15th March 2016

Living the dream… and a nightmare

MARKET CLOSE:
FTSE 100
6,175, +35
DAX
9,990, +159
S&P 500
2,020, -3
iTraxx Main
72bp, +4bp
iTraxx X-Over Index
315.5bp, +2.5
10 Yr Bund
0.28%, +1bp
iBoxx Corp IG
B+153bp, -6bp 
iBoxx Corp HY Index
B+529bp, -17bp
10 Yr US T-Bond
1.96%, -2bp

It’s great, but there will be consequences… Not wanting to dampen anyone’s spirits, but we have to ponder what might happen once the current spread tightening plays out. We’re going to have to turn to 2017 and think about performance thereafter. If indeed the ECB has altered the nature of the game for the corporate bond market (and possibly for good), it will effectively have commoditised it. A significant and not impossible compression of high and low beta risk would make a mockery of any differentiation we might get between credit ratings, as the distinction between corporate bond risk – as seen through spread markets – diminishes. That is, forget about (relative) value investing, it is all going to be about technicals and momentum. The potential for ECB action and its size and longevity is unprecedented in corporate bond market history (the BoE hoovered up just £3bn or so of bonds, less than 2% of the outstanding market at the time). The boost will have saved performance for everyone in 2016, and 2.0%-or-more-like returns in IG and 5% in HY look possible again. If these kinds of returns are achieved, it will mean that spreads will be at around or through their historic tights by the time we close out 2016. That will leave the question as to how asset managers will return ‘decent’ performance to their investors in 2017. Full-on paper, heavily weighted towards a higher beta positioning (long duration and low credit-rated corporates) and a market which is untradeable (no liquidity) all point to a rather unexciting and worrisome 2017 from a returns perspective. It won’t be exciting, that’s for sure. But before we get there, we live for the moment. Q1 is going to be good, and we expect issuance, tighter spreads and investors scurrying around to get risk on board will all sustain a good feel-good factor and a positive tone through the second quarter.

More aggressive tightening seals recovery… With spreads now tighter YTD on an index basis in IG (iBoxx), benchmark investors will be joining total return funds in recording a positive performance. Most went into 2016 neutral or perhaps – at a stretch – slightly long beta and will therefore be flat or ahead of the index given the spread recovery we have had (assuming they were not over exposed to commodity or AT1 risk). The Markit iBoxx kicked us off in 2016 at B+154bp, saw a high of B+192bp, but after tightening 23bp in the last four sessions alone, it takes us a basis point tighter for the year. Remarkable. The story of the day though had to be the pricing and demand for the 3-tranche DT deal. Priced cheap initially to the curve, the €18bn of demand saw to it that the leads slashed the spread and priced the deal THROUGH the curve. It’s not often that this dynamic has occurred in the primary corporate bond market, especially for such a large transaction, but it might be a harbinger of things to come. The pricing/demand dynamic saw to it that the leads were fast in coming forward and the tightening on the 7-year fixed tranche saw it 5bp through, while flat on the short-dated floater (still +10bp in the 12-year). That will only reprice the older deals tighter. Jumping on the bandwagon and carrying on the tightening trend, Fluor Corp added €500m in a 7-year maturity (-25bp versus IPT), while Mexico’s FEMSA also plumped for 7-year funding and €1bn (and -20bp versus IPT). Rabobank added €2bn for the senior financials and UBS got a $1.5bn 6.875% yielding high trigger CoCo away.

It may not have saved the world… But the ECB’s actions have brightened the outlook for most risk assets. The only sour note in yesterday’s session was that Brent fell below $40 per barrel (-2%, WTI -3%) and while once upon a time that might have elicited some kind of negative response in equities, we simply brushed it aside. Even eurozone industrial production in January rose more than expected on all comparative measures. This will hearten the ECB, but before they get too carried away, there will be concern that the euro hasn’t weakened – nor is it showing signs that it will. In fact, it is up at $1.11, having been as low as $1.08 just after last Thursday’s announcement. Still, equities pushed higher, with the DAX up another 1.6% but just failing to close above 10,000, while other bourses found up to 0.5% of performance in the session. Despite gaining several hundred points in recent sessions, the DAX is still down over 7% this year to date. In government bonds, the bund underperformed, giving back some yield (higher), while the periphery saw some upside as yields here declined a little. For credit, as suggested above, the Markit iBoxx IG index closed out at B+153bp, or 6bp in the session as the grabfest continued. Every industry sector contributed as did every sub-asset class. It wasn’t quite as strong as the previous session, but the die has been cast for corporate bond markets. The underperformance came in the iTraxx indices, with Main higher at 72bp and X-Over at 315.5bp (+2.5bp). The cash market seems like it has now become very technical, all of a sudden; while the synthetic market might be a truer reflection of the risks inherent in credit.

High yield should be back in vogue… Elsewhere, S&P’s latest default comment suggested that the European default rate could rise to 2.4% by the end of the year, which would still be below the long term average of 3.4% seen between 2002-2015. Furthermore, the rating agency added that the negative rating bias is below the historical average, that macroeconomics continue to support a low default rate environment and credit weakness is concentrated in a few small sectors – oil and gas, and mining. There are reasons to be cheerful in this latest report and with refinancing risks likely to be less onerous thanks to the ECB’s latest (IG) largesse, we think that the HY market is likely going to curry much favour. And with that, the HY market closed on a high, with the iBoxx index lower at B+529bp (-17bp in the session). We started the year at B+526bp. Enough said.

Back tomorrow, we trust that you will 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.