The volatility in equities are steadily moving higher in sovereign yields and a strong demand for debt are likely to be the reasons the corporate bond market has held firm.
Source: Financial Times
As investors sought to digest the first swoon in US stock markets since early 2016, chipmaker Broadcom outlined plans to tap the debt markets for $100bn to help fund its hostile bid for US rival Qualcomm.
While Broadcom has plenty of hurdles to overcome to seal the acquisition, the fact it is relying on debt for financing underlines a striking feature of this month’s stock market volatility: the relative immunity of the US corporate bond market.
Prices for an index of easily traded investment-grade corporate bonds has this month reflected a slight increase in risk — but only to levels from December. And the spread of an index of liquid, riskier high-yield debt over US government bonds has widened more quickly — but still has not exceeded levels since November.
The subdued reaction from the corporate bond market is in contrast to the previous two corrections on Wall Street — in the summer of 2015 and early 2016 — when anxiety about a global economic slowdown saw risk appetite evaporate across markets. The minor movements so far indicate that high-yield bonds have withstood investor withdrawals of about $12bn from mutual funds and exchange traded funds this year, according to daily flows data from EPFR.
In fact, the volatility in equities and steady move higher in sovereign yields is likely to be one reason the corporate bond market has held firm, traders say, as companies tend to steer of selling new debt during market tumult. Companies have issued 25 percent less debt than they had at this point last year, according to UBS.
A robust global economy is also a benign economic backdrop for those companies with debts to service. Strategists and investors say the corporate bond market’s resilience is underpinned by a basic equation: demand to buy bonds far outstrips the available supply — a dynamic that began when global central banks introduced quantitative easing programmes after the financial crisis.
“You’ve got this supply concern that there won’t be enough,” says Peter Tchir, head of macro strategy at Academy Securities. “Every day, month, and week income comes into bond funds, so a lot of excess cash has built up.”
Yet as the global economy heats up — threatening inflation and higher interest rates — the question facing investors is how long the forces of supply and demand will keep working in favour of corporate debt.
There are events on the horizon that could swell the total supply of bonds, making corporate debt less attractive, strategists say. While it is not expected to involve turmoil of the sort that unfolded in equities as volatility spiked, it could mean a widening in spreads — the extra compensation investors demand over government debt — that have been near the tightest levels since the financial crisis.
Investors began the year knowing that more central banks intended to retreat from the market. From January, the European Central Bank cut its monthly bond purchases, while some strategists expect the Bank of Japan to begin targeting higher yields for Japanese government bonds. The Federal Reserve is, of course, unwinding its portfolio of Treasuries and mortgage-backed securities.
The typical progression of the credit cycle could also prove a headwind. Corporate treasurers may be more willing to fund acquisitions with debt instead of cash or equity, which would lead to increasing bond issuance and corporate leverage.
“We could get a normal later-cycle environment where credit does start to underperform equities,” says Stephen Caprio, global credit strategist with UBS AG. But “the big thing to watch — and the biggest risk we have in US credit — is global monetary tightening.”
Global monetary tightening could boost yields of international sovereign debt — such as bonds in the eurozone or Japan — leaving US corporate debt less attractive. There are already signs that US corporate bonds have lost some of their appeal for international investors, as it becomes more expensive to hedge their exposure to the dollar in derivative markets and as short-term interest rates rise.
“The foreign bid is slowing into US credit,” Mr. Caprio adds, citing data that show Japanese insurers have been buying less foreign long-term debt securities. While demand has been strong from US investors, he says, that may change as the Fed raises rates and individuals start to see their bond funds’ performance suffer on paper as a result.
If the central bank retreat is the proverbial elephant in the room, the tax reform signed into law by US president Donald Trump in December offers some support for the market.
Strategists expect the new tax law will prompt US corporations to issue less debt this year. One reason is that large multinational corporations will be able to access profits they reinvested offshore without paying a tax rate of up to 35 percent. Another is that companies will now have caps on how much of their interest payments they can deduct from their tax bills. Microsoft, for example, has said it plans to continue its capital-return plan without needing to access capital markets.
As a result of these reforms, strategists at Bank of America Merrill Lynch predicted a 17 percent drop in investment-grade bond issuance this year.
These factors do offer corporate bonds protection against any future squalls in the stock market. But credit, particularly the high-yield segment, remains the place to watch for clues on whether the first correction in stocks in two years means markets are entering a new regime.