- by Suki Mann
|MARKET CLOSE 2017:|
|10 Yr Bund
|iBoxx Corp IG
|iBoxx Corp HY
|10 Yr US T-Bond
|FTSE 100 7,769.14, -9.50||DAX 13,200.51, -44.52||S&P 500 2,786.24, +18.68|
But don’t fret, it isn’t all over…
The extraordinary run for credit markets is set to continue through 2018, in what could be its last hurrah. We anticipate 15bp of tightening in euro-denominated IG cash spreads as measured by the iBoxx corporate bond index for 2018, which is a modest tightening, but takes us deep into record territory (record tight B+94bp, y/e close B+96.6bp).
We believe it is one which is achievable given the outlook for economic growth, the low default rate, limited levels of transformational M&A, continued conservative corporate investment strategies and the stoic underlying demand for corporate risk assets.
That better growth dynamic and feel good factor around credit ought to see a 40-50bp tightening in the high yield market, again setting fresh record levels (record tight B+251bp, y/e close B+286bp). However, we do not think there will be anywhere near the same levels of high yield supply we saw in 2017’s record-breaking run. Demand will remain robust though and this could be the driver for that spread tightening.
As for returns, the modest rise in rates will eat into returns, but IG credit can still deliver between 1 – 1.25% following an excellent 2.4% in 2017. The shorter duration high yield market ought to be on course to pipe up with somewhere in the area of 3% in total returns, not able to repeat the impressive 6.3% it delivered last year.
Data Source: Markit, CMD
|2017 (Actual)||2018 (Forecasts)|
|IG corporate spreads||B+96bp (-39bp)||B+80bp|
|HY corporate spreads||B+286bp (-127bp)||B+240bp|
|IG non-fin corporate supply||€265bn||€260bn|
|HY corporate supply||€75bn||€58bn|
|Senior bank supply||€135bn||€140bn|
|10-year Bund yield||0.43%||0.75%|
|IG corporate bond returns||+2.4%||+1-1.25%|
|HY corporate bond returns||+6.3%||+3%|
The questions on everyone’s mind in the corporate bond world for 2018 are plenty. The level of performance garnered across the corporate bond market was fantastic in 2017, and bested all prior expectations as investors picked as much of the low-hanging fruit as was possible. We hit record tights at one stage in spreads, we had record high yield supply, inflows continued into IG funds (and found their way into high yield debt) and the ECB propped us up when it could have got messy.
The Goldilocks economy sustained a good bid for fixed income while geopolitical event risk kept duration risk well bid. Equities had a fabulous year and US tax reforms into a rising growth dynamic suggest that 2018 will be that ‘inflexion’ period.
Back to those questions. Can spreads continue their three-year long tightening trajectory? Will total returns manage to deliver something positive in 2018? Indeed, if we get spread weakness can we contain it while the pressure to rotate into equities possibly intensifies? With a reduced – or declining – back stop bid from the ECB for ‘assets’, are the days of mass market manipulation coming home to roost for credit investors?
Do we have something that might resemble an economic cycle and can we start investing for it, rather than just lift the highest beta asset ones portfolio allows, and ride the spread tightening wave? And with it, is fixed income’s halcyon period which started in 2009 and saw out several crises subsequently, finally over?
In hindsight, it has been so easy for corporate bond market investors. Investing in corporate bonds with the lowest default rate ever for such a prolonged period of time, it would be very bad luck if someone held a bond which eventually defaulted. With low policy rates seemingly in place forever (in market terms) and absent an ‘economic cycle’ as we know it, corporate bonds were the place to be.
We clipped the coupon with a certainty that we would get our money back (all the way down to single-B rated bonds) leaving investors with their greatest exposures (on a portfolio basis) to higher beta risk, which most do not fully understand – and likely still don’t. If ever there was a ‘gimme trade’, that was it.
