Bond market shoots first, asks questions later

By:
Louise Bowman
Published on:

The election of Donald Trump prompted a vicious sell-off in global bonds. Investors face the new year with warnings over volatility and inflation ringing in their ears. Will it be as bad as they think?

This is good news for the ECB. The constant pressure of finding eligible bonds to buy in Europe could have also contributed to December’s taper-esque decision. 

Speaking before the announcement was made, Franck Dixmier, global head of fixed income at Allianz Global Investors warned: "It is difficult to anticipate whether the current Trump-inspired rise in yields will be sustainable. Should president-elect Trump’s economic policy disappoint, the consequent fall in US yields will have a direct downward pressure on eurozone yields."

Although yields outside the US have risen in line with it since November, 2017 will see the impact of divergence in central bank policy between the Fed and its European and Japanese peers. While the ECB is unlikely to expand QE to FIG, the recent extension of the programme shows the direction of travel.  

There is a view that borrowers have had sticker shock and felt they have missed their chance to fund cheaply. That is certainly not the case – even if you let rates run another 50bp they are still at historic lows 
 
- Marco Baldini, Barclays

A continued rise in European yields should not, however, be discounted. When US rates rise, European rates rise too, even though technically they should not. 

"I would expect the rate differential [between the US and Europe] to widen," says Marco Baldini, head of European bond syndicate at Barclays in London, "but the investor base is broad and global. The market is much more international than it was 10 years ago." 

The extent to which this divergence of monetary policy is reflected in yields between the various geographies will be a key theme of 2017.

"In Europe, the ECB has managed to thread the needle, engineering a benign taper and a steepener," says Rajan. "Limited growth and inflation prospects and a vigilant ECB will continue to put a lid on long-term rates there."

Repatriation

While it is difficult to determine how some parts of Trump’s agenda would impact the bond markets, his plans for US corporate tax repatriation are very clear. If the corporate income tax rate on the $2.5 trillion in profits that US firms hold overseas is cut from 35% to 15% that would mean huge cash repatriation that would optimistically be spent on M&A, or, maybe more realistically, go on share buybacks. 

The impact would be sharply felt in bonds.

Brendan Hanley-160x186
Brendan Hanley, BAML

"There is still a long way to go, but potential tax reform and the implications of the reforms could likely have a meaningful impact on how clients evaluate capital structure and specifically the structure and duration of the debt complex," says Hanley at BAML.

If it spurs M&A, that is good news for the large US banks that can provide sizeable and lucrative bridge facilities.

"In a low interest-rate environment, bridges are a super-attractive proposition for banks: they enable them to make interest income," says one banker. "Banks are therefore desperate for acquisition business as it is a prime source of revenue. Even European banks will step up for acquisition business. It is the best business." 

If, as Trump hopes, US corporates spend their tax windfall on M&A and expansion, this, together with fiscal stimulus, raises the spectre of inflation. How much of a concern this should be to the bond markets is a matter of dispute. 

"Trump’s programme will drive up the demand function and the labour market will overheat," predicts McAdie. Others believe that inflationary pressure is being over-anticipated. 

US_inflation_races_ahead-300

"The risk of the US overheating is slim," says Beck at Franklin Templeton. "Inflation has picked up, but only since oil prices collapsed in 2014, and even full employment is not having much impact on wages. There are a lot of structural pressures driving wage costs down – such as companies like Uber. Global competition will keep long-term inflation pressure under control." 

Beck believes that both emerging market and corporate credit will be able to withstand US monetary tightening. 

"Headline inflation will rise with oil at $50 a barrel, but in the last 30 years oil has been anything from $8 a barrel to $148 a barrel, so it is difficult to predict with any level of certainty," he says.

The situation will have to be very carefully managed, however, and if the last few years in the capital markets have taught observers anything it is that rate rises are very hard to predict.

"If growth in consumer or commercial credit expands at a faster pace, it could suggest that inflation growth might accelerate sooner than expected," warns Jim Kochan, a fixed-income strategist at Wells Fargo Asset Management. "In that situation, the Fed might need to quicken the pace at which it raises rates." 

At its December meeting, the Fed indicated three rate rises are likely in 2017, up from two previously suggested.

Bankers confident – or maybe hopeful – that what rate rises there are in the US will not impact issuance.

"There is a view that borrowers have had sticker shock and felt they have missed their chance to fund cheaply," says Baldini. "That is certainly not the case – even if you let rates run another 50bp they are still at historic lows." 

BAML sees US investment-grade spreads tightening by 20bp in 2017 and supply falling by 17% – a big change. When inflation is on the agenda, investment-grade bonds will usually suffer.

"It’s noteworthy that the higher-quality, most interest-rate sensitive part of the bond market underperformed during the taper tantrum [of 2014]," explains Kochan. "By contrast, lower-quality high-yield bonds held up relatively well. 

"They did so again in November 2016. We typically don’t want to take on duration risk at a time when interest rates are likely to rise, but taking credit risk might make sense, especially if corporate earnings growth remains steady."

Corporate leverage

Investors seem confident in this course of action despite the rise in corporate leverage on both sides of the Atlantic.

"In the US, the increase in corporate leverage has been management-driven. A lot of single-A rated corporates decided to lever up to triple-B. There is still event risk, but there is a lot of discipline about not moving to high-yield. In Europe the increase in leverage has been different. It has been ebitda-driven not management-related," says Edward Farley, head of the European corporate bond team at PGIM.