- by Suki Mann
|🇩🇪 10 Yr Bund
|iBoxx Corp IG
|iBoxx Corp HY
|🇺🇸 10 Yr US T-Bond
|🇬🇧 FTSE 100 ,||🇩🇪 DAX ,||🇺🇸 S&P 500 ,|
Trying to make sense of the credit market…
There’s an argument that the corporate bond market has failed to deliver this year. The evidence is stark when we look at the usual drivers of expectations for the market. Investment grade spreads are 40% wider so far as measured by the iBoxx IG cash index (B+96bp to B+135bp), against most expectations that the first half would offer a more fruitful level of performance. Higher beta credit has not though fallen out of bed as it might have, given that IG performance, with spreads widening roughly in line if not less than the IG index.
Of course, credit markets are at risk of a significant level of further weakness if the economy takes a serious nosedive, and/or if there is a serious equity market correction of some sort. But it would be the lesser of all evils if any of those occurred.
Nevertheless, on the surface it is difficult to fathom as to why we are actually wider in spread terms. It could simply be that spreads are wider because markets are forward-looking and uncertainty has risen, and ”the power” is in the “investor’s hands”. For so long it was a seller’s (borrower’s) market and the investor community had to play along. Now they are “fighting back” into the uncertainty and exercising restraint and sticking to their spread levels. Or, total returns are in negative territory (around -0.8% YTD iBoxx for IG) and investors need to be certain that any further investments produce a positive return, hence the need for NIPs to go wider – so they aren’t putting good money after bad. Returns for many IG funds already exceed -1%.
Otherwise ‘nothing’ has changed for us these past six months versus the previous six years to suggest such a relatively aggressive weakness in secondary risk was even possible. In fact, the eligible market has shrunk given that the ECB had sucked up over €160bn of IG non-financial risk while net/gross new issuance has fallen – hard. Some issuers are pragmatic and understand that, say, an extra 15bps won’t kill them over 7-years on a fixed rate basis as coupons are still low, but others are stubborn and don’t believe the new paradigm. The first cut is the cheapest.
We haven’t had too much by way of meaningful inflows into the asset class, but outflows have been limited and there is absolutely no sense of panic amongst market participants. Most would probably agree that the IG market still holds much attraction. Spreads are at their widest levels seen in the past couple of years. Secondary market liquidity is poor (admittedly) but paper is available. But few are adding in secondary, preferring the primary route, but that market has failed to deliver. And it doesn’t look like many are in a rush to add through secondary as judged by the level of activity we’re witnessing.
In addition, investors are at limit long portfolio cash levels. Some might be adding short-dated floaters to stop the breaching of fund cash limits, and borrowers like Safran SA last week will feed into that. But there’s little sense in keeping hold of cash where depository institutions are charging -0.8% or more for the privilege to hold that cash. Those custodian rates are not going to decline until we see a change in the ECB’s deposit rate (currently -0.4%) and that is unlikely going to change anytime soon.
We don’t get a sense that investors are waiting to pounce on secondary should something change for the better on the macro and geopolitical levels. Secondary can tighten only slowly from here should any sustained improved tone with confidence in the asset boosted by any increased primary activity and a follow through in new deal performance. That’s the driver. So, at best, we should only be looking for modest upside in spread tightening for the rest of 2018. The opportunity though is higher beta risk where we have had some overzealous weakness in say the AT1 market and where entry levels now look enticing enough to buy the dip.
In summary, it’s not terribly exciting. Credit technicals coming from supply, demand, sidelined cash and the level of rates suggest we should be having a ball in credit. Fundamentals emerging from the default rate, rating transmission risk, corporate cash balances, the need to borrow, the funding wall and the receptivity to new deals are as supportive as they have been – ever. There hasn’t been much of an economic cycle, but fear lurks on that event risk – leading to the non-trivial potential for a correction on other markets which will impact credit. So, investors sit on the sidelines waiting for someone else to move first.
Positive close, but watch out
The US non-farms employment report clocked up ahead of the 195k expected job additions for June at 213k, while the unemployment rate ticked higher to 4% from 3.8% in the prior month. However, average hourly earnings at 2.7% although unchanged, were below expectations of a 2.8% rise. The markets reacted by bidding up Treasuries (yields fell), the dollar came under a little pressure and equities moved higher.
Overall, allied with the recent data elsewhere coming from the US market, the economy generally appears to be in decent health. Unfortunately, we are in “trade war territory” and much of the impact of it is yet to be felt (capex, investment, inflation) hence the need to proceed with caution and not read too much into the current health of the US economy. The Chinese have reacted tit-for-tat, and this is one situation which can – and quite possibly will – spiral out of control very quickly.
Still, we closed the final session of last week with equities higher across the board but with a more subdued tone in Europe versus the 1% rise or so in the US. There was clearly a little more concern from rate markets and government bonds managed a better bid as a result, the 10-year US Treasury at 2.82% (-1bp) and the Bund left to yield 0.29% (-1bp) at the close. The US 2s/10s compressed some more, now at just 28bp!
There was nothing from corporate primary on Friday, and while we think that the market window is open for getting deals away for the next couple of weeks, it does now appear that we are not going to see too much. The iTraxx indices managed to claw back some of their previous losses in good fashion too, with iTraxx Main 2.3bp lower and back below 70bp at 69.4bp with X-Over 6.9bp lower at 305.3bp.
Cash credit was also better bid for choice, and that left the iBoxx index to close the week at B+135.1bp (-1.1bp on Friday), and much to our surprise – given how the weakness has played out in IG cash of late, we were 1.5bp tighter for the week. It was the same dynamic in cash, slightly better bid and the index 3bp tighter in the final session but 13.5bp tighter for the week.
As for this week, Trump is on tour across parts of Europe and will surely be dropping a few bombshells along the way, in Brussels first for the NATO summit and then in the UK and Scotland thereafter. The markets are likely to remain tentative. On economics, we have US inflation data released towards the end of there week and then the second quarter earnings season to keep us occupied on Friday onwards (banks reporting are Citi, JP Morgan and Well Fargo which usually start the ball rolling).
Have a good day.
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