Alas, at the end of 2017, we hit a brick wall – we’ve hit a few since the crisis began, but always found a way through. Spreads visited record tights across the board (we will include IG risk in that as this market fell shy by just a basis point when measured by the Market iBoxx index), but bounced off them in November and failed to regain much impetus to push on again. In the last couple of weeks of the year, we did admittedly edge better.
Inevitably though, we are asking if this is a sign of something more sinister to come, or are the many geopolitical uncertainties into improving macro likely going to foster that extended inflexion period whereby spread markets move sideways/slightly tighter, in unexciting fashion, and delay the inevitable… until 2019?
2018 will not be any different to last year
We’re quite sure that we will kick-off the opening quarter with a positive tone, as we seamlessly and almost effortlessly move over the line from 2017 and into 2018. Positive equities, rising cryptocurrency prices, good economic data, range bound market rates and tighter corporate bond spreads are likely going to be what we encounter. Few will bet against that positivity in the opening weeks and will position accordingly for it. It must finally get much more challenging for fixed income, but not necessarily this year.
Supply will likely be heavy in the opening weeks given the lighter levels in later November and December. Because it will be taken down well (as usually is the case), that will give confidence elsewhere in credit. We do not believe the short-term supply/demand dynamic (imbalance) will necessarily cause concern that spreads might come under pressure. As IG deals perform, more will come. That will push down the curve – and we’re sure high yield borrowers as well as AT1 structures will fill the first quarter’s primary allocations.
Positive macro should provide a continued reason for corporate creditworthiness to further rise. Fundamentals can only improve so long as re-leveraging (investing and/or M&A) remains controlled, or rather conservative. That’s the sign we currently get across the European industrial area. Furthermore, global growth heading for 4% or more is going to boost the credit rating upgrade downgrade ratio higher.
Technicals are not going to change anytime soon, either. We will more than likely retain a healthy flow of funds into the corporate bond market and although they will be largely earmarked for IG funds, a high proportion (20%) of the IG inflows will find their way into the high yield market as part of the IG portfolios allocation towards HY debt. That trend will largely replicate the one seen in H2 2017. Asset allocation decisions are unlikely going to alter their make up much either and we think that credit will maintain its lustre as part of the fixed income proportion allocation.
Secondary market liquidity isn’t coming back either as we might have liked. There are still enough market participants on both the buy and sell side who would like it to return and continue to voice their displeasure with the current state of affairs. But ‘things’ have changed.
Banks don’t see the need for providing the kind of capital required to run the sort of positions on their trading books which were the feature of the market and business in the ’80s, ’90s and early 2000s. We’re all buy-and-hold players now. It’s taken much of the day-to-day excitement out of the market, but that’s no bad situation. Corporate bond investing is not meant to be an exciting pastime.
It’s just the cycle, relax
Eventually, it will be about protecting performance, but we can probably position or worry about that towards the end of the year. The firming of an old style economic cycle will naturally force the issue. However, the cyclical recovery will be supportive in the early throes of this recovery, which has been exhibiting Goldilocks-like characteristics for the past 12-months or so. Not too hot, not too cold on growth and just tepid levels of inflation, allied with cautious rate increases as central banks seek a normalisation in policy but dare not get ahead of the curve has been the corporate bond markets friend.
We are therefore not going to see 40bp of tightening in IG spreads (iBoxx index), we won’t see the 100bp+ of tightening in the high yield market nor will we see 250bp+ of performance in the CoCo market. But the slow recovery dynamic leaves investors (insurers, asset managers, retail) still willing to put their cash into the corporate bond market looking for a pick-up in a still relatively safe-haven asset versus the risk free rate.
The modest cyclical upswing will have all the uncertainties associated with it in terms of its sustainability and so we think aggressive forms of M&A will be few and far between, thus re-leveraging concerns ought to be on the back burner. Conservative corporate balance sheet postures have been a feature of these crisis years and we should have another year of them. Corporate balance sheets in Europe are rammed full of cash and debt raised at record levels; we see no hurry for the industry to spend their booty. The ability of the corporate sector to service their obligations is the best in the history of the market.
