Weekly Bond Update: The next crisis is near — #SaxoStrats
• 2018 will be another year dominated by LBOs and junk deals
• Central banks are more and more hawkish
• Investors need to go beyond comfort zone in order to successfully diversify
Reading about Jordan Belfort aka ”the Wolf of Wall Street” advising against crypto currencies in an article in such a major financial newspaper as the Financial Times, makes me realise that investors are just waiting for the end of the world. Belfort manipulated the stock market for many years. He was charged and found guilty and spent almost two years in jail yet he’s reborn from the ashes and is now playing the role of adviser. He’s able to do that simply because investors are living in a “it’s too good to be good” world and they expect the market to collapse sometime soon. Because of this, they are willing to listen to everybody and anybody in order to understand how the next crisis will explode.
Maybe it’s a tragic way to look at it but many have been predicting a bubble from soon after the 2008 crisis. As a matter of fact, since Lehmans’ collapse we have been living in a world where the “invisible hand” Adam Smith talks so fondly about it hasn’t been invisible at all. Indeed, central banks have given a very visible hand to the economy and the fact that many businesses are still alive today is thanks to extremely dovish policies. The real problem is that after years of extremely heavy QE, we have arrived to a point where we don’t know any more what is the real value of many assets, bonds included.
In the past few years there has been a proper witch hunt for yield. Investors have turned every stone in order to find those undervalued assets that may return a little extra. I personally find that it is wrong to say that investors have been disregarding the central banks’ effect on bonds’ rally or that they have paid little attention to the risk of higher yielding assets. In fact, most of the time investors have been very aware and very realistic about what was happening. However, they didn’t have any other choice. Indeed, sleeping on a large amount of cash would have proven costly over the past few years and the only way to make money was to put it to work.
Now that 2017 is almost finished, investors look at 2018 and wonder whether the great depression is doomed to happen again, but the reality is that the world is getting ready for another year dominated by LBOs and junk deals. The quality of the issuers is continuously going down and while this year only the Bank of Cyprus was able to issue €250m subordinated bonds with a Caa2/B (Moody’s /S&P) rating, in 2018 this phenomenon might be even more frequent. Although this bond is very risky, it has attracted much interest even in the secondary market and at the moment it trades well above par, offering only 6.5% in yield for a 10-year risk.
The market that is going to see the majority of these junk issuances is the EUR bond market as it will be cheaper for companies to issue debt in EUR than in USD. According to Bloomberg, EUR HY issuance this was dominated by government bonds followed by financials and consumer discretionary. The lowest coupon paid by a HY issuer has been of 0.875% by Ericsson, while the highest coupon was the one of the perpetual junior subordinated bond issued by Caixa Geral de Depositos paying 10.75%. While the latter has rallied and now trades well above par, Ericsson lost a little bit of ground, however it still offers a skinny yield of 0.87% for a 3-year Ba1/BB+ (Moody’s / Fitch) issue.
The party might be soon over though. As a matter of fact, yesterday we the Eurozone PMI numbers come out stronger than expected and many think that tomorrow ECB president Mario Draghi might be hawkish. This might push core bond yields considerably higher and according to Bloomberg the bund 10-year yields could even touch 0.63%. In my opinion however, this wouldn’t change much as hungry investors would see an excuse to enter the bond market in a moment of weakness and would drag yields back down. Thus, HY issuers would still issue junk debt in EUR as it would be still cheaper compare to other bond markets.
If yields in the area are disappointing and the US bond market worrying (as the Fed is planning to further hike interest rate) we shouldn’t be buying in this region and we should be looking elsewhere.
China might offer interesting opportunities as the government is solidly investing into shifting towards a consumption-driven growth. This mean that the Chinese government will do whatever it takes in order to meet its targets. In addition, Chinese society is changing and is moving towards bigger urban areas, and people are travelling more and using more and more technology. This means that many consumption focused businesses will be supported by increasing Chinese domestic demand. This leaves a wide range of opportunities to choose from in various sectors such as in real estate, technology and transportation. One might say that Chinese bonds are expensive; however if ones expects the returns that Chinese bonds were providing 10 years ago, then one must know that this is not possible as China is better equipped and more global than it was a decade ago.
Another country that might offer interesting opportunities is Russia, as a matter of fact Russian bonds are less correlated to US interest rates, and in a world where central banks are increasingly hawkish it might be good to see how to further diversification current holdings:
The reality is that nobody has ever made money by holding onto safe assets and being afraid that a crisis will burst. One of the most common trades in 2017 has being shorting the S&P 500 as many investors thought that because it had reached new heights it would soon fall more steeply than ever seen before. As all of you know, this trade has been extremely costly. There is no doubt that the music will stop and volatility will kick in, however, we don’t know exactly when. That’s the reason why instead of putting all one's eggs in a safe basket in preparation for the worst case scenario, one should instead look at available products and look at what they can provide. Diversification is the key to success and looking beyond what we normally are comfortable may lead to satisfactory results.
– Edited by Clare MacCarthy
Althea Spinozzi is a sales trader at Saxo Bank