3rd January 2016

Outlook 2016: Sunrise or sunset

Selected CMD Forecasts
Source: Markit, Dealogic, forecasts CMD
2015 (Actual) 2016 (Forecasts)
IG corporate spreads  B+154bp (+44bp)  B+130bp
HY corporate spreads  B+528bp (+93bp)  B+440bp
IG non-fin corporate supply  Eur265bn  Eur250bn
HY corporate supply  Eur48bn  Eur40bn
Senior bank supply  Eur195bn  Eur180bn
 CoCo/AT1 supply Eur10bn Eur30bn
10-year Bund yield  0.62%  0.40%
IG corporate bond returns  -0.80%  +1.5-2.0%
HY corporate bond returns  +0.5% +5.0%

Overview: Keeping expectations tempered… Greetings and a happy New Year to all our readers. Let’s start by acknowledging a thoroughly depressing end to 2015 for risk assets. The markets were in a right pickle through much of 2015. We go into 2016 faced with commodity prices at multi-year lows, an uncertain direction for equities and credit spreads under some widening pressure with over-stretched credit funds liquidating assets/closing down, ultimately leaving a fear in many quarters of the potential unfolding of a 2008-like systemic financial crisis. And this time, all because of the lack of a secondary market ‘liquidity’ dynamic – many have been concerned about it impacting the risky-end of the credit market and it has been causing much angst, fear and panic. So can the arch credit bull look at 2016 for the asset class as optimistically as ever? Unfortunately not this time; we are hamstrung with worsening illiquidity everywhere (we need to be able to ‘trade’) and beseiged by a plethora of many other difficult situations, taking in macroeconomics and political and regulatory event risk – and with no historical precedents with which to make effective comparisons. We’re in the dark to some extent – and the markets hate uncertainty. However, in relative terms versus stocks and government bonds (perhaps commodities too), the corporate bond market does offer defensive characteristics. And needing to stay cautious in 2016 means that there is still a strong case to be made for corporate bonds. Because we must be looking as much as ever to preserve capital as the overwhelming modus operandi of the investment process. Stocks, commodities, perhaps FX, offer liquidity (and quick entry/exit channels) as well as the potential for huge capital gains, if one gets the trade right. But we do not see an obvious macro trade in there. There are too many unknowns to contend with – moving parts like the US vs Europe, US vs EM, the US itself, China, non-uniform directional interest rate policies, uncertain growth outlooks, little sign of inflation, ongoing commodity pricing pressures, difficult geopolitics and high (and rising) leverage levels, all combining to leave the economic cycle disjointed. We can throw in manipulative central bank policy distorting asset prices: the list is long. That said, the simple maths supporting a bullish case for corporate bonds would see credit in euro IG return upwards of 3.5% on 40bp of spread tightening (though even that would not recover last year’s spread weakness). But those returns are unreachable. One’s money back at maturity and some coupon income in the meantime should be.

Sorry end to 2015 for most… The poor end to 2015 saw oil and gas returns down by 30% or more. Equities gained much but gave up more, and many bourses ended the year in the red. The CAC and DAX were in the black (+8-10%!), but the FTSE, Dow and S&P 500 for example were all in the red. The Markit iBoxx eurozone government index closed with returns up at 1.35% owing to the ECB’s largesse, helping peripheral bonds in particular. In credit, corporate bonds had a torrid time of it. IG spreads (Markit iBoxx) were 44bp wider against our expectations of 20bp of tightening. HY spreads widened 93bp against an expected 50bp of tightening. Returns saw HY in Europe up 3.5% at the best point, but they closed out the year up only 0.5% as the rally was blasted away by the US HY contagion impact. IG corporate bonds were up 1.7% on a total return basis in Q1, but gave that all up and some more, to end in the red at -0.8%.

Another difficult year ahead on the macro front… Globally, the OECD growth forecasts come in at a disappointing 3.3% or even lower, principally with uncertainty around China, the majority of EM space (especially South Africa and Brazil) and, of course, the eurozone. China (OECD growth forecast 6.5%) is probably the canary in the coal mine given its importance to international trade (which is dropping) and the slowing in domestic imports, as well as the multi-year internal rebalancing its economy is embarking on. The US is forecast to grow by 2.5%+ and the eurozone by an ambitious 1.8%. Even if we get 1.5% GDP growth in the eurozone (the ECB itself projects 1.7%), this will not be enough to make a material dent in the historically high unemployment rate and will still leave inflation well below target levels. In the eurozone, we think more QE will be needed in due course. The 2015 closing data releases may have been better than expected, but the whole area is still prone to lapses, leaving it difficult to be certain that a definite recovery trend has been established. Labour markets might tighten in some countries, but there is still a clear barrier to them indulging us with higher wage growth (the UK being a good example). We have the British referendum on eurozone membership to contend with and will continue to be faced with a whole host of other geopolitical risks, in particular around the situation in the Middle East. Politics in Spain have been transformed with a (likely unstable) coalition government, leaving much uncertainty and asset price volatility. Global M&A has had a record year in 2015, but much of it was around the pharma/commodity/food industries and in/or around the US; we had little of the transformational, huge leverage-driven M&A in the broader industrial arena, especially in the euro area – which typically frightens credit investors. That is unlikely to change much in 2016. With balance sheet integrity still utmost into macro uncertainty, we believe capex and investment will stay at lower levels while low or declining oil and commodity prices will see to it that that the commodity sector’s contribution to overall investment is on a multi-year downtrend. Overall, macro risks are to the downside (the IMF warned on global growth only last week), with oil, equity, FX and general market volatility likely to leave sentiment towards corporate bonds as cautious to say the least.

