Friday’s U.S. non-farm payrolls report has the potential to move the tectonic plates of global interest rates, marking a turning point for the corporate credit cycle if it favors a December U.S. Federal Reserve liftoff, writes Bloomberg strategist Simon Ballard.
The post-global financial crisis era since 2008 has been characterized by unprecedented levels of central bank monetary policy accommodation and this has provided a funding boon for corporate treasurers and, at times, a source of great frustration to yield-hungry fixed income investors.
Corporate bonds, which currently offer the reassurance of low default rates, are often viewed as the asset class of choice amid a market underpinned by open-ended stimulus in the form of quantitative easing (from the Fed, the European Central bank and the Bank of England) and the ever more rarefied levels of government bond yields.
As a result of QE and declining levels of market yields, investors have found themselves being enticed further and further down the credit curve seeking incremental yield.
Subsequently, loose monetary policy and a sometimes seemingly complacent assumption of “low-for-longer” interest rates has opened up debt funding opportunities for ever-weaker-rated corporate entities and at the same time has pushed investors into those aforementioned borrowers’ arms.
There have been myriad uses of the proceeds from the open monetary sluice gates including corporate deleveraging, strategic and opportunistic mergers & acquisition (M&A) funding and general corporate purposes. We have also seen evidence of bondholders’ own Lord Voldemort, namely “shareholder-friendly initiatives” (stock buybacks and dividend payments) being funded with debt.
Perhaps the latest epitome of cheap funding is reflected in Angola’s (Ba2/B+/B+) 10-year US dollar benchmark with yield guidance of 9.75 percent. This risk-reward combination is fueling “top of the credit bubble” talk among some investors.
Over recent months, investors' hunt for yield has flattened quality curves. The spread between U.S. high-grade and sub-investment grade bonds has rallied from 521 basis points on Sept. 18 to the current level of 434 basis points. The spread between the two indexes reached a low of 218 basis points in April 2012. Meanwhile, the Euro quality curve currently sits around the 328 basis-point mark, compared with 402 basis points on October 2, but well below the 483 basis-point reading in June 2012.
With the U.S. Fed now potentially on the verge of its first interest rate rise in over a decade -- even as the ECB maintains a loose interest rate policy bias -- the outlook for risk assets is becoming more fragile on the belief that an interest rate increase by the Fed could prove to be a multi-standard deviation event for risk assets.
While risk assets are holding up well for now against the specter of liftoff, the accompanying Fed rhetoric and perceived pace of any subsequent rate rises will be key to how risk assets perform going forward.
A hawkish tilt by the Fed in the wake of a robust October jobs report on Friday could fuel anticipation of a meaningful rise in the underlying yield structure over the coming months and trigger a sharp decline in risk appetite. Higher government bond yields may see investors migrate up the quality curve as they become able to achieve a given yield target in better rated, lower-risk assets.
Profit taking may become a theme in the high-yield space on the implied rise in corporates' debt service costs, especially among those weaker-rated, covenant-lite (HY) borrowers.
Longer-term, higher funding costs seem likely to fuel a rise in the corporate default rate, which again may lead to a moderation in risk appetite. Indeed, even before any move by the Fed, S&P data shows that U.S. corporate speculative grade default rate rose in October to its highest level since 2012.
If the rates outlook begins to encourage investors to exit high-risk positions, at a time of reduced market liquidity and the reduced ability of the sell-side to absorb inventory, the impact of such a selloff could make the recent volatility related to Volkswagen and Glencore look modest.
Note: Simon Ballard is a strategist who writes for Bloomberg. The observations he makes are his own.