Weekly Bond Update: Why 4% is where it's really at
- Demand is still supporting the high-yield market
- Once 10-yr US Treasuries break 3.10%, the next support level is 4%
- Rally of USD is a threat to weaker corporates and emerging markets
Last week's Korean peace talks were a spectacular attention-grabber. Just a few months ago a North Korean war was a horrifically real probability, but now we have a smiling and smartly-turned-out Kim Jong-Un on camera shaking hands with world leaders. After something so shockingly unexpected, it seems apt to imagine that anything is indeed possible. And if we extend this thought to the bond market, we find an underlying truth when it comes to junk and yields.
I have underlined several times that while we did see volatility in the equity market in Q1 2018, the bond market was numbed to any market movements, and while Treasuries were falling, junk bonds didn’t widen much compared to how they were trading at the beginning of the year. I regard this as rather odd behaviour. On more than one occasion, my colleagues and myself have speculated that "things would soon change". But now, I really do wonder whether this is the case at all.
Junk bond issuance has notably being falling since the beginning of the year as the cost of funding in USD has steadily risen. Although this phenomenon has kept investors out of trouble, it has also made them more and more hungry for yield for too long. This is why as soon as WeWork, the US shared office space company, said it wanted to issue $500m of high yield bonds, we saw people's morale perking up as they dived right into the new issuance.
Although WeWork’s revenues rose sharply last year, its costs rose even faster. Because it has virtually no hard assets, it offers very little security to investors. Regardless, the company was able to raise $702m at a yield of 7.875% while at the initial offering it was seeking to raise $500m with an indicative yield of between 7.75%-8%. In fixed income language this means that although unprofitable, the company was able to raise more money than it had planned at a reasonable price.
To many, this would sounds like déjà vu. As a matter of fact, last summer we saw Tesla raising $1.8bn, or $300m more than expected at a yield of 5.3%. The issuance of that bond was extremely successful although many had warned against Tesla’s high leverage and weak balance sheet. For sure Tesla's business is complete different from that of WeWork, however, it is a great example of how the market is blind when it comes to yield. Tesla suffered of a major repricing after Moody’s downgraded the company to B3, it continues to struggle in speeding up the production of its Model 3, and the fatal crash that occurred while testing its driver-assistance system triggered many negative headlines. The 2025 bonds are now pricing in the high 80s, offering approximately 7% yield
One might assume that while it is normal to take risks and fail, because we are intelligent individuals we wouldn’t do the same mistakes twice. However, it seems that although there are plenty of alarming signals, the market is not willing to accept that things have changed and what might have been a great investment in the past might not be so now. The high yield rally that we have seen since 2016 until now until now might not be viable in the next few years as the Fed steepens interest rate hikes and cost of funding increases, as we explained in an article published a couple of weeks ago.
Sentiment in the high yield space, and in particular in the corporate space, is supported by central banks' rhetoric. Indeed, although the Fed has started with its tapering and plans to continue with interest rate steepening in the near future, there is always a reassuring message that if things don’t go as well they should, the Fed will be always there to set the score straight. A powerful example was given by the European Central Bank last week, as the market was fearing that the bank was about to start tapering its Corporate Sector Purchase Programme (CSSP) as the rate of purchases fell compared to the first quarter. However, ECB chief Mario Draghi pushed back against the “stealth taper” speculation and reinforced his message by saying that the ECB has “certain flexibility” and if it needed he wouldn’t hesitate to use it.
The reality is that investors don’t fear taking risks when central banks hold their hands and we will need some major event before we will see a sell-off within the fixed income space. The real question is what will it take in order to put weaker credits under stress if the 3% psychological level didn’t pose major risks for this asset class? The reality is that having the 10-yr Treasury trading with a yield of 3%, rather than 10bps less, doesn’t imply much change in terms of the cost of funding junk bonds, but it is still a mystery by how much US treasury yields have to rise in order to send a shock wave through the market.
The graph shows that 10-yr US Treasury yields have been trading range-bound since the beginning of the 1990s and that in order for them to break the upper boundary of the descending trend channel, at the moment they will need to break the 3.10% threshold. At that point there is no support up to the 4% yield target. Chart source: Bloomberg
It is true that Treasuries can be supported by counter-current forces such as a potential trade war, strong economic growth and a weak equity market, however, at this point it seems that the real yield level to fear is 4% as this would constitute an important change in the cost of funding for capital intensive companies and weaker emerging markets, which would in turn translate into a sell-off in the fixed income space.
At this point, fixed income investors should no longer beware the 3% psychological level, and since we are very far away from the 4% level they should look for external threats to the bond market. A much stronger USD can definitely be categorised as one of these threats as it would suddenly increase the cost of funding for those corporates and countries which have a soft currency as their base currency and which have issued debt in USD. In this case, deterioration of debt can happen fast and it would leave little room to manoeuvre to borrowers in a market where fundamentals are already shaking.
It is exactly at that moment that high yield investors will look at their books and understand that it is never wise to undervalue leverage.
– Edited by Clare MacCarthy
Althea Spinozzi is a sales trader at Saxo Bank