- by Suki Mann
|🇩🇪 10 Yr Bund
|iBoxx Corp IG
|iBoxx Corp HY
|🇺🇸 10 Yr US T-Bond
|🇬🇧 FTSE 100
|🇺🇸 S&P 500
The low-hanging fruit has been picked
Investment considerations will continue to be driven by excess/easy liquidity conditions – even if the real economy’s recovery barely raises a whimper through the first quarter. Fixed income isn’t dead. We think that IG and HY credit spreads will achieve record tight levels through 2021 – while generating total returns of as much as 1.9% and 7.5%, respectively, for the full year. Positioning for a recovery in global macro will benefit higher beta risk assets.
IG non-financial gross issuance, we believe, will drop by 25% – 30% from 2020’s record gross supply, and the 12-month trailing corporate bond default rate we expect to stabilise at below the 5% level after peaking at around 7% during Q1/2.
It’s almost a shame that the upside will be limited to this amount of spread performance – because the bid for corporate debt will be as firm as it has ever been. It’s just that we’re already at the tight end of the spreads spectrum and the asset class’ attractiveness might begin to wane. There won’t be much left for 2022 assuming macro recovery takes on a more sustainable footing.
And so, following much high/low spread compression through the year, Japanification of the European corporate bond markets will be complete in 2021.
Data Source: Markit, CMD
|2020 (Δ)||2021 (Forecasts)|
|IG corporate spreads (iBoxx)||B+101bp (-3bp)||B+70bp|
|HY corporate spreads (iBoxx)||B+358bp (+13bp)||B+210bp|
|IG non-fin corporate supply||€359bn||€270bn|
|HY corporate supply||€88bn||€75bn|
|Senior bank supply||€131bn||€120bn|
|10-year Bund yield||-0.57%||-0.50%|
|IG corporate bond returns (€)||+2.8%||+1.9%|
|HY corporate bond returns (€)||+1.9%||+7.5%|
Investors will be hunting for relative scraps. As suggested in the spreads and total returns expectations, the trade in 2021 is in high beta credit. Macro recovery and a default rate which only pops to around the 7% level will give confidence that increasing exposure to lower-rated corporate debt will help incremental performance. High yield returns – in any year in excess of 7% – will not be scoffed at.
The risks for the year are limited. They nearly all centre around the coronavirus. But given China’s performance through the second half of 2020, the marker has been set for a good rebound in non-Asian markets once control of the virus is managed.
Confidence will be boosted by coronavirus vaccines being administered to the global population. Investment and consumption will resume an upwards trajectory. Central bank accommodation of global liquidity will stay in place. The impact of event-risk on sentiment and markets will be short and limited – we believe.
Markets want to rally -and we think that asset prices will continue their upward trajectory.
2020: Not bad. Not bad at all!
Last year’s performance beat all expectations in just about every market. It seems strange to be able to say that. Equities saw record high in several markets, credit returns beat expectations, rate market total returns were boosted by central bank QE and, of course, crypto’s late rally smashed all comers.
All that against a coronavirus pandemic that ravaged global macro, piled on debt (misery?) for most sovereign nations, and risk markets performed remarkably well. Trump was a constant thorn in the side. Investors can now look forward to US political predictability, geopolitical stability and a sharp recovery in global growth in 2021.
The US markets displayed all their resilience in 2020. The S&P eventually closed above 3,700 setting several record highs in the process, eventually rallying by over 16% during the year, helped predominately by big tech. The Dow closed at a record high level of 30,606 and added 7.2% in the year.
In Europe, we had a more mixed picture but one which also highlighted a solid recovery in the indices. The €Stoxx50 might have closed 4.7% lower and the FTSE some 14.2% off the pace, but the DAX recovered to close shy of its own record high at 13,718 (+3.5% for the year). It was much worse earlier in the year and all those figures highlight a fantastic recovery.
Of all the European indices, the internationally-focused earnings make-up of the FTSE companies and a post-Brexit bounce could possibly help this market to being the best performer in European equities in 2021.
