4th September 2019

Anticipating HY/IG yield compression

MARKET CLOSE:
iTraxx Main

49.3bp, -1bp

iTraxx X-Over

252.5bp, -4.7bp

🇩🇪 10 Yr Bund

-0.67%, +5bp

iBoxx Corp IG

B+123.6bp, -0.5bp

iBoxx Corp HY

B+421bp, -5bp

🇺🇸 10 Yr US T-Bond

1.47%, unchanged

🇬🇧 FTSE 100

7167.95, (-0.61%)
🇩🇪 DAX

12670.11, (+0.32%)
🇺🇸 S&P 500

2989.69, (-0.21%)

The ECB will be the catalyst…

Don’t let the significant rally in European rate markets blur the issue. The crucial ECB meeting is just a week away, and the expectation in the market has been that they deliver a rate cut as well as some €15bn – €30bn per month of QE. Investors have been in ‘front-running’ mode. There has been a push of late for -0.75% on the 10-year Bund (we have got to -0.743%), while we happen to believe -1.0% is the next stop.

Spanish 10-year debt yields (now at 0.16%) were just last week in single digit territory – incredibly – while Italian debt has felt a massive reprieve on news that a new coalition government has been agreed, and now offers just 0.83% (almost -100bp in a month!). But what about credit, and that compression between the high yield and investment grade markets? It’s worth another look.

In Tuesday’s note, our high yield expert commentator George Flynn went through the technical dynamics specific to the market as well as highlighting the pitfalls investors face if they fail to do the appropriate credit work on their investment choices. Nevertheless, the market has performed and we think can gain some positive spread momentum through the final quarter, especially if the ECB announces corporate bond purchases as part of any QE purchases.

The chart above shows that the two markets have decompressed since the ECB started the process to wind down its purchases, having previously managed over 300bp of compression during the 2016-2018 period. With the spread differential now at around 300bp, we are thinking in terms of the metric heading for the 200bp level.

Admittedly, there is a huge distraction at the moment in the form of the welter of issuance in the IG market which is heading quite possibly for a record year (see Friday’s note). There’s plenty enough coming through to keep IG investor demand satiated. But when or, rather, if the ECB uses its manipulative hand, then we are most likely going to see much focus again on the high yield market. Crowding out really does happen.

Of course, the small matter of weakening macro is an issue for HY investors. But we haven’t fallen off a cliff, where instead central banks are doing their best to manage the decline in the face of some considerable pressure. Trump’s Chinese trade war doesn’t help. But the default rate stays low. There have been some idiosyncratic events. Overall, the ability to service obligations (low funding costs) has probably kept the market afloat.

HY issuance hasn’t exactly been as effusive as we might have expected either given the low funding levels. We haven’t yet hit €40bn for the year, and are seemingly only on course for €55bn – €60bn, which would be lower than the volumes seen in 2017 (record €75bn) and 2018 (€62bn). But we think that might change.

We’re in uncharted territory in many markets and many risks lurk. For instance, rate markets suggest a macro catastrophe around the corner but we would be misreading the tea leaves to believe that. IG spreads are not at record levels. IG yields are. HY spreads are far off their own record tights. The ECB might just be the catalyst for the next leg of the HY-IG compression trade.


Primary continues to churn out the deals

Primary market threw another series of deals, more again from the US and this time from AT&T with a triple-tranche offering for a combined €3bn. A 6.5-year tranche for €1bn was priced at midswaps+75bp (-15bp), followed by a 10.5-year tranche for €1.25bn costing midswaps+105bp (-15bp). The final tranche was a 30-year maturity for €750m priced at midswaps+175bp. Final books were a combined €6.5bn.

Next up was Carrefour Banque’s increased €400m in floater format, the 4-year priced at Euribor+65bp which was 20bp inside the initial talk off a €1.5bn book. And then there was Glencore. They took €600m at midswaps+115bp for a 5-year transaction off a €1.7bn book, and 20bp inside the initial price talk.

Eurofins Scientific became the latest to offer a hybrid deal. The unrated issue (implied HY) came in PNC3 format and the €300m was priced to yield 3%. Other deals took in REIT Vonovia’s (€500m each of 10-year and 15-year debt at midswaps+85bp and 115bp, respectively) and RBI’s €500m, 10.5NC5.5 Tier 2 offering at midswaps+210bp (-40bp versus IPT). Finally, senior financials were represented by Sparebank 1 which lifted €500m in a green senior preferred at midswaps+65bp.

Year to date, US borrowers account for 32% of the total issuance (€213bn) of IG non-financial corporate debt. The record annual participation from US borrowers came in 2015, where they accounted for 26% of the deal flow. The long-term range is somewhere in the 12-18% region, so this year’s total is currently a fresh record high. Given the level and direction of rates, it looks sustainable.


No grief from politics

At least we had some good news during the session – and for a change, it was driven by politics. It was led by the news that Hong Kong’s chief executive formally withdrew the controversial extradition bill that had caused the territory’s biggest political crisis in decades. Whether it does the trick for a calming and de-escalating tensions is to be seen (the protestors have other demands), but it is a step in the right direction.

Over here, we can safely assume the markets in the UK also found good in the overnight defeat for the government regarding the latest Brexit vote, as it potentially allayed fears of a no-deal Brexit. While in Italy, news of an agreement between the Five-Star and Democratic Party to form a new government also helped markets recover their poise.

That was most evident in rates. The 10-year Bund rally succumbed a little into the close, to 5bp to leave the yield at -0.67%. As stated earlier, the 10-year BTP is offering just 0.83% and is at around record low levels. Just four months ago, it was up at a yield of 2.75%. In gilts, the 10-year yield bounced 10bp to 0.50%!

The Dax closed off the highs but still rose by 1%, the FTSE 0.6% and US markets recovered around 1% (as at the time of writing).

In credit, the synthetic indices edged lower into the improved tone. iTraxx Main closed at 49.3bp (-1bp) and X-Over was 4.7bp lower at 252.5bp.

The cash market was, as usual, focused on those new deals so there wasn’t too much to get excited about in secondary. Spreads were marked tighter though. The IG cash iBoxx index closed at B+123.6bp (-0.5bp) with 5bp worth of tightening in the HY index taking the index to B+421bp. Total returns for the latter, year to date, rise to 9%. The AT1 market tightened too, pushing returns (iBoxx index) to 11.7% for the year to date.

Have a good day.

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.