Encouraging start to the year for corporate bonds
The fourth quarter of 2018 and the first week of January saw sharply falling prices in risk-prone asset classes such as equities, corporate bonds and paper from the emerging markets. Government bonds from industrialised countries, however, are regarded as a safe haven and enjoyed healthy demand. Investors in the capital markets were clearly unnerved, the main reasons being the softening of global economic growth and the trade dispute between the US and China. Another cause for concern was the US government shutdown. The US Federal Reserve continued unperturbed with its strategy of interest-rate rises, putting up the key rate by a further 25 basis points in December. This brought the total number of interest-rate hikes in the US last year to four. Europe continues to face not only the unresolved issue of Brexit but also countless country-specific economic policy challenges, such as the drafting of Italy’s budget, France’s yellow vest protests and the problems in Germany’s automotive industry.
This makes it all the more astonishing that the markets have been bouncing back since the second week of January. The mood has visibly brightened and risk assets are back in demand. The global stock markets have regained around 10 per cent, while spreads in the credit markets – in both the investment-grade and the high-yield segments – have narrowed significantly again.
Yields falling again
At the same time, yields on ten-year US Treasuries have dropped back below the 3 per cent mark. They were at 3 per cent as recently as November. In Europe, yields on Bunds are also falling, which reflects the slowdown of the European economy.
US Fed adopts more moderate tone
What has occurred to generate such a marked change in sentiment? After all, a long-term solution has not been found for any of the geopolitical problems. In the trade dispute, for example, there are merely early indications of agreement being reached between the US and China. But the US central bank has altered its tone. Up to the end of the year, the Fed’s main representatives still sounded rather hawkish. They doggedly maintained their positive assessment of the US economy and thus their strategy for 2019 of further interest-rate rises. But the tone suddenly changed. Shortly after New Year, Fed Chair Powell explained that US economic growth was slowing down and that the central bank would, after all, pay greater heed to the current data before making its next move on interest rates. He said that the Fed had not set its monetary policy in stone and would patiently wait and see how the economy developed.
This was met with a sigh of relief from the markets. The risk of the Fed blindly going too far with its interest-rate hikes, potentially stalling the global economy, has decreased markedly. Stock markets rallied sharply worldwide, as did EM bonds and corporate bonds. Over the period 1 January to 24 January, investment-grade paper gained 0.4 per cent, while subordinated bonds climbed by 1.6 per cent, high-yield securities by 1.5 per cent and CoCos by an impressive 2.7 per cent.
Rally in the year to date following the correction in 2018
Concerns about rapidly rising interest rates have been swept aside for now, making higher-yield paper all the more interesting. Since yields hit a low in spring 2018, the yields and spreads of high-yield bonds have returned to an attractive level again, especially in the closing months of last year. Spreads in the broad ICE BofA Merrill Lynch Euro Corporate index, for example, are currently back at 102 basis points, almost three times higher than their level a year ago (35 basis points). Against this backdrop of improved conditions and rosier prospects, investors are again willing to enter segments with higher risks.
Wider spreads make corporate bonds more attractive again
Demand for credits currently outstripping supply
Corporate bonds have been back in demand for a few weeks now. In the investment-grade segment, this high demand is being met with a respectable but still limited number of new issues. By contrast, the high-yield segment has seen barely anything come onto the market this year. So far, there has only been a placement by Telecom Italia and the expansion of an existing issue. The total volume placed in the European credit market in the year to date stands at approximately €26 billion. The average issuance premium has been a fair 20 basis points. As many market participants were positioned short until recently, the shift in sentiment led to substantial buying pressure. Issues are heavily oversubscribed at the moment, with allocation quotas of just 20–30 per cent. Demand for the latest VW bond, for example, was three times higher than the issue volume. Unsurprisingly, almost all paper that has entered the market since November 2018 is currently in positive territory. Yields rose so sharply in October and November last year that the first buyers came back for more. The only primary market issues that have been in negative territory since then are Telecom Italia and General Motors, although their markdowns are modest.
Looking at the average credit rating in the credit market, it is noticeable that the proportion of BBB-rated paper has risen significantly in recent years. In the ICE BofA Merrill Lynch Euro Corporate index, for example, the proportion currently stands at around 50 per cent. This means that the credit quality of the bonds in the index has, on the whole, deteriorated. Issuers’ debt levels have risen, and this trend is even more pronounced in the US than in Europe. If the macroeconomic situation worsened, there would be a risk in the medium term that bonds in the lowest investment-grade segment could drop into the high-yield zone and defaults could increase. But investors are currently accepting higher credit rating risks and again investing more heavily in high-yield paper. After all, even in the worst periods over the past 30 years, the default rate in the BBB segment has been no higher than 2.5 per cent.
Outlook: conditions remain favourable for credits
Although economic growth is losing momentum worldwide, we do not see a danger of recession. Growth rates continue to be in positive territory. In fact, an environment of moderate growth combined with stable interest rates might even open up attractive investment opportunities for the credit markets. Although there is still a risk that the markets will become jittery about a recession, the significant widening of spreads in recent months should provide a sufficient cushion. Spreads are currently far higher than they were at the beginning of the fourth quarter of 2018. Both the fundamental and technical key figures look positive. The highly promising start made in January provides a solid basis for 2019. Investors can therefore reckon on growth rates that are just into positive territory.
Unless otherwise noted, all Information and illustrations are as at 28 January 2019.