The cyclical upswing will likely see global growth peak at a lower level than what we might be used to, where we fail to see the heady growth levels of yesteryear. After all, the financial system across the board is riddled with highest levels of indebtedness in history. Hence the cautious trajectory in rate increases from the Fed (three 25bp hikes expected in 2018) and ECB, where the latter will stay pat for the whole of 2018, in our view.
There will be a de facto tightening of sorts in the Eurozone through the reduced level of QE rated asset purchases, but all that plays into market expectation of a steady, concerted and measured withdrawal of the accommodative policy.
The BoE will play to the Brexit gallery and/or the consumer price inflation trend. But sterling IG credit was an underperforming market in 2017 versus euro credit and dollar corporate risk. That was probably to be expected given those Brexit-related fears, the political event risk and the weakness in the economy. Nevertheless, returns were positive and spreads did tighten. We do not expect spreads to widen in sterling markets, rather anticipate a moderate tightening in 2018 – but less than for euro credit. Returns will depend on the performance in the Gilt market which is very difficult to predict, but anywhere close on 1.5% for the yield on the 10-year will see negative total returns for IG sterling credit this year.
Rate markets will likely be supportive
The views on rate markets remain as varied and plausible for a range of scenarios. The flattening of the US rate curve is a cause for concern because the markets are suggesting that a US recession is likely coming sometime in 2019/20. The Fed will have to tread very carefully so as to not tip the yield curve into inverted territory. Already 2s/10s is just 58bp versus around 125bp a year ago. That said, the 10-year bellwether UST yield, has been stuck well below 2.50% for most of 2017, and we don’t anticipate it moving to much more than the 3.00% area by the end of 2018.
Europe will follow suit, but Bunds are going to continue to be supported by the ECB’s QE purchases, albeit reduced from January. At the time of writing, the yield on the 10-year Bund resides at less than 0.40%, and is unlikely to push beyond a 0.70 – 0.80% range during 2018.
Gilts markets are much more tricky to second guess. Brexit event risk and the view of a faltering economy but with sterling weakness stoking inflation, the policy makers are going to have manoeuvre a very tricky path. The 10-year Gilt yield has been extremely choppy in 2017 playing out in a 60bp range through the year. That would not be impossible a feat to repeat in 2018, although we think the market will generally remain better bid, and the 10-year Gilt yield fail to see 1.50%.
Primary markets, same old
We’re likely going to get the same levels of supply as in 2017 in IG (that is, €260bn area) and as that issuance comes, we might get to the stage where tightening of deals (NIP – new issue premium) versus the initial guidance fails to garner the ‘accepted’ range – of 12-20bp.
As for trends, we saw much by way of US borrowers while German autos, especially VW, make a comeback adding over €20bn to the supply after the diesel-engine emissions related enforced absence. AT&T and GE took almost €20bn between them. The US tax reforms might have an impact on US corporate borrowing activity in Europe next year although the actual dynamic is difficult to work through and will be issuer specific in light of the potential for repatriation of offshore earnings.
The ECB will be winding down its purchases and higher rate markets will be adding to funding costs. That comes after yet another year where borrowing costs were at record low levels. We seem, though, to have found an average level of issuance for IG non-financials in the €250bn-€270bn area and we see no need to deviate from that established range when we look at 2018’s issuance expectations.
The stand-out primary market in 2017 was the high yield market. Anyone fretting about the so-called wall of funding that might impact borrower refinancing levels (2018-2020) ought to have their concerns assuaged by the record €75bn of issuance in 2017. That fantastic level of issuance is high unlikely going to be repeated.