Rates were well-bid throughout courtesy of the central bond-buying programmes, which to all intents and purposes were direct financing of sovereign budget deficits. Not allowed under the ECB’s remit, but brushed aside in extremis and to be expected given the ECB’s/EU’s usual overriding of the rules of engagement when the two institutions see fit. Total returns (iBoxx index) for the Eurozone sovereign sector came in a massive 5.0%, as a result.
In credit, the same remarkable recovery in performance was seen. Investment Grade spreads (iBoxx) were eventually 3bp tighter for the year (they were over 150bp at the height of the pandemic) and total returns came in at an excellent +2.7%. That beat most expectations set before the pandemic for the year’s expected performance. The IG sterling corporate bond market closed with spreads at G+122bp (-15bp), with this longer duration market returning 8.7% for investors.
On index spreads just 10bp wider, the High Yield market’s total returns were up at +1.9% – also capping off an excellent recovery for the sector, with index spreads just 13bp wider for the full year. At the worst point in the pandemic, spreads were almost 600bp wider. There was never a rush for the door from investors, nor did we see the default rate jump massively higher – as one might have expected when macro goes through a double-dip recession. More so, we saw record issuance.
Heavily distorted, manipulated markets? Yes.
The AT1 sector saw the worst – and then the best, of it. More illiquid than most, rate risk (to earnings) and fears of a possible systemic meltdown (didn’t happen) all contributed to a major sell-off where at the worst point in March, spreads gapped by over 1000bp (iBoxx index). In the period since and to year-end, they had recovered nearly all of those losses, with the index closing 2020 around 60bp wider – and with total returns of 5.3% for the full year.
Everything was trumped, though, by the rise in the crypto markets, where Bitcoin rose from $7,200 to a record $28,500 (and is still rising through $34,000 at time of writing). With larger, more prominent asset managers/hedge funds now taking big (treasury) positions in Bitcoin – and with the US’ largest cryptocurrency exchange Coinbase filing to go public, we’re going to see much much more interest in the whole crypto product.
Exuberance, greed, fear of missing out and that increasing institutional involvement, we believe, will see that Bitcoin is once again the likely big investment/outperformer in 2021. For others, adding some crypto could be viewed as this year’s lucky dip trade, again.
Back to normal in primary
Primary loves a good crisis. We saw record issuance in 2020 in both the euro-denominated investment grade and high yield markets. For the former, it was a similar picture in 2009 when borrowers scurried to get deals away (at record high funding levels, though), staring ruin face-on as the great crisis threatened financial armageddon.
Panic obviously set in again last year because, after the previous record of €320bn in 2019, few would have expected anything close to that in 2020, in IG non-financial euro issuance.
That we saw a record €359bn printed was against the backdrop of fears that treasury desks would be left exposed to liquidity risks as macro ground to a halt. Continued record low funding costs saw corporates pile into the markets in Q2, where three record consecutive months of €50bn+ were responsible for €165bn of the annual total.
IG Quarterly issuance
The receptivity to deals remained robust throughout. Inflows, asset allocation and the need for a relatively safe haven asset offering a pick up versus negative government bond markets all supported corporate primary. That will not change in 2021.
We actually believe that the bid for credit should be strengthened and look for even lower all-in corporate funding costs (already at record lows), tighter spreads (new records) and a continuation of deals being well-oversubscribed, and anywhere between 25bp – 50bp of tightening in final pricing versus the initial talk. And a whole lot of investor frustration to boot.
Although we think that primary markets will remain buoyant, we look for a drop in supply by around 25% – 30%. That would see issuance drop back to around the €270bn mark, and a level which was being established through the 2014 – 2017 period.
The recovery in macro will ease corporate treasury desk fears, but the lack of investment (opportunities) will see them hang on to their cash as they maintain bloated balance sheets.
IG Bond Issuance by Year
US borrowers accounted for just 15.5% of the total issuance. After a strong presence in 2019 where US-domiciled corporates accounted for a record 30%+ of the total, their reduced presence saw a drop back to the long-term average. We don’t think that will change much in 2021, and again look for somewhere around the 15% – 18% mark for US corporates issuing in the euro-denominated market.
