Macaskill on markets: Debt houses face up to the higher-rate challenge
The bond market tremors of late June maybe do not signal an impending fixed-income earthquake, but they do demonstrate the challenges banks face in maintaining revenue streams as investors adjust to the prospect of higher rates.
An orderly rotation from fixed income to equity exposure to reflect a combination of economic growth and gradually rising rates was obviously too much to hope for, even before the bond markets took a sudden downward lurch in the wake of comments by Federal Reserve chairman Ben Bernanke about tapering of quantitative easing measures.
The question now for investment banks is whether or not individual revenue streams can rebalance to support overall fixed-income earnings – still the dominant profit source for the industry – and whether or not rising rates can be accommodated without disruption to broader confidence in markets.
The rise in yields in key bond markets in June was certainly enough to set alarm bells ringing about a potential loss of investor confidence.
The drive in the 10-year treasury yield from a May low of under 1.7% to a June high of over 2.6% drew the most attention, but the jump in aggregate US high-yield debt yields from under 5% in early May to over 7% in late June was even more dramatic.
Bond fund redemption figures, such as the total of $23.7 billion that Lipper said was withdrawn from US funds in the four weeks to late June, or the comparable $23.3 billion drawn out of all global bond funds in the last week of June alone, contributed to the air of concern.
Bond fund withdrawals should be placed in context. Over $1 trillion has moved into fixed-income ETFs and mutual funds in the past three years, according to TrimTabs. And big shifts in fund balances as sentiment switches between sectors are routine in the equity markets, even when they result in substantial price moves.
But the fixed-income markets remain far more fractured than equity trading, with interdependencies that are less well understood or, in some cases, untested.
A tightening of collateral requirements for derivatives trades and financing agreements has the happy side-effect for governments of increasing demand for their debt, but it also increases the chances of sudden shortages of collateral supply, for example.
New rules on proprietary trading reduce the chance that banks will be stuck with unwanted bond inventory when prices fall, but they also hamper the ability of dealers to provide market-making services.
Corporate bond holdings by dealers are down by roughly 70% from their 2007 peak, according to Federal Reserve data, which contributed to the lack of liquidity in cash-bond trading during June and the by-now-familiar divergence between cash and derivatives prices in credit markets during downturns. Secondary cash-bond prices often look steady during periods of disruption, simply because they have stopped trading while investors and bank dealers concentrate on hedging exposure via credit derivatives indices.
The fixed-income business mix at dealers is likely to take on increasing importance as markets adjust to the prospect of higher rates.
Credit Suisse, with its strength in high-yield debt and securitized products, is obviously threatened by revenue-growth headwinds. Barclays, Deutsche Bank and other big European banks that have strong rates businesses should at least in theory benefit from higher volumes and increased interest rate swap and government bond volatility, after a weak start to the year.
Debt capital markets and other fee-based investment banking sectors face a difficult second half to the year. The overall 9% increase in investment banking fees in the first half of 2013, compared with 2012, was an unexpected bonus for banks, given that high-margin sectors such as M&A remained dormant. JPMorgan retained its traditional position at the head of the global fee league tables, although Bank of America Merrill Lynch made a strong push to a surprisingly close second place (demonstrating that life at BAML goes on despite the loss of former corporate finance maestro Andrea Orcel, which was probably a key goal for his former boss Tom Montag).
The equity markets would have to secure impressive further gains to spark any near-term revival in M&A, however. And the recent DCM boom appears to be over, even if corporate bond prices stabilize. Issuance by frequent borrowers is always heavily weighted to the early months of the year and even the most desperate yield-seeking fixed-income investors are now likely to taper their own appetite for corporate bonds with historically low returns.
|Apple’s bond looks like heralding the top of the market|
The Apple $17 billion bond issued in May is now firmly established in the investor psyche as the deal that marked the top of the market. Prices of the 10-year and 30-year tranche bond fell by over 9% by late June and spreads to treasuries widened sharply, leaving investors nursing deep losses surprisingly quickly for a top-rated corporate issue. The deal should not be viewed as an underwriting debacle for lead managers Deutsche Bank and Goldman Sachs, along the lines of the disastrous Facebook IPO that Morgan Stanley handled last year. After all, Apple locked in long-term debt at an enviably low rate and in enough size to make a meaningful impact on its shareholder-reward and tax-management plans. But the marquee mandate that Deutsche and Goldman must have viewed as a considerable marketing coup has instead turned into a warning about the dangers of taking a logical view (that well-rated corporate debt will see growing demand in coming decades) to illogical extremes.
The slide in corporate debt prices in June led some bank credit strategists to pitch in with comments that were probably designed to be comforting – often along the lines that the collapse in high-yield prices had presented investors with an attractive potential new entry point.
These remarks could be viewed as a sign that the fixed-income markets are gradually becoming more equity-like, in that sell-side analysts can normally be relied upon to provide a positive spin to any unexpected downturn in a market they cover.
Or the remarks could be interpreted as an indication that concern is mounting within the fixed-income engine rooms at banks. Away from the levels of client activity seen by dealers there is another potential worry – their own funding levels as expressed by their credit default swap spreads. Even banks with strong balance sheets suffered spread widening in the week after Bernanke gave the Treasury markets a jolt. HSBC’s five-year default swap quotes pushed out by 40 basis points and its subordinated default swap spread widened by 55bp, for example, in part because of concern about its reliance on emerging markets, which have been having a terrible year.
Nerves will be jangling at most investment banks over the summer, even if supervisors manage to head off sharp yield rises with soothing talk of delayed withdrawal of support for markets.