3rd June 2016

The countdown begins: T minus 5

MARKET CLOSE:
FTSE 100
6,186, -6
DAX
10,208, +4
S&P 500
2,105, +6
iTraxx Main
75bp, +1bp
iTraxx X-Over Index
321bp, +5bp
10 Yr Bund
0.11%, -2bp
iBoxx Corp IG
B+146bp, unchanged 
iBoxx Corp HY Index
B+486bp, -2bp
10 Yr US T-Bond
1.80%, -3bp

Oooo, it’s suddenly got exciting, not…

ecb_headquarters

Get set: The corporate bond purchase programme lands on Wednesday

They’re rocking up on 8 June. In the latest of a long line of mass market manipulation measures, the ECB will start it’s long-awaited corporate bond purchase programme on Wednesday next week. The ECB has given itself the widest possible berth in terms of which corporate debt it can buy. There was little additional news to be garnered in the press release or conference that added to the market’s understanding of what the ECB can/can’t buy, apart from clarifying some points on downgraded debt (they are not forced sellers) and other eligibility criteria – for instance, issuers previously eligible for the public sector programme will now be included in the corporate one.

The excitement will come from the boost to performance all will get from tightening corporate bond spreads to add to the superlative returns the asset class has already achieved in these opening five months of 2016. But also from the anticipation of being up against the biggest buyer ever to enter the corporate bond market. This all comes against the backdrop of difficult macro, a poor economic outlook and much volatility with other asset classes. Deflation, little growth, rock bottom rates and yields, and yet the corporate bond market is heading towards returning 4%+ in investment grade in 2016 (already 2.9%). Incredible. How can it be so?

All things being equal – and if there was no QE, we would be looking at a busted European corporate bond market where the default rate would be well-over 10%. That would have been several years ago and we would by now have worked our way through the normal boom/bust cycle. However, low central bank rates (from classic policy moves) and government bond yields (from non-classic bond purchases) have stretched the bottom of the cycle through enabling cheaper refinancing and other funding costs (for the corporate and the consumer sectors) without resulting in any upturn.

The default rate is super-low in Europe. The ability to service sometimes quite onerous debt loads is the best it has ever been. So, investor confidence is sky high (albeit tinged with some nervousness). It doesn’t matter even that we’re going to be buying more negative yielding bonds soon enough. As crazy as that sounds, it makes sense if holding cash with a custodian bank can cost 40-100bp. It makes sense also if bond prices continue to rise and capital appreciation offsets investors paying corporates the privilege for holding their debt. It won’t make sense when the market turns.

Rotation trade not in sight

It comes to an end when the Eurozone starts to stabilise, when sustainable growth starts to emerge, when we have some inflation in the system and we can start to look forward to more normal interest rates, higher yields and a rotation from fixed income to equities. No more will we be looking to preserve capital (and clip a coupon) – it will be more about looking for an appreciation of it (never mind the dividend), and that will come through equities. That is, the rotation trade. It is not 2016’s story, nor is it likely going to be (the first of) 2017’s. So for now, we do look to boost performance through hanging on to corporate bonds, and await how technicals might change once the ECB starts to lift the market. Credit did little in yesterday’s session, but the upcoming purchases are not in the price.

If the economic backdrop looks as weak in Q4, we could think – expect even – more aggressive policy action to be announced. ‘Spend some money’ is the message they are giving out! After dumbing it all down to zero, the ECB will look to drive it all into negative territory. That’s not just government bond yields out past 10-years likely being in negative yield territory, but the next step will be for them to further savage corporate bond yields. We already have a sizeable chunk of corporate paper offering negative yields. Pushing this into longer-dated illiquid non-triple A, “non-safe as houses” paper is so risky and another unprecedented move. This policy dynamic itself risks causing a systemic financial crisis when the market eventually turns.

Overall, ECB underwhelms

opec

OPEC: No agreement on supply reached

The potential for a dip in Eurozone GDP growth (suggested by Draghi) in Q2 and no decision on a Greek waiver allowing the banks there access to cheaper funding saw a sharp reversal in Greek debt prices, and kept stocks anchored around unchanged territory in the Eurozone. As if to compound the misery, OPEC failed to reach an agreement on supply (Iran digging their heels in) leading to oil price falls too – these were later reversed, we think on news of lower US oil stocks. In all, we endured a lacklustre session and there is promise of more of that to come today given we are in the non-farm payroll slipstream.

At the close, stocks were unchanged, government bonds better bid and yields on 10-year Bunds just a shade of hitting single figures again. Gilt yields dropped too, the 10-year now at 1.34% and down another 3bp on escalating Brexit fears. Oil – as measured by Brent – was parked at $50 per barrel.

In corporate bonds markets, we had no supply in non-financials corporates anywhere (IG or HY), while graced with just a couple of covered bond deals. Secondary was in unchanged territory and the Markit iBoxx index was left at B+146bp. The rally in bunds though helped see returns (+3.0%) a little better with the index yield back down at 1.30%. In HY, it was the same picture with spreads essentially unchanged with the index at B+486bp while the rally in bunds helped both the index yield to drop and returns to rise. Something for free, another words.

Have a good day and weekend. Back on Monday.

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.