26th October 2017

When the music plays

MARKET CLOSE:
iTraxx Main

52.8bp, -2.6bp

iTraxx X-Over

237.1bp, -4.1bp

10 Yr Bund

0.45%, -3bp

iBoxx Corp IG

B+101.7bp, +0.1bp

iBoxx Corp HY

B+262.3bp, +3.5bp

10 Yr US T-Bond

2.45%, unchanged

FTSE 100

7,380.68, -6.26
DAX

12,993.73, -53.49
S&P 500

2,578.85, -6.79

Just make sure it doesn’t stop…

When we get record-breaking levels in markets there is a natural inclination to believe that we have peaked and that we can go higher and on to better things thereafter – in equity markets, because that’s the nature of that particular asset class. It doesn’t quite work like that for fixed income/credit markets, where spreads/value are inextricably linked to the underlying credit worthiness of the borrower – and its relative ability to service to obligations. Product technicals aside, the credit asset class is inherently a cyclical one where an economic downturn has always meant wider spreads, while economic prosperity usually heralds a tightening spread regime.

The difference this time, as we smash records all over the place in spread markets, is that we haven’t quite had a normal economic cycle, nor have we previously faced the unprecedented 10-year economic stimulus which has necessarily altered the investment process and thinking. It begs the question as whether we can check out – in an orderly fashion, en masse? Will it matter?

If we get no systemic financial crisis over the next few years and indeed manage to record decent levels of economic growth amid rising equities and rates (yields), then fixed income is going to offer minimal positive returns – if any at all. Already this year, European government bonds have resided in the red on a total return measure, while credit has managed superlative returns only because spreads have ratcheted tighter. Benchmarked investors have rarely had it so good.

The higher beta asset classes have done better in this respect, because that’s where the juice has been. There isn’t going to be anything left to offset the rising yields in 2018 – we thought that would be the case in 2017 – so this year’s strategy is deferred to next year. The low hanging fruit was picked in the period to 2016. High yield spreads have since compressed to record tights versus investment grade, CoCo/AT1 spreads are dropping through the floor to record levels as well and for sure have more to go even as investors ‘forget’ that this is a ‘designed to fail’ product.

Senior bank spreads versus non-financial investment grade have room to compress as well, although long gone are the days senior financials traded through non-financials. The new bail-in’able senior (usually HoldCo) debt is going to come with a significant to premium to the ‘old style’ plain vanilla (OpCo) obligation.

So we dare suggest that there is going to be a year of materially poorer returns. Maybe more than one year too. The ECB/Fed/BoE rate and/or taper policies will dictate when that comes. In the meantime, growth, economic recovery, higher policy rates and market yields into that the slow path of policy normalisation will be our enemy.


ECB dovish, market rallies to continue

ECB DayThe most important part of the ECB’s announcement was around the taper situation and they duly delivered what the markets expected – in its totality. That is, the central bank will reduce its monthly asset purchases to €30bn from the current €60bn from 2018, and also extend the program to September 2018.

As if to show the markets that they remain vigilant (like we need reminding) the governing council will remain open to increasing the size or duration of the buying programme should conditions warrant. Draghi actually later suggested they will continue to buy bonds beyond that date, albeit at a lower monthly level. It also means that the current policy rate regime (main facility 0% and the deposit rate 0.4%) will remain unchanged until well into 2019.

Oh yes, maturing proceeds will continue to be reinvested. Risk assets can only rally some more from these levels.

The news overall will be very good for equities while safe-havens are also expected to benefit from the continuation in the buying/reinvestment effort. We saw the reaction immediately, as equities rallied across the Eurozone (up to 1.5% higher) and government bond yields dropped back, too. US stocks were in fine form too. The 10-year Bund yield fell to 0.45% (-3bp), Spanish Bonos to 1.54% (-10bp) helped by news of no snap election in Catalonia (that is, no declaration of independence) while BTPs yields dropped to below 2% again (1.96%, -8bp).

The moves were much less in US Treasuries and Gilts where 10-year yields dropped a basis point or so, at most! For the Gilt market, we think any initial bid came as a result of the impact from the poor retail sales survey by the CBI which suggested October’s sales fell off a cliff. That rally soon faded.


Corporate primary still delivering, secondary credit rockin’

We suggested on Wednesday that rate incentive high yield markets might see a deal or two priced on ECB day. And we duly got a dual-tranche offering for a combined €510m from Takko Luxembourg 2. That takes the monthly total to €13.2bn (the best since at least 2014) and the YTD total higher into record territory at €61.4bn.

As for the cash markets, Draghi said that large sums of corporate bonds will continue to be purchased into the reduced overall purchases. If they stick to the current €1.7bn average of weekly purchases, then all spread market sectors will be in record spread territory very, very soon. We believe that the Street is going to be even less accommodative in their liquidity provision and if IG primary activity doesn’t perk-up, then the squeeze tighter in spreads is going to leave a few watery eyes. High yield spreads will tighten disproportionately, which means more aggressively.

So, with that dovish ECB statement and subsequent press conference – along with the rally in stocks, credit moved better too. iTraxx index spread dropped as the cost to protect credit cheapened, leaving Main at 52.8bp (-2.6bp) and X-Over 4.1bp lower at 237.1bp. But that is just about where the tightening in spreads occurred in the credit markets.

Because in the cash market, flows were predictably light and there was no issuance save for the dual tranche high yield issue. And the strong risk-on tone elsewhere didn’t seem to feed into the IG market (it will in time) as the IG market closed unchanged. The Markit iBoxx index was left at B+101.7bp (+0.1bp). In high yield, we similarly had a lacklustre session and lacked a zest in the tightening seen of late as the exuberance faded to leave us to edge wider, the index at B+263.2 (+3.5bp) – noise.

What a week. Back Monday.


For the latest on corporate bonds from financial news sources, click here.

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.