1st September 2015

The Cold Turkey Treatment

FTSE 100
6248, +56
10,259, -39
S&P 500
1,972, -17
iTraxx Main
71.5bp, unch
iTraxx X-Over Index
324bp, -2bp
10 Yr Bund
iBoxx Corp IG
B+139bp, unch
iBoxx Corp HY Index
B+454bp, -4bp
10 Yr US T-Bond

The fat lady readied her voice… “There were ten in the bed and the little one said roll over. So they all rolled over and one fell out.” Oil futures were first to go. “There were nine in the bed and the little one said….” Chinese growth wobbles came next. You get the gist of it. Asian FX, then global equities, high yield credit spreads in the US, most commodities and so on. They have all fallen out of bed through a quite tumultuous second half of August. Lest we even mention Greece. When it rains, it occasionally pours. Seasonally poor market liquidity and fewer market participants have exaggerated the moves from a pricing perspective, and on the poorest of volumes. But let’s not blame that – confidence is shot, and faltering Chinese growth is finally coming home to roost. The ructions in the market caused by it gave us all that cold turkey treatment. It hurt. There’s belief in many quarters that going cold turkey actually makes addictions worse. So the Chinese are adding back some stimulus, but the patient’s response is going to be more limited. It is like that last bit of hope that the authorities have left; and it won’t work save for a short-term prop-up. We will need to get used to a world where growth rates are going to be materially lower than what we have been used to – and revalue risk assets and returns accordingly. After all, with oil prices hovering around multi-year lows, input costs falling, wage growth subdued, no inflation and yields at very low levels, we should be booming. We’re not.

Rates on hold everywhere… Nonetheless, all is seemingly good again at the moment. We’ve rallied quite hard and are off those lows pretty much everywhere. Still, the big decisions are yet to be made: the Fed ought not raise rates in September (likely not even in 2015). The BoE isn’t going to do anything either for a while, and the ECB might have to expand/extend its own Eur60bn monthly asset purchase programme. After all, the much watched 5yr5yr forward rate for inflation expectations is likely going to start falling again. We will hang on, hoping that any additional stimulus will work, just like we have been over that past 6-years. Hence the recent ‘dead-cat-bounces’ in asset prices. But China’s slowdown (and future lower growth rates) will have a more lasting impact on asset prices. I think we’re already into global deflationary territory leaving credit, in Europe anyway, worth its weight in gold for a while longer. Capital preservation is utmost and stays the modus operandi of the investment process. How long, will depend on the play off between those deflationary forces and the growth dynamic. For the moment, the ability for corporates to service their obligations is intact and remains the best it has ever been. But we should be prepared to accept lower returns for a while longer.

Environment supportive for corporate bonds… Therefore, and relatively, credit (corporate bonds) will hold its own against other classes for the foreseeable future, and we don’t see that there has been any sign of panic amongst investors in the corporate bond market in Europe. Concern, of course, as returns fall into the red. Interestingly, the threatened wholesale US shale gas E&P default hasn’t happened (yet), and yet HY has been battered with some weakness in Europe too. We think any emerging weakness in European HY and IG ought to be seen as an opportunity. That is, the spiral of contagion has unleashed some good entry levels – and that’s how we in the credit market should view it. Little has changed for us in European corporate credit, in terms of localised fundamentals. The Eurozone economy is barely growing, rates are stuck here ‘forever’, yields will stay low and corporate balance sheets defensive. ‘Twas ever thus.

Additional support for corporate bonds will come from a still low default rate as corporates now benefit from those defensive balance sheets, jam-packed full of cash that has had nowhere else to go for the past few crisis ravaged years. Raised at record low costs, financing burdens are anything but onerous. We still have work to do, decisions to make. But there is no need to panic, pull the trigger and bail. It’s time for reassessing and looking at the market with some pragmatism following the summer break. Most other markets have seen this year’s gains wiped out – and more, in a flash; corporate bond prices have been up and down like everything else; but we have regular income and, if in it for the long term, a buy-and-hold strategy will see principal repaid in full. Clip, clip, clip… that coupon.

