4th July 2016

State of Independence

FTSE 100
6,578, +74
9,776, +96
S&P 500
2,103, +4
iTraxx Main
iTraxx X-Over Index
10 Yr Bund
-0.13%, unch
iBoxx Corp IG
B+151bp, -2bp 
iBoxx Corp HY Index
B+501bp, -9bp
10 Yr US T-Bond
1.44%, -3bp

Mexican stand-off fails to dampen spirits…

UK-GovernmentThere is a stand-off on the political front, with the EU refusing to negotiate until the UK invokes Article 50 while the UK is delaying this trigger until it is ready to do so. But the markets for now are done with their delirious – if not predictable – reaction, and there has been a bit of a decent, albeit mixed, recovery. This is one “event” we should all have been prepared for. Equity markets are or have recovered and oil (Brent) is still holding $50 per barrel, while government bond markets admittedly remain circumspect and are still better bid for choice. Mind, growth expectations have been downgraded, so it’s “lower for longer” and with the ECB possibly coming in for more, yields look anchored here, at worst.

Admittedly, the corporate bond market shut up shop for the best part of two weeks and is only now showing tentative signs of reopening. We dare say that we will have a few more difficult periods. After all, the UK will now go through the process of selecting a new Prime Minister, the UK/EU negotiations are due to start in earnest thereafter, and there will be pressure elsewhere for other referendums possibly to follow, and so on. We can also anticipate some hits to second and third-quarter growth as the uncertainty unleashed by the UK referendum results in lower investment, orders, perhaps lower consumer spending and the like. We’re not taken in by the “blame it all on the Brexit” brigade: as we suggested in our comment earlier this week, this would have happened anyway, just not so abruptly. The fuse just shortened.

It’s political, not systemic

For now, this is potentially still only a political crisis and it does not necessarily have to become a systemic one. There’s little sign that it will. The central banks saw it coming and have reacted accordingly and swiftly, although the arsenal at their disposal hasn’t been used. And we have bounced back sharply, with the market’s most liquid and visible risk proxies – equities – seeing some excellent interest as bargain-hunters enter the fray. Some will use the bounce to reset shorts and while there is always the possibility of a shock event derailing us again, we believe the big move has likely happened. That said, the nerves are frayed and safe havens are still in vogue, as evidenced by the refusal of government bond yields to jump higher. The 2-year Bund yield is at -0.66%! It’s been lower, but there’s trouble in paradise for it to be at these levels. The 10-year Gilt is still well-below 1% (record low 0.88%) and the equivalent Bund is anchored at around -0.10% (and the 15-year maturity benchmark went negative too, for a short period), while the whole of the benchmark Swissie curve is negative-yielding.

As for corporate bonds, the ECB has lifted just shy of €5bn in two weeks, which has surely helped support the IG corporate bond market and reduced material weakness and much volatility. It will continue to do so. Investors know there is a rock solid backstop bid out there and will have been comforted by that, especially while other markets were in freefall on Friday and Monday. Once upon a time, the cash market would also have been hammered and we would have had sellers into the poorest of bids, followed a scramble to recover positions as markets calmed. Not so now. There’s a safe-haven feel to corporate bonds, and there has been since this crisis began. Our sell-off – prices marked down – was predicated on defensive Street bids, with low volumes and flows and, to be frank, a fairly decent willingness to add paper. It has just been difficult to get hold of anything (the Street, flat risk, is refusing to short, and there are few sellers). Corporate bond markets are outperforming

It’s all over, time to enjoy the summer

The extraordinary open to 2016 was bettered by the two sessions following the Brexit vote, leaving June as the most astonishing of months. Massive equity volatility, Bund yields up to 10-year maturities in negative territory, oil recovering to hold around the $50 per barrel level and the ECB containing any fallout which might have been expected from Brexit-related volatility to make the corporate bond market a relative oasis of calm and thereby a winner. Mind, the primary markets were pretty much closed for business with just €11.1bn issued in IG non-financials – after €45bn+ in May; senior financials fared as badly with just €8.8bn issued, while surprisingly the HY market was in better form and saw €5bn of prints. Almost all that issuance came in the opening two weeks of June, as the upcoming UK referendum and central bank meetings got the better of the market’s nerves.

