Fixed income

Given the magnitude of the amounts involved we do think there is potential for some temporary volatility in the US Treasury market as the volumes change. We will be keeping a keen eye on both in the months ahead.

As we approach the quieter summer months, fixed income investors have some good news and they have some bad news.

Yesterday the US Federal Reserve released the results of its annual bank stress test, subjecting the 23 largest US lenders to a punitive set of scenarios. Some observers might think the events since March 2020 had been sufficient to test the resilience of the banks, but the Fed went beyond this recent real-life challenge and tested bank balance sheets against a range of hypothetical crises.

We have a high opinion of Kensington as a mortgage lender and when we score it for ESG as part of our investment analysis it performs very well even without this latest Green initiative, but we do feel it can stretch further.

All told, while we think relative value in WBS can be attractive, we believe the trend of refinancing in the bond market is only going to continue in the coming years, though it will be gradual.

With all of the recent data pointing to higher inflation expectations and the Fed expected to maintain a transitory interpretation, we will be focusing our attention on comments from the various regional Fed presidents on conditions that could prompt a tapering move at some point in the future.

Since their inception in 2013, Additional Tier 1 (AT1) bonds have developed into a $250bn multi-currency asset class that, with a high level of due diligence, can offer an attractive opportunity for fixed income investors facing another decade of ultra-low yields.

We believe UK government bonds are ultimately most vulnerable to a rise in inflation, and the 10-year Gilt currently trading at 0.73% does not come close to compensating for this.

Frustratingly for fixed income investors looking to buy bonds, the data seem to fully justify the high valuations we see in so many parts of our market at the moment; it really would not make sense to be able to buy bonds cheaply when conditions are so good.

While we don’t expect any material spread widening in the near term, we remain extremely wary of higher duration bonds given our view that the potential persistent inflation suggested by recent data isn’t priced into US Treasury yields, which currently sit around 1.58% at the 10-year point.

2021 looks set to become a post-financial crisis record year for European CLO issuance and refinancings, but amid the rush of activity we are seeing a concerning trend for weaker documentation in refinanced deals that in our view investors need to fight against.

After unleashing the strongest combined emergency package we have ever seen in 2020, central banks are now entering perhaps the most challenging phase of their COVID-19 response, trying to balance the economic recovery while at the same time having to reassure the markets they can control the threat of runaway inflation.

Last week there was a rare occurrence in the high yield market as German airline Lufthansa announced it would be deferring the coupon on a hybrid bond issued in 2015.

From our perspective, the potential wage pressures we see make us uncomfortable with 10-year Treasury yields at current levels, despite their significant rise since the start of the year.

Having witnessed the most remarkable turnaround in risk markets over the last 14 months, it makes sense to take stock as fundamentals look to us to be approaching optimal levels. Credit spreads have ground into levels not far from the prior cycle’s tights, and while we remain confident in the underlying fundamentals and a good technical backdrop, recent developments mean that despite this constructive view, our risk appetite has ticked down slightly.
 

At 8.1m, the number of job openings as of March 31 was the highest it has been since the data series began some 20 years ago.

Additional Tier 1 bonds, or AT1s for short, are part of a family of bank capital securities known as Contingent Convertibles or ‘Cocos’. They are bonds issued by banks that contribute to the total level of capital they are required to hold by regulators.

Markets can often be tricky for investors in May as bond issuers take advantage of a window of opportunity following the Q1 earnings season and ahead of the typical summer lull. This often results in heavy supply in late April and early May, hence the old trader adage of “sell in May and go away”.

As long as coal usage is not illegal, a private buyer of any origin will be able to purchase these assets cheaper and run them for as long as possible with no regard for ESG matters.

There has been a lot of focus on the performance of the high yield markets since the start of the year, particularly in Q1 when many rates markets were selling off aggressively.

Crucially while the Fed may wait to see the evidence, markets won’t, and we therefore expect a ‘second wave’ of Treasury selling to happen well before then.

Having been at the heart of the GFC and then contributing to the Eurozone sovereign crisis, we have long argued the European banking sector would have to prove its newfound resilience to investors by successfully navigating a challenging period.

Tobacco company bond spreads were volatile last week on news that the Biden administration is exploring a ban on menthol cigarettes and may pursue a policy to reduce nicotine levels in all cigarettes to non-addictive or minimally addictive levels. Rumours about an increased tobacco tax also surfaced, further shaking up the industry.

Had this happened a month ago, we suspect the move would be materially more pronounced, and the muted reaction indicates to us that markets are now quite comfortable with the current levels of expected growth, forecast inflation, and yields.