US Corporate Borrowers as a % of Total Euro IG Issuance
A surprising as the record level of deal flow we witnessed in the IG markets, the high yield market was also in top form. Against all expectations, a record €88.5bn of debt was issued. Spreads might have gapped in Q2 and panic might have set in as macro collapsed on coronavirus lockdowns, but the recovery in valuations and receptivity to new deals was nothing short of superlative.
High Yield Bond Issuance by Year
Spreads were close to back to flat, as highlighted above, and the deal flow remained quite consistent save for the zero issuance in a six week period from the middle of February to the end of March. The appetite for high yield corporate bond risk never really fell away. Spreads might have gapped but we think that was largely because of a defensive Street bid amid low levels of liquidity combining to exacerbating the price action.
In addition, the default rate didn’t really pop higher and the high profile casualties were few and far between. Covenant waivers and generally looser covenants of late were probably also a factor in keeping the market stable. With macro expected to recover sharply in 2021, the high yield market per se appears well placed to benefit.
We expect high yield issuance to drop by around 15% in 2021 and back to around the €75bn mark. We think that the HY market, in Europe, might have established an annual volume in the region of €70 – €80bn. Its maturity (investor and issuer) is establishing itself, but there is still some way to go in order to get to US levels of maturity judging by the zero issuance in March.
The Risks – Limited
The risks are predominately centred on whether the vaccine will be effective enough in containing the virus across the globe. The roll-out of it is underway but the virus’ mutation might be ahead of the roll-out curve necessitating further significant lockdowns. If not (as is likely), we think that the worst case is now behind us.
Geopolitical risks are always an issue, and the recent sophisticated hacking of US government computer systems (allegedly by a sophisticated Russian operation) has called for the incoming Biden administration to react with a strong retaliatory response. And then there is the China trade issue and it is currently unknown as to how the Biden administration will evolve Trump’s Sino policies (if at all).
The possibility of central bank policy tightening is worth a mention – if only to dismiss it, as it is highly unlikely that we are going to see any of that through 2021. Inflation is dead in the water. All the existing programmes will stay in place (QE related) and we would think that there is a non-trivial probability that they will be expanded (extended in time or increased in size) – likely in Q1 if those recession fears emerge.
In the UK, those Brexit trade negotiation fears can now be put aside following the trade agreement between the UK and the EU, but the general reading is that they will impact the UK economy positively. We would think that the prospect for negative UK policy rates is now also very unlikely.
Macroeconomic activity is expected to bounce back, sharply, at some stage in 2021. Suggestions of 5%+, for example, across the Eurozone are pencilled in by the IMF (3.9% ECB). The risks are to the downside, though while we are not expecting pre-pandemic levels of GDP to be achieved until well into 2022.
Anything more than those growth numbers and we will get the inevitable ‘rotation’ trade calls (out of fixed income and into equity). Again, we dismiss this as a material event, with investors preferring to hold on to their fixed-income allocations (i.e. credit) into any recovery which, after the initial sharp bounce, is expected to moderate at lower levels (seen pre-pandemic).
Capital preservation strategies will still be the modus operandi of the investment process rather than chasing capital appreciation investments through an asset reallocation trade.
Macro’s recovery will be laboured in Q1 as vaccines are rolled out, but the picture will be clear that a late Q2 recovery will exhibit V-shaped potential. Close to the ECB forecast of 3.9% would be a record for the Eurozone. With consumer savings through the roof, there is an extraordinary amount of pent-up spending power and we expect that to be deployed as confidence grows.
There is every possibility that Q1 will show that the Eurozone is still in recession, however. But, as suggested, the IMF is looking at 5.2% growth for the region in 2021, meaning that recovery will be sharp and fast after the first quarter – if they are to be proved correct.
High beta again in 2021
Little changes versus how we had called it at the beginning of 2020. Performance was savaged in Q1/2 2020 due to the effects of the pandemic, but the recovery was excellent across the board. Going into 2021, we think the broad message will be the same. So the broader credit market is going to remain fairly well-supported from both a fundamental and technical perspective.
We are not going to see any material outflows from the asset class. Rate markets have lost all the lustre although there is an argument to add BTPs where the yield, on the 10-year, has every opportunity of falling into the negative camp with just 50bp to go.
