3rd September 2017

Risk(y) business

iTraxx Main

53.3bp, -1.6bp

iTraxx X-Over

233bp, -3.2bp

10 Yr Bund

0.38%, +2bp

iBoxx Corp IG

B+109.9bp, -1.5bp

iBoxx Corp HY

B+298.4bp, unchanged

10 Yr US T-Bond

2.17%, +4bp

FTSE 100 (live) [stock_ticker symbols=”INDEXFTSE:UKX”  static=”1″ nolink=”1″] DAX (live) [stock_ticker symbols=”INDEXDB:DAX”  static=”1″ nolink=”1″] S&P 500 (live) [stock_ticker symbols=”INDEXSP:.INX”  static=”1″ nolink=”1″]

Low beta on the up…

Last weekend’s underground thermonuclear test by the North Korean regime will be the focus the markets as we open for business. It’s a new development in a rapidly escalating situation which could lead to something much, much more serious. In terms of focus for investors, it ought to have been the ECB that was afforded that privilege. So we’re likely going to be off to a defensive start on a quiet Labor Day opening session. And the ramifications of that escalation in hostilities will likely see equities down and safe-haven risk better bid again, in a repeat of how much of last month played out.

As for last month, it was the US non-farm payroll report that took centre stage at the end of last week, and the result of the August print will be felt for a while. The Goldilocks-like economic growth dynamic is still in play. Adding just 156k jobs in August against expectations of 180k coupled with lower than expected wage growth (0.1% versus 0.2% expectations) means that the Fed isn’t going to move this month.

Throw in revisions (lower) in the previous two months and the Fed could stay pat until year-end. So we’re going tighter in credit (hunt for yield), lower in iTraxx index as the cost for protection drops (defaults stay low/rating transmission risk limited), and likely higher in equities (funding costs stay low and policy rates lower for longer) – assuming the earnings story stays intact.

But reflecting on August’s performance, we observe that it was a recovery month for low beta risk assets. The geopolitical concerns around east Asia saw to it that returns perked up hard for government bonds and subsequently boosted low beta corporate bond portfolios. We think that this might continue to be the case as the US/North Korean situation continues to unfold, while markets grapple with the next Fed/ECB move – whatever that might be.

The government bond rally has seen to it that Eurozone sovereign returns (Markit iBoxx index) are now essentially flat year-to-date, having languished in negative territory since the start of the year. The trade for choice was to short government bonds into higher US rates, dragging Eurozone markets with them. Add into that the potential for economic recovery (everywhere) and ECB tapering, it was supposedly a ‘gimme’ trade. It might still be.

For now, they’ve been better bid through a difficult month on the prospect of something more than just sabre-rattling occurring between the US and North Korea, while that prospect for ECB tapering (they meet again this week) hasn’t been enough to promote higher yields in rate markets.

The rally in the underlying means that investment grade credit has been the other winner. That is, returns moved from +1.2% in the year to the end of July to +1.8% at the end of August. Spreads were wider by 8bp on the index in the month. But the level of returns will have met most full-year expectations already for this asset class.

Elsewhere, the high yield market saw cash index spreads 20bp wider in August, but returns edged up to 5.0% in the opening eight months. That performance is closely followed by sterling corporates where returns reside at 4.9% in the year so far following a strong August as Gilts rallied hard.

The AT1/CoCo index is still showing total returns of 12% this year on spreads almost 200bp tighter. And after 38bp of index spread weakness through August, we’re already in recovery mode as seen in the opening session of the month last Friday (a little tighter with barely any flow).

A more difficult time for European equities in August came on the back of that event-risk and a sharply stronger currency, leaving DAX index returns to drop to 5% this year so far, while the FTSE has been boosted to 4% in the same period. It goes without saying that a choppy month for the US has not sullied the market there with the S&P and Dow still up 10.2% and 11.1%, respectively, in the period to end August 2017!

More of the same for September

We’re inclined to keep beating the drum for corporate bond risk through 2017. September’s going to throw up much in terms of issuance and we don’t think that spreads will necessarily go wider on the back of it. The demand for paper is as strong as ever and inflows continue into investment grade funds. Assuming nothing disastrous happens on the geopolitical front, we think that a global economy blowing neither too hot or too cold will promote continued demand for corporate bonds.

Policy uncertainty will make for rate markets likely holding their current ranges. And tighter spreads with a supportive underlying means that corporate bond returns are possibly going to defy even the most optimistic of forecasts with which we set out 2017 with.

Investment grade spreads might have widened by 8bp in August to B+111bp (now 109.9bp), but yields on the iBoxx index have dropped to 1.03% (saw 1.00%) and have a good chance of breaking through the 1.00% barrier soon enough. We last saw that occur in October 2016, although the record low index yield of 0.79% (September 2016) is likely out of reach.

As for the high yield market, it might have had a worse time of it than IG given the closer correlation of this asset class with equities (which were choppy), but into calmer climes and now boosted by the potential for little movement in policy rates, we think the B+278bp record low level set just a couple of weeks ago on the index will be tested again (currently B+298bp).

As for the indices, a better session on Friday left iTraxx Main at 53.3bp (-1.6bp) and X-Over at 233bp (-3.5bp).

High levels of supply will not necessarily have a negative impact on spreads. If we get a €30bn+ month for IG non-financials it would also mean that macro and geopolitics will have been kind. We could also be looking at €5bn+ of issuance for high yield markets. That confidence gained from getting deals away will see us go tighter in secondary as new issues perform.

This week’s business ought to have started proper on Tuesday and then likely slow into the ECB press conference on Thursday. Our view is for no change and likely no new information regarding QE and tapering changes, either.

However, the nuclear underground test by the North Korean regime over the weekend suggests that we’re going to be risk-off as we open for business and might scupper primary expectations. Depending on how events play out on the geopolitical front, we ought to have a couple of busier sessions prior to the ECB press conference – while any hopes that the odd borrower try to get deals away today (Monday), even if the US market is closed, have likely vanished because of the escalating sense of crisis in east Asia.

Have a good day.

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

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.