Corporate bonds still exhibit defensive characteristics in 2016 … After the VW scandal; the commodity sell-off impacting equity and debt valuations at the likes of Glencore and Anglo American; and a market deprived of any meaningful secondary market liquidity, which is a constant source of frustration, it’s a struggle – on the surface – to make a case for corporate bonds. But, as suggested above, a belt-tightening capital preservation strategy with a bit of income is how to play out the likelihood of an uncertain and difficult-to-predict 2016. That’s because the economy is not going to break out of its current low growth malaise, rates are not going higher (save perhaps in the US), yields are going to stay low and corporates will remain defensive. It does not help that there is no “traditional” economic cycle as such. There can’t be: we have effectively zero-bound growth, high leverage levels everywhere and little or no inflation. And, in Europe anyway, a 12-month forward default rate of less than 3%! The ability of IG and double-B rated corporate sector (perhaps even solid single-Bs) to service their obligations remains steadfast and still the best it has ever been. That’s one of the upsides of hoarding cash, cutting costs and refinancing into this low-rate, low-spread regime where investors have piled into an asset class offering and supporting the characteristics listed above (income and preservation).

Primary market to offer much of the same… First, to the numbers for 2015. IG non-financial issuance came in at Eur264bn, making it the second best year ever (according to data supplied by Dealogic). US-domiciled borrowers accounted for around 25% of the total, which was a record: the long-term average has been around 15%. We look for a similar level in terms of total IG issuance, where Eur250bn+ has been the average for the past 3 years, and we would not be surprised if US borrowers are again more prevalent than usual given the difference in rates between the two regions. Redemptions again come in at over Eur200bn, which is the average of the past 5 years. We had Eur49bn of HY supply and that also made for the second best year in the history of the fledgling euro HY market. We would not expect to beat this level in 2016 on the back of the contagion of the weakness in US HY affecting sentiment here, with the primary market likely to be closed for long periods as a result – much like it was in 2015. In senior financials, Dealogic data shows Eur195bn of supply, still down almost 50% on the halcyon days of 7-8 years ago. Banks don’t need the cash: the opportunities are more limited and fraught with risk, so they take less of them. We have been surprised that only Eur10bn or so of CoCos were issued. Admittedly, there is some regulatory risk (as in the case of Switzerland recently), but banks have failed to convince investors through more difficult climes that there is a case for AT1 risk. Still, Eur10bn is a disappointing effort, especially set against expectations of Eur40bn+, with another $50bn+ expected in dollars. For 2016? We need calm corporate bond markets, regulatory certainty, declining spreads so the all-in cost of funding is more palatable and some uniformity in structure to help make effective comparisons.

The case for and against HY in 2016… The case against is simply the US HY bond market. Routed on the back of the shale industry’s demise and potential further more significant defaults, there is a clear contagion impact elsewhere in the US. Unfortunately, the headline figure of an 8-10%-like default rate does impact sentiment. And we have seen how weakness in US HY bond markets still has a very contagious effect on markets elsewhere. We lived through it in 2014, we saw it clearly in 2015 and unfortunately, we will see it again – if it happens – in 2016. This is one market which fails to distance itself from the dynamics and valuations in the US. We ought not to follow it. The context is different in Europe. The default rate is low, there is less issuer concentration risk now as the market has developed and grown, the refinancing wall is 2-3 years away, the funding route is (usually) open and the market has survived, grown and thrived while Europe has had to handle its worst economic period in decades. Rate risk is de minimis, we’ve had record supply over the last 3-4 years, outflows from the asset class are on the up but manageable, there is no global financial crisis (yet) and as spreads back up, index yields at over 5% in a low rate/yield environment make it all look attractive again. Alas, poor secondary market liquidity and the investor herd mentality are likely to keep us pegged to the fortunes and trends of the US market. Mature market in Europe? Seems not. That is, a consistent Eur50bn of issuance per year for the past several years is no measure of maturity, as it hides many ills such as the market being closed for long periods on several occasions. However, with the front end of the underlying anchored and likely not going anywhere given the ECB’s shopping programme, 5%+ returns in 2016 are “theoretically” possible. The index yields 5.31%, spreads are at B+528bp and a small tightening/widening from here through the year makes this look an attractive opportunity. Stay with the better names – hybrids of IG senior-rated corporates, widget makers with a business model in place to withstand a sustained period of weakness. And be prepared to see valuations suffer – just like elsewhere – but be comforted that coupons and principal are (mostly) protected.

