La marcha de la renta fija

Chris Iggo, AXA IM - Viernes, 18 de Agosto

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Credit spreads continue to tighten, generating a positive excess return against risk-free bonds. The market remains supported by decent economic growth, very low rates, strong corporate earnings, high share prices and low equity volatility. There has been a lot of borrowing but many leverage measures remain below levels registered a decade ago, just prior to the financial crisis. So although credit spreads offer less compensation for taking credit risks, maybe the risks are low until either central banks become much more hawkish, growth slows or the equity market suffers a major set-back. Until then credit might keep on performing better than government bonds. Is credit rock solid? It’s hard to be too bullish but until there is more confidence in the fundamentals changing, it’s hard to be aggressively bearish either.      

 Jumbo – Recent corporate bond issues from the likes of AT&T, Tesla and Amazon have again illustrated just how strong demand for fixed income products remains. In a 7-tranche deal, Amazon raised 16 billion US dollars (USD) on 15 August just three weeks after AT&T printed its own 7-tranche deal of USD 22.5 billion. So far this year the total issuance in the US corporate bond market stands at USD 1.3 trillion with investment grade companies responsible for just shy of a trillion dollars’ worth of borrowing. Indeed, the mini-market wobble that was associated with the increase in US-North Korea tensions at the beginning of August seems to set up a perfect storm for the bond market – spreads got a bit wider thereby making bonds more attractive for credit investors whilst the overall level of yield was still low enough to tempt treasurers into securing long-term financing. For AT&T and Amazon, deals were done to finance specific acquisitions but for all borrowers the overall cost of long-term funding is still low. 

 

·         Tighter – Headline grabbing deals always raise questions about the market’s vulnerability. As readers will know, we have expressed concerns about the valuation of credit markets in recent months as spreads have fallen to 3-year lows in many credit sectors. In the case of the European high yield market, today’s average spread is now the lowest since before the great financial crisis and another couple of weeks of spread tightening will take the market to its tightest ever levels. However, taking a view on the market just based on a simple valuation metric like the credit spread has not been that helpful in predicting performance. Spreads have continued to narrow and investors have continued to buy. In the end, taking a stance on valuation should pay off but being defensive this year would have led to an underperformance against benchmark indices. For example, the BBB-rated part of the US corporate bond market has delivered a total return of 5.39% compared to just 3.5% for the AA-rated part of the market. High yield has outperformed investment grade and longer duration sectors have outperformed the short end (these observations based on the performance of Bank of America/Merrill Lynch bond indices).  

 

·         Good growth – So let’s consider a broader set of influences on credit bond markets. At the macro level there is little cause for concern. Growth is reasonable in all major economies. The US reported a 2.6% annualised growth rate for the second quarter, Japan grew at a year-on-year rate of 2.0%, the UK slipped a little to 1.7% growth, while the euro area accelerated to 2.2% growth. While there are concerns on the political side, the global economy is in rude health and there are few signs of a serious slowdown. In terms of monetary policy, central banks are on hold and it is not clear even whether the US Federal Reserve (Fed) will raise interest rates again this year given the weakness of inflation data. Markets have pushed out expectations of tax reform in the US but even that has not dampened investor confidence in the economic outlook. Meanwhile, Europe is finally benefitting from years of austerity and painful reform. A fact highlighted by the strong performance of the euro in the foreign exchange markets since the beginning of the second quarter of the year. According to the Bank of England’s estimate of the euro trade weighted index, the currency has rallied 8% since mid-April.

                                

·         Less debt stress – At the macro level we should not only consider the cyclical position of the economy. It is also important to look at aggregate trends in borrowing. After all, a rise in aggregate leverage was a characteristic of the period prior to the crisis. At the total economy level, according to the Fed’s ‘Flow of Funds’ data, total debt growth has been rising steadily since 2009. However, the growth rate has been much slower than during the period prior to the crisis and has more or less been in line with nominal gross domestic product (GDP) growth whereas debt growth was in excess of nominal GDP for most of the two decades before 2008. As a percentage of GDP, non-financial corporate debt is slowly getting up to the level it reached in 2008 but obviously companies are less leveraged overall because of the much lower cost of debt funding. On the household side there does not seem to be much to worry about. Mortgage debt has been falling as a percentage of GDP since 2009 while house prices have been rising since 2010. These two measures going in opposite directions is quite unusual as the thirty or so years prior to the crisis saw both leverage and house prices moving in tandem to ever higher levels. According to Fed data, total household debt is some 20 percentage points of GDP lower than in 2007. So although the US is still a high-debt economy, the aggregate picture is mixed with households less leveraged than they were 10 years ago and the corporate sector marginally less leveraged, in terms of debt/GDP, than it was at the peak of the last cycle. The domestic financial sector has also seen much slower debt growth while Federal debt growth has also been slowing after its surge in the immediate wake of the financial crisis. The sobering thought here though is that total debt in the US still represents 330% of GDP compared to a peak of 370% in 2009. No wonder people are worried about rates going up.

 

·         Risks – At the asset class level, the macro assessment is a key input into the fundamental valuation of credit markets. So far we can conclude that the macro outlook is not a threat to credit markets at the moment. Growth is reasonable, inflation low, interest rates very low and there are few signs of excessive leverage at the macro level, at least in the United States corporate sector. Things don’t look quite so good when we think about sovereign bond markets because, like the US, few countries have been able to reduce their debt levels significantly. The United States itself could be heading towards a fiscal crisis if President Trump is not able to manage a deal with Congress on raising the debt ceiling later this year. This is perhaps one of the key near term risks to markets, along with the general unpredictability of the US Administration on both the domestic and international fronts. 