Staying with primary, July’s issuance levels will be difficult to judge. There is calm in the markets at the moment and one could argue that there is a backlog of borrowers needing or wanting to get deals away. July can be a mixed month – we have seen high issuance levels into the holiday period, and we would not be surprised if we see some decent levels of supply into the first two weeks, possibly three. When they do print, the question and dilemma is going to be around the new issue premiums. We think that the first few out of the blocks will be coaxed by syndicates to offer a significant concession and a “let’s see how it goes” strategy, hoping to ratchet pricing depending on the demand. It makes sense, and that sort of pragmatism can install greater confidence into the market if the deals are successful (as defined by oversubscribed books and good performance in secondary on the break) and then coax other borrowers into the market.

Rally into month-end helps boosts performance

The prospect of an imminent rate cut thrust the FTSE into delirium as we closed out the month, doing away with the Brexit fear plunge – or rather because of it. That was a great week in many ways. The FTSE is now up a stunning 4.2% for the first 6 months of 2016, clearly boosted by the rate cut musings from the BOE’s Carney last week. As for the DAX, this index is down almost 10% in the same period, while the S&P500 managed to claw its way back into the black during the final week of the month to return 2.8% in the 6 months to end-June.

And in government bonds, it has been incredible. Record lows everywhere! 10-year BTPs at 1.11%, Bonos at 1% flat (having been lower) and Portugal back below 3%. JGBs the same, with record lows. In Europe, the ECB is coming and its trolley is bigger. Dumbing it all down to zero? You heard it here first. That rally in the final sessions into month-end ensured that returns for the month and 6 months would be fantastic. And they are. Eurozone government bonds have returned 5.3% in this opening period.

The rally in government bonds into month-end also helped returns improve in the corporate bond markets, making the month-end numbers look excellent here too, and might even help some investors steer more cash into the market. There’s still some yield to be had after all, especially after the rally in peripheral governments. There certainly will not be – nor have there been – much by way of outflows. So returns are being boosted by the rally in the underlying, but we think the ECB’s heavy lifting is soon going to squeeze liquidity further in corporate secondary, such that spreads will need to respond much better than they are doing at the moment. At over B+150bp, the Markit iBoxx IG corporate bond index has some way to go before it hits our year-end target of closer to B+100bp. We think it can still get there and we might see a more sustained tightening trend now that the coast is clear in terms of potential major negative events (or otherwise) for several months.

Anyway, we closed out June with IG returns sitting pretty at a stunning 3.9% and with spread tightening barely contributing to those returns. We think 5% is now a reasonable target to aim for given we look for yields to remain at around these levels but do expect that spreads are going to ratchet tighter. The index yield has dropped to below 1.20%, and our 1% target is also now within range. In high yield, returns have been sullied a little by the equity sell-off introducing some contagion-related weakness into the sector, but they are still up at a respectable 3.1% YTD.

Sterling corporate returns are up at a stunning 7%. Spreads have edged wider over the past couple of weeks, but they have not fallen out of bed. The longer-dated nature of the sterling corporate bond market has been the biggest contributor to the super performance from a total returns perspective, and returns in this market currently sit atop the aforementioned pile of asset classes.

The world is still bedevilled by macro but now also by the longer-term repercussions and implications coming from Britain’s decision to leave the EU. However, the status quo is sustained by the prospect of further easing – be it rate cuts and/or more QE from the BoE and the ECB, or no tightening in policy in the US. To play into that, any additional liquidity being injected into the financial system will sustain asset bubbles. For instance, low yields for longer will play directly into the hands of corporate bond investors, while a continually low default rate will also sustain confidence in that trade. Go with the flow. We closed Friday with the IG index rebalancing over month-end and the spread down at B+151bp while the yield on it fell to 1.13%. It was a similarly upbeat session in HY with index spreads lower at B+501 (-9bp) and the yield down at 4.54% (also 9bp lower).

That’s it. It should be very quiet given that it is July 4. Back tomorrow.

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.