Bond markets adjust to ECB step into the unknown
Vladimir Lenin once said, “In politics, there are decades when nothing happens; and there are weeks when decades happen”. It would be easy to think we are in the midst of the latter, after the recent flurry of activity by central banks.
In particular, the latest salvo from the European Central Bank has plunged macroeconomic policy into unchartered territory and also forced investors to take a step into the unknown.
With the ECB not only lowering rates further into negative territory, the addition of corporate bonds to its shopping list of assets adds another layer of uncertainty to bond markets. Investors now have to navigate the wider impact of a “price-insensitive buyer” of corporate bonds.
This development might appear like a game changer, but in fact it merely continues several themes that have been playing out over the last 12-18 months. A walk through these helps offer a guide to the future.
One is monetary policy divergence. While on the one hand the Fed is still considering a tightening cycle (and “normalisation”) on the other we have Europe’s experiment with negative interest rates and corporate bond buying.
This dynamic means investing globally will become increasingly challenging.
For example, relative value trades where fundamentally similar companies would be expected to trade together will no longer work. With the ECB now directly buying corporate bonds, it is in effect an artificial market where correlations will break down between bonds in the US and Europe of similar companies or sectors. In the past, a popular trade for funds has been to look at trends in the US and extrapolate to Europe. It is doubtful that this will work as it has in the past.
While we contemplate this unfamiliar market, the historical case of Japan offers some guidance. In the past it was possible to marvel at the extremely low yields on Japanese credit for very poorly rated paper. But this anomaly did not lead to any convergence as it was discounted as “well …that’s just Japan”.
This time around, given the number of issuers (especially fallen angels) who have issued bonds in dollars and euros and the size and trading volumes going through in Europe, any yield divergence will be much harder to ignore. At the very least, expect traditional gauges of relative value to weaken, which will make life a lot harder for traders.
On the plus side, however, expect new opportunities for trading and speculating on liability management in both the US and Europe. The wave of “reverse yankees” (where US companies issue bonds in euros) should continue and be followed by Asian issuers, also seeking to take advantage of tighter yields.
At the same time, another trend that we expect to become more pronounced is the polarization in between quality issuers and everything else.
In an increasingly discriminatory market, central bank liquidity no longer means “a rising tide lifts all boats”. Even in Europe with yields as low as they are, there seems to be little or no patience for any kind of “miss” with investors selling first and asking questions later.
This is perfectly rational with yields at basement levels, and also means low portfolio break-evens, where one default could wipe out an entire portfolio’s annual performance.
As weakness in China and the commodity cycle continue to impart distress, we expect this theme to continue. The result will be a large number of “distressed” securities with yields in excess of 20% and on the flip side, a big premium for “safety” from well-known and large issuers in non-cyclical industries.
This dichotomy can provide rich pickings for value investors who are willing to do the work on the long and short side and have patience while this cycle unfolds.
Lastly, the other big trend that cannot be ignored is the liquidity landscape during this period of extreme central bank intervention.
While there has been considerable commentary on bond market liquidity and I am loath to add to it, unfortunately it cannot be ignored. Much of the discussion has centred on the inability of people to hedge positions due to limited liquidity. But this is really a red herring. The more plausible explanation is it’s simply down to the lack of divergent opinion in the market. When markets are trending with only buyers or only sellers, it is difficult for dealers and clients to express a view in anything aside from new issues.
This will change, however, as the cycle progresses. As the macro backdrop becomes less supportive and more leveraged business models come under pressure, this should lead to greater divergence on credit views.
Ultimately, this will act as a catalyst for trading and liquidity.
In addition, as we see bid-offers spreads widen and with it higher returns on efficiency capital, this will attract more non-traditional players to enter the market and reverse the liquidity shortfall.
In conclusion, while central bank intervention appears to trump all other considerations in the current unchartered market – and it certainly makes trading strategies more challenging – this will only be temporary. If investors adapt and focus on the key underlying trends at play, they will also find many opportunities.