 

·         Watch equities – However, back to credit spreads. One theory of corporate credit risk argues that the credit spread is equivalent, conceptually, to the premium of a put option that the investor sells to the issuer (borrower) with the risk that the option is exercised should the economic value of the company fall below the level of its outstanding debt. Equity owners (conceptually the buyers of the put option) exercise the option through the act of default, putting the ownership of the company in the hands of creditors and leaving them to try and recover some of the value through asset sales or restructuring. So as credit spreads get lower this is the conceptual equivalent of the option premium falling which reflects a lower probability of default. This risk of default is driven by factors such as leverage and the market value and volatility of equity. So at the aggregate level, all things being equal, a rise in corporate borrowing as a percentage of earnings or GDP would be a negative sign for credit spreads as would an increase in measures of equity volatility (falling in equity market value). Where are we today in the US market? Corporate borrowing has been on an increasing trend even if the leverage ratios are not at alarming levels. Debt to GDP is below pre-crisis levels and net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) for the S&P500 as a whole is well below where it was in 2007 (although debt measured against earnings rather than EBITDA is higher – I’ll leave that one for the corporate accountants to figure out).  On the equity side volatility is low, the VIX (Chicago Board Options Exchange’s volatility index) did spike in early August but has been moving back down again. The level of debt relative to the market value of equities is also much lower than in 2007. However, a sharp increase in volatility and a significant market correction in equities would inevitably and rightly move credit spreads wider.  Are equities overvalued enough to make a large market correction likely? Many would argue yes but they have for some time. The S&P500 is trading with a price-earnings ratio of 21.2 times which has been steadily increasing since 2011. Earnings are strong and earnings growth forecasts for the S&P500 and other markets remain elevated. However, it must be said, that credit risk option premium is very low, equity valuations are very high and equity volatility is low at a time when corporate leverage is moving higher.  A scatter chart of the US high yield spread and the level of the VIX shows that both are at their lows and that the relationship is such that if the VIX goes up, so will spreads. Putting it another way, things don’t get much better for credit than they are today.

 

·         Technicals a worry – That notion of credit being rock solid is perhaps a reason why sentiment in the credit markets seems strong.  It must be otherwise investors would not keep on buying new issues at lower spreads. More broadly, investors would not buy bonds in general at very low or negative yields if sentiment towards fixed income was poor. Central banks are doing a good job at not upsetting investors while the aforementioned fundamental and macro outlook is reasonably benign. A change in sentiment is unlikely to be a random event, it will be triggered by either a political or economic shock that impacts on the forward growth and earnings outlook and thus the valuation of equity markets. A deterioration in sentiment will lead to selling. It is this technical picture that is perhaps the most worrying and misunderstood part of the puzzle. Did the Amazon deal go so well because index investors, including ETFs, needed to buy it to maintain index weightings? Can markets cope with a negative liquidity event should those flows that have gone into credit markets through ETFs reverse? Is part of the technical nature of the bond market related to monetary policy and the fact that interest rates are zero and investors have been crowded into bonds? I think some of these things are worth being concerned about because they will exaggerate a move when the fundamentals eventually change.

 

·         At these levels, caution prevails – The markets are expensive even if macro and credit fundamentals are still supportive. Work we have done across credit sectors suggests that the risk of underperforming government bonds is significant given where spreads are but that this will only be realized if there is an increase in volatility. Calling for additional spread tightening today relies on either a strong view that the technical forces behind credit markets will remain strong (central bank liquidity provision, strong index-related inflows) or that the fundamentals will get even better (earnings growth and higher equity valuations). And of course there is the interest rate risk. Central banks appear to have turned more dovish again during the summer but there are plenty of economists who are arguing that US inflation will begin to rise later this year and that will bring the Fed to hike rates again, as well as begin the process of balance sheet reduction. Typically higher interest rates would be associated with lower credit spreads but given the level of spreads today there may not be enough of a cushion to allow this to happen, especially in investment grade markets. So higher rates will lead to weaker total returns. But again, is it likely to happen anytime soon?

 

·         Waiting game – There may not be any immediate reason to look for the credit risk premium to rise significantly. Growth is unlikely to fall off a cliff and the corporate sector has a healthy balance sheet. One tranche of the Amazon deal was a 40-year bond that was issued with a 14 basis point spread above US Treasuries. Held to maturity that would provide a compound 77% better return than owning the equivalent US government bond. Clearly many investors find this attractive and are happy to be a creditor to an online retailing giant that is increasing market share of consumer spending. For more active portfolios, however, there is a clear risk that the market will not stay so benign and marked to market losses will be experienced. Believing the market expensive requires managers to be hyper sensitive to any evidence that the fundamentals are changing.   

 

·         United are back? – Any sensible fan knows not to make too much of the opening day of the new season. However, I must say I had a very warm glow after watching Manchester United beat West Ham last week (and not just because I was watching it in Mallorca). The two new boys, Lukaku and Matic, played very well and Pogba looked like a world class player at last. Early days of course and I am sure it will be as competitive as always at the top of the Premier League, but allow me some indulgence after 4 disappointing seasons. Next up is Swansea who have just sold their best player, so roll on Saturday lunch-time.

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