Little real panic in the corporate space… The alternative to corporate bonds? In the ‘risk-free’ space, those filling the ECBs coffers with government bonds are subsequently prepared to park the cash with depository banks and are paying more and more for the privilege of doing so! Really, they are. Outflows from corporate bond funds in Europe have actually been muted. Illiquidity and lack of an alternative safe, liquid value-asset might have something to do with it. The bund has whip-sawed hitting a yield of 5bp (10-year) earlier this year and been up at close on 1% earlier in the summer; only to drop to yield a still paltry 50bp+ more recently on flight-to-quality flows (around 73bp now) and of course, ECB buying. Flight-to-quality flows have also seen the front-end well supported, the 2-year yield now at -0.21%. Corporate bond spreads have backed-up too, the iBoxx corporate bond index is 28bp wider now this year, having been 20bp better through a glorious Q1/2015; but the weakness in spreads has been less about panic, and more about a revaluation/illiquidity into that maelstrom of headline-driven event risks and copious levels of cheaper US borrowers’ paper.

Corporate bond love-in set to resume… So what happens next? Well, we wait and see to start with in these opening post-holiday sessions. Few will look to reduce risk – because they’ll fear that they won’t get the bonds back if need be (sell ’em and one will almost certainly kiss ’em goodbye). That is, the lack of secondary market liquidity might just be coming to the rescue of corporate bond valuations. And secondary market liquidity remains a shocker. Credit spreads have gapped in both directions because dealers aren’t bidding on much (or bidding to miss and thus setting the next lower clearing level) but are refusing to offer much either (on any upside), thereby keeping the market parched – and exacerbating price movements. No one wants to be left holding the baby. That dynamic will hold, until the growth and interest rate axis shifts against corporate bonds. That will be a while yet. As for Greece, she has become bit of a sideshow, but has managed a stay of execution; otherwise, without doubt the speculators might have headed for Portugal. And drilling down, is Portugal sovereign-risk safer than say, an EDP issue; or for that matter, is it better to be in BTPs (Italian govvies) than say an ENI or even TI bond? ‎I’m with corporates.

Slimmer pickings, but safety and income must come first… For corporate bonds, we might expect slim pickings on the new issue front early on. The US corporate bond market has been extraordinarily quiet. As we roll into the September, we need the stars aligned to coax borrowers out into the open.‎ That said, Merck KGaA pulled the trigger on a 3-tranche deal last week, but the Eur2bn offering was very cheap. It had to be, as syndicates (and less so the borrower) needed the deal to get away smoothly and with little altercation. For instance, before tightening up the longer 7-year tranche by 12bp, the new issue premium (NIP) was a significant 30bp! And the high triple-B/low-A borrower is viewed as a good name, ideal for this jittery market. Demand was skewed to the front-end as one could expect in these opening skirmishes. Anyway, we were running with new issuance close to a record rate, but it came to an abrupt end through that second quarter. Resumption – or a return to normality after the summer break will come, but only when we see calm on the macro front (not uncertainty).

Spreads? They’ll likely stay in range-bound fashion early on with the iBoxx IG index now at B+139bp. Targeting B+115-120bp into year-end is reasonable, but I can’t see it getting much tighter than that. For HY, the numbers show that spreads are also wider (iBoxx index, B+458bp), but returns are up at 1.5% (anchored front-end yields and a shorter duration asset class). The default rate at below 3% looks sustainable for a while yet, while it will may tick up in the US on the back of oil/shale gas related borrowers going to the wall; but even so, confidence in this asset class in Europe is with us for a while longer. We still get the impression that investors prefer higher beta risk, and believe going down to low double-Bs without too much homework should be do’able. The CoCo bond market is still worth a decent exposure to. The risk to all this is how China plays out over the next several months and the contagion impact any further downside/event risk might have.

Let’s be careful out there….

Suki Mann

A 30+ 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 CreditMarketDaily.com.