US high grade bonds – fading romance?

Mid-Week Bond Update

US high grade bonds – fading romance?

US highly-rated corporate bonds delivered on Valentines’ day a present that investors should have loved: their spread over US Treasuries fell to 119 basis points (bps), the lowest since November 2014. However...

that didn’t prevent an overall 5-day loss, given the rising yields of the US government bonds that the asset class uses as a base. There is more: their precipitous 96-bps compression over the past 12 months is raising questions about the sustainability of the rally and some of the sectors’ fundamentals (read more below). High Yield (HY) and Emerging Market (EM) bonds, however, posted another week of gains as their traditional higher coupons can better cushion the rise in Treasury yields, which they also use as a base. Their surge was also backed by further White House talk about changes in fiscal policy, aimed at igniting economic growth.

The general optimism was also underpinned by positive Japanese growth and above-expectations inflation and export data from China. The buoyant mood continued to lift equity markets, commodity prices and EM currencies, especially those linked to soaring copper and aluminium prices, such as the South African rand or the Chilean peso. Such positivity pushed US Treasury yields higher, with the 10-year yield reaching to 2.51%, the highest so far this year. The increase was also fuelled by strong US inflation data: the Consumer Price Index jumped 0.6% in January, the fastest pace since 2013. US Federal Reserve (Fed) chair Janet Yellen also told Congress that waiting too long to hike rates would be unwise, a comment that some investors described as hawkish (this was expected by Western Asset’s John Bellows – click here to know why). European sovereign bonds were practically flat, as increasing uncertainty over the forthcoming national elections in France, Germany and the Netherlands, was almost offset by weak data and the continuous support from the European Central Bank’s monetary stimulus. Mexico raised rates by 50 bps to 6.25% in order to rein in inflation and defend its struggling currency. The US dollar rose against most leading currencies.

 

ON THE RISE

US investment grade bonds – investors’ true Valentines?  The rally in US investment grade corporate bonds that started on Feb. 13 last year is being questioned by some investors, despite the spread over Treasuries falling this week, on Valentines’ day, to its lowest level since 2014. Political risk, as shown in the chart below, is one of the main concerns, given the uncertainty over president Trump’s plans to change fiscal policy, as well as the potential outcome of three national elections in Europe – where some candidates want to break out from the monetary union. Valuations are also questioned, given the recent outperformance, while fundamentals seem to be trending sideways: while earnings haven’t been outstanding, some sectors, such as banking, appear to be supported by prospects of higher rates and faster growth. In terms of technicals, however, US high grade bonds still attract global yield-hunters, especially those in Europe and Japan, where central banks still hold negative reference rates. Still, some investors continue to look for signs (or canaries in the coal mine) that may point towards the end of the credit cycle, such as the purpose or price of Merger & Acquisition activity: recent deals tend to have higher purchase multiples and a more unclear strategy behind, some investors say. Time to be selective.

 

Any canaries in the coal mine?

Are corporate bonds pricing in rising uncertainty?

Source: Bloomberg as of 15 February 2017. Please find definitions in the disclaimer. Corp is corporate. OAS Is Option Adjusted Spread. RHS is right hand side.

 

EM local bonds – the week’s gems: EM local bonds have delivered positive returns yet another week, managing to reverse the heavy losses they suffered following Trump’s US election victory. The asset class is now up 0.5% since Nov. 8, in local currency terms, mostly driven by a better global economic outlook and rising commodity prices. The spread that investors pay to hold EM corporate bonds over US Treasuries fell this week to its lowest level since 2014, while the best performing HY index was in Latin America, outperforming its US and European counterparts. Improving domestic fundamentals also explain the rally. In South Africa, for example, inflation fell in January for the first time in five months, to an annualised rate of 6.6%. This, plus the double-digit year-to-date gains of the gems and precious metals that it exports, lifted local bonds 1.7% over the past 5 trading days, the best among peers. The rand surged 2.8% against a rising US dollar, only surpassed by the Russian ruble, which rallied 3.1% against the greenback as the country is close to ending an almost 2-decade recession. 

 

ON THE SLIDE

Fed – Markets communication: you say 2 – I say 3: The US central bank and financial markets are back on divergence mode, after coming close to an agreement late last year. The central bank, which has missed its growth and inflation forecasts over the past few years, is expecting 3 quarter-point hikes in 2017, while the futures market points at only 2, as seen in the chart. On the one hand, investors remember how the Fed saw 4 hikes in 2016, but delivered one, at the same time that the US economy, while improving, is far from full traction. Fed chair Yellen didn’t give clear signals when she spoke this week, although her slight hawkish tone helped lift the market-implied probabilities of a rate hike in March to 40%, up from 30% earlier in the week. Still, some investors remain unconvinced, arguing that the present euphoria is more based on talk than real walk, and that while inflation is approaching the Fed’s target, it still remains below it. Read more: is the present optimistic scenario overdone?

 

Fed and markets’ rate hike forecasts: the mismatch is back

Source: Bloomberg as 15 February 2017. Dotted line means projections; straight line is historic data. The market implied forecast is based on the Overnight Index Swap rate. Please find definitions in the disclaimer.

 

European growth – same old:  European fourth-quarter economic growth was revised down to 0.4%, from 0.5%, another blow to a continent already stuck in an ailing economy, facing the uncertainty of 3 major national elections and dealing with unprecedented challenges such as Britain’s departure from the Union. Tensions between the International Monetary Fund and the European Union over Greece’s bail-out also added to the negative feel but more worryingly, the disappointment came from Germany, the region’s economic engine, which grew below expectations. Some investors have said that Germany needs to grow and spend more in order to reduce its ballooning current account surplus – which leads to a deficit in other European countries, adding to their already long list of challenges. The euro fell 1% against the US dollar over the past five trading days.

 

Source for all data: Bloomberg and Barclays Capital as of 15 February 2017

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