Our own view is that while funding costs remain relatively attractive for sub-investment grade rated borrowers, demand is a little weaker with the marginal buyer being IG investor portfolios. We think that issuance levels will fall back to the €55-60bn area – which itself will be slightly above the average of the previous few years.
Senior financials have had another light year for issuance as those pre-crisis era league table deals remain absent. The deals are now predominately senior non-preferrers in order to meet the new regulatory requirements. As for supply in 2018, we again look for somewhere around the €140bn level for senior financial issuance as banks remain cautious into the improvement we are seeing on the macro front.
Given the view we have for spread tightening (15bp in IG, 40-50bp in HY), we are anticipating more high/low beta compression. That’s not just between IG and HY, but within IG. So we would continue to retain a clear positioning bias towards triple-Bs versus double-AA and single-A risk.
Considering the upbeat growth projections but only a slow removal in policy accommodation, then we are likely going to see an improvement in credit fundamentals help sentiment towards lower rated risk, as well as from demand for higher yielding risk as rates move higher (but only gradually).
The spread compression in 2017 saw the difference in spreads between high yield and IG collapse to their lowest ever difference. The iBoxx index differential started at 278bp and tightened to a record 159bp in early November before widening back to 190bp as we closed the year. That was all due to the widening in the high yield market through November, although we ended the year with a squeeze again in HY cash. We can expect compression between the two markets again and we ought to come close to testing those tights again in 2018.
We’re not overly-excited about a portfolio structure made up favouring cyclicals and against non-cyclicals either. Such is the (rich) level of the whole corporate bond market and the need for higher yielding assets, the natural portfolio make up favouring cyclicals over non-cyclicals into an economic upturn may not even matter at the margin. That is, we still think that the trade and positioning for choice will be very directional and yield driven.
That directionality and need for yield means – beta – and the more, the better. The year is probably going to be the last hurrah for the credit markets and a chance for investors to squeeze the last drops of performance from it, before the economic cycle likely takes over. So a higher beta positioning favours longer duration (carry and roll down) and staying with a triple-B and lower rated corporate risk bias.
We would probably have a slight underweight in non-financials but an overweight in financials with a more favourable bias for subordinated risk. Banks’ credit quality is going to improve into better economic conditions and the need for yield will favour subordinated assets. The AT1 market is likely going to see spreads compress versus senior preferred risk (the new senior benchmark) and issuance costs will likely fall, too.
Synthetic iTraxx indices going lower
The cost to protect corporate credit ought to decline through the year. The driver for the tightening will be the economic back drop although we fully expect that event risk will see a pull back at times in the cost of protection. The retreat can and likely will be sharp at times just as it was in 2017. In addition, any event-driven weakness in protection markets will not necessarily be reflected like for like in the slow-moving, more illiquid cash market.
As well as the economy being a driver, the need for higher yielding risk will see better sellers of protection looking to clip the incremental yield and X-Over can be a big beneficiary of this trade. Improving credit fundamentals and hopefully a positive rating transmission will feed into a more confident market. This ought to take X-Over through the 200bp barrier (S28 currently 230bp) to the 180-185bp area and Main through 40bp, perhaps as low as 35bp for the current contract (now at 44bp).
Those directional moves in the iTraxx indices (cash/synthetic correlation) will ultimately tie in with the tightening we expect to see in the slower-moving, less volatile and more technically driven cash market, where the long-term correlation between the two is extremely high.
The risks – are big impact
The risks of a material drop in risk asset prices can only come from what we might call ‘big impact’ situations. The little things don’t seem to matter. Over the past 18 months, the markets have shown that their resilience amid a welter of skirmishes – Brexit, political surprises in the US, the US/North Korean spat, cyber attacks and the like have all been brushed aside. There’s too much liquidity oiling the system and needing investment for the aforementioned situations amongst others to have a lasting negative impact.
War, serious geopolitical conflict, panic somewhere which sets off potential crisis in the global financial system that needs immediate and drastic policy response to curtail any potential upheaval are the biggies. We don’t really see any of those occurring anytime soon. However, they are currently slow-burning fuses as we could think of them as developing situations and because any of them could eventually happen.
