For investment grade corporate bonds it will be the rate move that dominates total returns short-term
30th September 2016 by Chris Iggo
One of the fundamental implications of quantitative easing (QE) in the bond markets has been the impact of pricing of the highest quality bond assets. Investors pay a cost (in terms of reduced yield) to own the safest of assets. But increasingly they get pushed down the credit curve so over time ratings buckets become increasingly expensive one after the other. It’s happened to a very large degree in investment grade markets – especially in Europe where QE continues – yet in the lower rated sectors of high yield there are very clear differences in risk premiums still. If you want return, you have to be down the credit curve and hope that the waterfall effect of portfolio shifts driven by QE prolong and extend the credit quality compression. If credit generally is to keep outperforming then it’s the most credit-like assets that have to perform.
- Quality – Global high grade bond returns have essentially been flat since the middle of the summer with the exception of the UK market which got a boost from the Bank of England (BoE). Higher yielding bond markets have continued to perform with investors being rewarded for exposure to high yield and emerging market bonds. This is of course a reflection of the impact of QE. Higher rated bonds which are eligible for central bank purchases have become very expensive, such that higher yielding bonds are attracting investors and are still seeing capital gains. There is a waterfall effect as the wave of asset allocation shifts to the next best rated asset class. Furthermore, in Europe at least, the preponderance of negatively yielding bonds means that there is a limit to how much highly rated investment grade spreads can be reduced further – after all, investors do want a positive yield on corporate debt, no-one is in the business of lending money to companies for a guaranteed loss. So we have a situation, particularly in European bond markets, where additional performance can only really come from the narrowing of quality spreads – i.e. spreads on lower rated bonds converge towards higher rated bonds. This has happened to some extent. For example, the spread between BBB rated (investment grade corporate bonds) and BB (highest rate high yield bonds) has narrowed from over 250 basis points (bps) in Q1 to around 170bps today. However, these quality spreads are not at the levels we saw in 2014 when the BBB-BB spread went below 150bps. For credit returns to remain positive, these quality spreads need to decline further and bullish strategies on credit should really be focused on higher beta positioning. The real risk on strategy in this market would be to invest in a portfolio of the lowest rated corporate bonds – CCC high yield – where the spread versus AAA rated is still almost 1000bps! Essentially this is a trade based on a view that the technical position generated by the European Central Bank’s (ECB) ongoing purchases will diminish risk premiums even more.
- Rates – Credit markets have generated positive excess returns relative to government bonds 50% of the time this year, with January-February and May-June being negative markets for credit, resulting from bouts of concern about global growth. However, year-to-date the performance is positive in Europe, the UK and the US. In my team’s recently concluded quarterly fixed income strategy meetings we retained a positive view on the fundamentals for credit but saw little scope for high quality spreads to narrow much further given the very low level of overall yields. So, again, any overall performance in credit markets will come from a flattening of the credit quality curve and this leads to a preference for high yield and emerging market debt. The main risks to this, and to overall fixed income returns in the period ahead, come from rates and concerns about financial stability and the particular situation of European banks. On rates the main risk is from a steepening of yield curves. In the US this would come from the Federal Reserve (Fed) moving ahead in normalising interest rates. It certainly has plenty of macro data to draw on to justify further tightening, including trends in the labour market and with prices. Steeper yield curves elsewhere could come about partly because of US market moves but also because of better inflation trends and policy uncertainty. Even though our conclusions on fiscal policy that we should not get too carried away in the short term, the fact that central bankers are increasingly stating that they have done as much as they can with monetary policy and it is time for governments to also increase spending is a reason to price in some policy uncertainty for the future. We also think inflation will be higher in 2017 so that also points to some upside risks for yields and for wider break-even inflation risk premiums in the US and the UK. For investment grade corporate bonds it will be the rate move that dominates total returns in the short-term and only if rates are reasonably stable will credit contribute through the carry that is still available on the asset class.
- Risk – There is also the potential for risk off. We have discussed the political event risk at length and the precise risks for bonds and currencies of a Trump victory in November are still being considered. On the one hand his inclination to use aggressive fiscal tools should send Treasury yields higher, but his aggressive stance towards foreign relations could also create volatility in risky asset markets and in the dollar. If you really want to be concerned about things that might accompany a more confrontational US with Trump in the White House then let’s think about tit-for-tat corporate fines, potential for foreign investment from US Treasuries, volatility in oil markets, rotations out of foreign market focused corporates as a shift in attitude towards globalisation increases the cost of foreign trade, and so on. Beyond that, and perhaps somewhat conditional on the state of affairs in Washington at the time, are the important elections in France and Germany in 2017 at which the future of the European Union will be central.
- Government – Bankers claim that their lives have been made difficult by increased regulation and low or negative interest rates. This is undoubtedly true. However, a critic would say that many parts of the industry have failed to adapt to the new regulatory environment, to the new political environment with regard to risk taking and to the challenges of disruptive technology. Retail banking appears to be doing this but investment banking has not done enough to reduce expensive fixed cost bases and run-down legacy business. Areas like market-making have been transformed by both regulation and technology and increasingly banks are being crowded out of the intermediation business in trading markets. Corporate activity is subdued, especially in Europe, so fee income is not what it used to be and regulators are more watchful of creative financing to support M&A activity for example. Equally, there could be more government aid to help the sector clean up balance sheets – it is just that someone somewhere has to take a hit on assets whose intrinsic value is far less than par (there have been some examples of secured Italian bank assets being sold at extremely deep discounts to book value). More of this needs to happen, there is plenty of risk capital that would buy discounted cash-flows on troubled assets, but it probably needs more government help. Otherwise we face many more years of concerns about capital ratios and zombie business models. It is not the case for the whole of the banking sector, but the systemic nature of banking, the relationship between banks and sovereigns and banks and corporates, means that it does not need to be the whole sector to cause significant concerns for financial market stability. It would be really radical if the ECB increased its buying of structured assets to facilitate the process but again, there has to be an incentive for banks to accept a huge haircut to book value in that securitisation process.
- Portfolios – I began this week with a comment that global bond returns had flattened out. I don’t see this changing. Indeed, the risk is to the downside. September has been a mixed month. High grade government and corporate bonds are flat to lower, as are high yield sectors, while inflation linked have outperformed. This may be a canary signal – markets starting to be more convinced that the inflation cycle is turning. Our conclusion is to be more cautious overall in fixed income, limiting duration exposure because of the risk of higher yields, reducing the beta in high quality credit names where spreads are compressed between AAA and BBB buckets, but with some remaining exposure to high yield and emerging markets where there is still scope for spreads to move lower. However, this is more about momentum and technical at this stage and this a view that has limited conviction. We are in a well advanced business cycle and rates have been extremely benign for some time. Credit fundamentals are not likely to get that much better unless we see a very rapid increase in top line growth and, even then, we would be concerned about a re-leveraging process. Perhaps we are back to the favoured bar-bell strategy- short duration in lower rated high yield bonds combined with a flight to quality risk hedge in long dated Treasuries.