Credit rally: Bubble or not?
Corporate bonds are back in vogue this year but how sustainable is it?
Just to highlight how bullish people have become, see following comments from fund managers:
“We do see scope for 2012 to deliver narrower corporate credit spreads and that will be the major positive contributor to fixed income returns this year.” – Chris Iggo, CIO Fixed Income, AXA Investment Managers)
“Corporate bonds should be a major source of performance for the bond component of Carmignac Patrimoine (fund) in 2012.” – French asset manager Carmignac Gestion
Bank of America Merrill Lynch’s performance data as of end-Jan shows high-yield bonds are the second best performing in the bond group with YTD gains of 2.9%, ahead of 10-year Treasuries at 0.8 percent. The best performing is “preferreds”, a sort of hybrid bond/equity instrument which returned 4% this year already.
BofA’s investment team thinks equities will catch up and outpace bonds over the medium term however, because equities have had secular underperformance, pension funds and other clients are structurally under-positioned in stocks, and relative valuations favourequities.
The bank also warns: “Recent inflows into high-yield funds have been bubble like, with record-setting inflows into HY bonds.”
Iggo from AXA is also cautious.
Corporate bonds in sweet spot
Anticipation is running high for the ECB’s LTRO 2.0 due on Feb 29.
The first such operation in December has largely benefited peripheral bonds even though estimates show banks used a bulk of their borrowing (seen at just 150-190 bln euros on a net basis) to repay their debt, as the graphic below shows.
At the second LTRO, banks are expected to use the proceeds to pay down their debt further. That is a good news for non-bank corporate credit because banks — busy deleveraging — are more likely to repay existing debt than roll over and existing holders of bank debt will need to look elsewhere to allocate their assets.
“Apart from the shrinking size of (European bank bonds) some investors might want to get out of them anyway and allocate assets somewhere else… Credit spreads are pricing in a very pessimistic scenario. There’s a very good value in non-banking credit,” says Didier Saint-Georges, member of the investment committee at French asset manager Carmignac Gestion.
Euro periphery: Lehman-type shock still on cards
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The passing of Greek austerity measures is fuelling a rally in peripheral debt today with Italian, Spanish and Portuguese yields falling across the curve.
However, one should not forget that peripheral economies are still under considerable risk of becoming the next Greece — rising debt and weak economic growth pushing the country to seek a bailout — as a result of tighter financial conditions.
Take this warning from JP Morgan:
Financial conditions have deteriorated far more in peripheral Europe than in the core. The drag from this on peripheral GDP is akin to that seen following the Lehman crisis.
JP Morgan uses analysis based on quantifying the impact of financial market developments and monetary policy actions on economic activity. The main variables the analysis uses is: the three-month LIBOR rate, the yield on investment grade corporate bonds, the spread of high yield corporates over that of high grade, real equity returns, the change in the real exchange rate and bank lending standards for businesses as reported in loan officer surveys.
According to JP Morgan’s calculations, the 838 basis-point rise in the peripheral HY spreads implies a drag of -2.2 percent of GDP relative to what it would otherwise have been, had the HY spread unchanged.