Headline and event risk will change from those which greeted us last year. Trump is out, so we have political orthodoxy back. Geopolitics, as a result, might be less of an unknown dynamic. We have a Brexit trade agreement, but the unknown is how amicable the divorce between the ‘sovereign’ UK and the EU ‘organisation’ will be – and evolve.
So from a fundamental perspective, we are in the first instance looking at an initial weak uptick in the recovery. However, we ought to accelerate into Q2 as the vaccine deployment allows a sense of normality to return. That looks delayed now until Q2 with a recession likely to persist across the Eurozone through the first quarter. The hope therefore will be for a strong improvement in Eurozone growth through H2.
Look for further policy accommodation in H1 as the bowels of the winter months wreak further pandemic havoc (lockdowns across the continent). But that ought to be the worst of it.
HY Key for Investors
The high yield market (rather higher beta ones) will hold the key for investors in 2021. That and the banking AT1 sectors are where the out performances will be. The default rate will stay at low levels given the various support packages but also the expected top-line revenue recovery as the year progresses.
The demand side of the HY market remains intact, in our view, with European retail, insurance and crowded-out IG investors all retaining an interest in the market.
Euro-denominated credit spreads eventually tightened by a handful of basis points in IG in 2020. With the iBoxx index starting the year at around B+102bp, our forecast is for spreads to tighten by up to 30bp, offering up total returns as high as 1.9% for the asset class. The record low spread on the index is B+82bp. Financials will outperform non-financials and the attractiveness of the AT1 market should be noted.
In sterling credit, the iBoxx index tightened by 13bp to G+124bp. For 2020, we look for the favourable view of sterling corporate bond risk (despite Brexit, and helped by stable government, higher government spending) to be maintained and the market to tighten by 20bp, with the index tighter at around the G+100bp level by year-end.
The support for spreads will come from several areas. Global macro will be uncertain but we have shown that through 2020 investors and policymakers can manoeuvre a path through it. The default rate will rise but stay relatively manageable (around 5-6%), as the corporate sector has largely managed over the past few years to term out maturing obligations – and to limit refinancing risks.
Low rates have allowed the corporate sector much room and a comfortable buffer with which to service its obligations. While the rating transmission risks might deteriorate some more (more rating downgrades than upgrades), there ought to be very little which offers concern. The ability for companies to service their obligations remains supportive through 2021. As suggested already, record low funding costs are with us a while longer.
Thus for the high yield market, we look for spreads to tighten (iBoxx index) by 150bp (against almost +15bp in 2020) – and we should still see total returns in excess of 7.5%, which is not far from above the long-term average for the asset class.
Inflows into the asset class will wane – eventually. We think that in Q1 they will remain fairly robust, but they might decline as the year progresses as the rich market loses some appeal to any sharply rising equity market as macro recovers. Still, outflows will also be very limited and the ECB’s big pockets will come into play to help preserve performance (if need be).
Lower levels of primary market activity should help limit any spread weakness, and likely help the spread tightening trajectory.
We expect compression between the high yield and IG markets. Using the iBoxx cash indices as a broad proxy for the cash markets, they closed 2020 trading on a 3.6x multiple – but our forecasts look for that to decline to 3x. That might be easier to play through the synthetic indices, where the current X-Over/Main ratio of 5x could be closer to 4x.
We, therefore, continue to prefer lower-rated risk versus high rated and would overweight triple-Bs versus single-A risk, overweight double-Bs and to be much more selective in our choice of single-Bs.
We continue to like the AT1 market and recommend being overweight accordingly. We also think that spread-tightening in IG non-financials will underperform higher spreads offered in subordinated financials and would run a strategy expecting financials to outperform.
So stay overweight subordinated financials versus senior, and while it does look as if the non-financial corporate hybrid market is rich, it is worth a slightly overweight stance.
US rates are expected to rise through 2021 with forecasts pitching the 10-year yield as high as 1.75%. We don’t think Eurozone rates are going to necessarily follow, and will likely remain in a range through the year.
We don’t think that there is significant risk from rising European rates. We forecast the 10-year Bund yield will end the year at around -0.50%, for example. Hence we would have an overweight bias in credit duration favouring the 7-10 year maturity sector.
Happy new year and have a good day.