Bond Outlook by bridport & cie, March 21 2012
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Bond Outlook by bridport & cie, March 21 2012

When risk is “on”, serious analysis is “off”, allowing many unknown companies, from all over the world, to tap the corporate bond market

The mood of optimism is continuing on both sides of the Atlantic. We have our reservations about its sustainability (we note Bernanke’s affirmation that the recovery is “desperately slow”), but let us focus this week more on the consequences of the “risk-on” mood.


An obvious effect is that government yields have risen whilst corporate spreads have narrowed. The low levels of the former reflected both the fear factor, and the expectation that interest rates would stay low for years. Whilst the interest rate outlook is unchanged, the contraction in corporate spreads suggests that fear has declined.


In the USA, corporations have built up enormous cash reserves. There is also an echo of this in Europe amongst, for example, major consumer product and pharmaceutical companies. The positive aspect of this phenomenon is that the corporate component of economies is healthy; the negative is that successful corporations see little opportunities to deploy their cash. The consequence is that there are moves afoot to return cash to shareholders via dividends and stock buy-backs, and to creditors via tenders for outstanding bonds.


It is not obvious what the effect will be of this transfer of funds from one part of the economy to another. It could lead to a rise in stock prices, and/or it could help keep interest rates low. It could also lead to greater consumption and a widening of the US trade deficit. We lean towards the former, as the return of corporate cash is not to the broad mass of consumers, but to investors only. Perhaps the one firm observation is that the release of corporate cash reduces the need for stimulus, notably quantitative, easing or its European backdoor equivalent.


From one perspective, cash is currently in the wrong place. While large corporations are gorged with liquidity, smaller companies cannot get access to it. Banks are too focused on meeting enhanced capital adequacy requirements, by reducing their asset bases, to make loans to SMEs. Nevertheless, medium-sized companies, even those without a stock-market record, are tapping the corporate bond market with great success. The phenomenon is by no means limited to Western companies: the new issues are also in a whole range of Asian currencies, led by, but not limited to, the Chinese RMB and HKD.


Many commentators are struggling to identify the next asset bubble, following the massive surge in Central Bank liquidity of recent years. We would suggest that the almost indiscriminate take up of new corporate issuance might well be this cycle’s “dotcom revisited”. In the late 90’s, money could be raised by unheard-of companies via IPOs which investors snapped up “sight unseen”. This time, it is a huge range of previously unheard of corporate issuers, many from emerging markets, who are finding their way into the welcoming arms of investors via new debt issues. We cannot help but question the rigour of much of the research which is taking place before many of these issues are bought.


It is many years since we proposed that the world needed a third major trading and reserve currency, either built around the RMB, or the RMB itself. It is becoming increasingly evident that it is the latter. The long march to the RMB taking this role is well underway, with the issuance of RMB bonds by medium-sized companies a further inexorable step forward.


It is paradoxical that banks are buying back their Tier 1 instruments when they are supposed to increasing their capital adequacy. It is true that the profit they realise from these operations enters reserves, but, unfortunately, it reinforces our observation that banks prefer to increase their capital to assets ratio by reducing the latter, rather than by expanding their equity capital. That should be the major concern of every central bank, and will no doubt be something we revisit in future comments.


Macro Focus

USA: the budget shortfall for 2012 will be $1.2 trillion, about $93 billion more than forecast two months ago. Housing starts hovered in February near a three-year high and building permits rose. The Fed is keeping additional easing on the policy-making table, even after upgrading its view on the U.S. expansion. Net foreign purchases of Treasuries totaled almost $83 billion in January, with China, the largest foreign U.S. creditor, increasing its holdings of U.S. government securities for the first time in six months


Spain: public-debt burden surged to the most in at least two decades, underlining concerns about its ability to reorder state finances as contagion from the debt crisis focuses on the euro area’s fourth-biggest economy. The nation’s overall debt last year amounted to 68.5 percent of gross domestic product, exceeding the government’s forecast of 67.3 percent


Italy: Prime Minister Mario Monti’s planned overhaul of the Italian labor market will include a revision of firing rules, and an expansion of jobless benefits. Monti is leading talks with unions and employers in a final round of negotiations


Netherlands: in view of the bigger-than-planned deficit, the coalition must find EUR 9 billion in budget cuts this year, equal to 1.5 percent of GDP


Greece: despite the second bailout package for Greece, the International Monetary Fund said the country may require additional funding or a further debt restructuring


UK: Britain is proposing to revive “perpetual Gilts,” to allow the government to borrow for as long as possible at record-low rates


Switzerland: while deflation still threatens the economy, growth shows signs of stabilizing, and the government raised its growth forecast from 0.5% to 0.8% for this year, helped by exports and consumer demand


Norway: the central bank’s decision to cut interest rates in order to weaken the Krone is spurring credit growth, and overheating the property market as borrowers bet rates will stay low


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