, it seems.

Have a good week.

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.