Secondary market liquidity a thing of the past… Admittedly, liquidity is never available in crisis mode, and over these crisis-fuelled years the Street has become ever more adept at pulling in its horns at the first hint of trouble. Any subsequent forced selling exacerbates the downside price action and frustrates investors, and the contagion is usually unforgiving. It’s been no different this time with those fund closures. For many investors looking for income and capital preservation, corporate bonds have offered just the place to park cash. Rather unfortunately, that means one is increasingly a “buy-and-hold” investor. That’s because the ability to trade (in size) and at a reasonable price has long gone, leaving us increasingly locked into positions. Heaven forbid idiosyncratic event risk à la Volkswagen or a sectoral situation emerging and blighting performance as has been the case with the commodities sector. And all that is with no widespread (financial, systemic, or other) crisis. So secondary market liquidity will not return – the politicians and regulators have seen to that. We need to get used to it. The central banks will not buy equities or corporate bonds should disaster strike. Do your credit work.

Hopes and risks… The hope is that the economy can go another year without keeling over. That rate policy stays benign and government bond yields remain at these low levels or go a little lower. That there is no obvious rotation trade, nor much by way of outflows from euro-denominated European credit funds. We will always get idiosyncratic situations afflicting certain names, but let’s hope for nothing of the Volkswagen ilk in terms of borrower size or importance. There ought not to be a systemic crisis, as the central banks will react to the potential for one arising. They still have some ammunition left. And we look for a steady spread tightening trend through 2016, with sentiment and confidence holding sway for corporate bonds. The risks are clear. The chances are that commodity prices will continue to fall, leading to volatility in equities, US high yield and the dollar, and event risk in commodity-dependent sectors. The US rate outlook is volatile, with anywhere between two and four further hikes being talked about. Two would be acceptable, but we can’t see four increases right now. Some will bet on the Fed cutting again – they have form – but only if the US economy fails to offer a sustainable growth trajectory. The uncertainty around each meeting is a cue for further apprehension, market volatility and thus inactivity. Middle East geopolitics have a part to play we think; the Brexit vote might too. China though could be the biggest of all risks, with the growth and investment theme quite possibly having a binary outcome.

Positioning… The 2-year Bund ought to keep setting new record lows, the 10-year we think will see 40bp or lower at end-2016 (0.56% currently) and peripheral yields will drop more, with Italy outperforming Spain again. We think credit spreads have backed out too far and while we don’t envisage a ratcheting tighter in spread markets (we would need equities materially higher too), we can expect moderate tightening through 2016. A 20bp tightening this year, with underlying government bonds at worst showing a small increase in yields, would leave anywhere between 1.5% and 2% in total returns. More than 20bp spread tightening (needing an oil price recovery, raging equities and so on) and we would be looking at 2% or more in returns. We find it difficult to see upwards of 2%, but more up to 1.5% for a portfolio with a beta slightly greater than 1.0. Unfortunately, the risks in corporates have increased from continued low commodity prices, greater exposures built to emerging markets and of course, there is always the potential for increased idiosyncratic situations. We would advocate a slight bias for financials and therefore move to a small verweight in them vs underweighting corporates. That is, underweight the commodities sector and neutral/underweight autos, with an overweight in telecoms and utilities – particularly through their hybrid bonds. We would look for a bias towards triple-Bs and solid double-Bs, with a portfolio duration slightly longer than benchmark. This is similar to what we advocated in 2015, except that we don’t see the need to go into single-B high yield given there is enough yield higher up the food chain and single-Bs will feel any US HY contagion with greater severity. For the brave, some opportunities have opened up with the likes of Glencore and Casino (one could add the likes of Brazil Foods), where yields are well into the trough of the single-B curve. As for financials, they are still in capital-building mode and de-risking their balance sheets. We would go down the capital structure in tier 2 and old-style tier 1 paper (these should be long-held positions for most anyway) and retain CoCo exposures (CoCos were pretty resilient during last summer’s sell-off) in a few of the higher-rated banks to help boost returns. And finally, there’s no need to get involved in the emerging markets.

On a housekeeping note, we have added a series of new pages tracking the recent history of corporate bond issuance in the euro markets, with data supplied by Dealogic.

Good luck. Happy New Year. Back Tuesday morning.

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.