For example, the US/North Korean issue is a real even if not a clear and present danger, in our view. Geopolitical conflicts are flaring up a little more than some would like – for instance, Spain/Catalonia amid a broader spread of nationalism across the EU (Poland, Hungary for example), and then there’s Russia’s multitude of sins – and so on. A systemic panic could come from any of them, or from something borne out of the crypto world.
We can add into that global indebtedness reaching record levels as a percentage of GDP having risen to a massive 325% (China-driven over the past few years) and it is going to rise further on the back of Trump’s tax cuts. Accommodative policy vis-a-vis low interest rates have sustained the ability of all and sundry to service burgeoning debt burdens but the move to normal policy is going to have an impact – likely leaving a slowing in growth and an increase in delinquencies eventually. And then that recession.
We do appreciate that it is difficult to position for the aforementioned situations – and few will, given the likelihood of being left behind as the short-term sees the markets move higher (equities), or tighter (credit spreads). It will be too late to exit when it eventually happens.
The purveyors of doom have time and again been proved wrong through the financial crisis years about how the corporate bond market was heading for a collapse in bond spreads amid an exit by investors from the asset class. Instead, year after year – which have included a couple where annual spread/return performance was relatively poor – corporate bond investors have remained resolute allowing the euro-denominated market to grow almost exponentially.
Over the past couple of years, the ongoing lower yielding global rate environment has seen investors take ever greater higher levels of risk into their portfolios as they continue to chase yield/higher returns. It’s not lost on us that some have built positions for which they have little experience or knowledge in, but have been comforted by safety in numbers and the herd instinct of their peer group.
Many others though will have been educated about the risks, aware of them and realise that the current macro backdrop, rate policy regime and so on suggests that the incremental corporate bond risk taken on board has performance legs in it still. For example, the probability of a significant important financial institution going to the wall – or not able to pay its AT1/CoCo coupon is remote (in our view). So the trade into this asset class – and a gain of 18% or more of performance in 2017 – made sense, and in our view still does given the meagre pickings on offer elsewhere.
So we are going to stay positive around what we expect the corporate bond market can and will deliver in 2018. Supply will unlikely deviate from the average of the past few years in IG (around €265bn) which will be unremarkable, while we don’t think the high yield record of last year (which was a remarkable €75bn) could possibly be repeated and look for something lower, closer to €60bn.
Expect solid demand for higher yielding assets to remain though, and more AT1 supply where the coupon will start to drop on new deals through the record low 3.5% offered by Nordea in Q4 2017.
As for spreads, ‘grind tighter’ will be the mantra. We will see periods where we back up which will be more noticeable for higher yielding assets given their correlation with equities, with equities being the driver for the weakness. Nevertheless, we are looking for 15bp or so of tightening in the IG market and 40-50bp in the high yield sector which will see both iBoxx cash indices at record low levels.
With that, we would retain a higher beta portfolio positioning through taking both a longer duration and lower credit quality stance. The ECB corporate bond purchases totalling €132bn have helped, but by how much is difficult to quantify. And with total asset purchases set to decline from now on, it’s going to be a good test for corporate bond market valuations. .
Finally, the synthetic credit market, this will be more choppy with the iTraxx indices moving in more volatile fashion than the cash market. The synthetic market is a more reactive credit market to events than the illiquid cash market and as such, is considered credit’s liquid risk proxy. However, the ultimate trend will be the same, in our view – the cost of protection will decline through the year. Using the current contract as the measure for where we might be heading, we think that S28 Main can move to 35bp (from 45bp now) and X-Over to 180bp (from 233.5bp) and a ratio of about 5x maintained between them.
Have a good day and here’s to a happy and prosperous 2018.
For the latest on corporate bonds from financial news sources, click here.